In the home page of our website, the first thing that greets all visitors is this sentence: “We start, buy and invest in alternative assets and wonderful businesses”.
Wonderful. What a wonderfully difficult and whimsical word to define properly. This difficulty is further compounded in the context of investing. To some, it may mean “spark joy”; to others, “supercalifragilisticexpialidocious”.
What wonderful means to me is something I personally gyrate for the longest period of time during my investing journey. At the start of 2010, I purchased shares in a company in the mining service industry, that earns amazing return on its capital. It provides mining services in numerous mining services sectors. Wait a moment.This sentence alone should alert you that I have zero flying flippity flop what this company does. Despite eventually selling the shares for a good 40% return - pure luck -, I have many sleepless nights in between. Is it wonderful financially? Yes maybe. Is it a wonderful company to me? Definitely not.
To us at Epitro, a wonderful business is defined by 4 characteristics:
Understandable
High return on employed capital
Difficult to traverse moat
Everyone wins
It is through deliberate intent that the first characteristic of “Wonderful” for us is actually “Understandable”. In fact, it may even be linguistically incoherent to many to describe understandable as wonderful. However, if a business is not understandable, or in other words, within our circle of competence, how will we know if it is wonderful?
Too many fortunes are lost in investing in the new sexy, the up and coming, without the investor having the faintest clue about the economics of the business. Thus at Epitro, we strive to only invest in companies we truly understand, despite narrowing our opportunities significantly. But as stewards of capital, better to be on the straight and narrow, than risking everything you need for things that you might need.
"Never risk what you have and need for what you don't have and don't need" - Warren Buffett
Next up is “High return on employed capital”. Too often, too much focus is on the more popular Return on Equity metric (ROE). That is good and all, but they forget one crucial fact: that debt is as much of a capital as with equity. Often times, companies juice up their ROE by leveraging precariously. Being profitable while standing on a sand pile of debt is not something that sits well with us. Debt is the time bomb to every wonderful but highly leveraged business. A company without debt cannot go bankrupt.
"Smart men go broke three ways - liquor, ladies and leverage" - Charlie Munger
Thirdly, a “difficult to traverse moat”. Moat is often times referring to the river surrounding an ancient castle in medieval times. When the drawbridge is raised, olden armies won’t be able to swim to attack the castle in their kilograms of heavy chain armour. And no, they cannot take off their armour to swim as then they will become meat skewers.
Thus, it is a wonderful analogy to describe the competitive advantage of a business. The harder it is for the enemy aka your next door competitor - sorry pal, it’s just business - to traverse this moat, the longer your business can continue to generate outsized profits.
That is why airlines are notoriously un-wonderful or horrible business. Irrational competition due to mirage of factors which includes irrational nationalistic ownership competes away the slimmest margins in their profits. In short, there is no moat. A good example of moat on the other hand is the network effect of Facebook and Instagram. Sure, you can migrate to another social media platform, but you might be the only one there. The more people uses Facebook, the more content is being created, the longer your scrolling will be, the longer you stay on site, then the more you use the site, the more you create content by posting pictures or commenting and the flywheel continues.
Finally, in a wonderful business, everyone wins. If a business requires taking advantage of a certain stakeholder, it is not wonderful. For example, the gambling or in general, the sin sector. Sure, many fortunes are made investing in this area, but destroying lives while profiting? Count us out. A wonderful business has a sustainable business system that benefits the owners, employees, customers and suppliers. More than just a morally imperative stance to take, investing in a win-win business is actually very profitable and rewarding. It is more likely to have high sustainable strength, garner higher cooperation among the stakeholders and win trusts from its customers.
While taking advantage of another person or relationship may achieve the desired results, it comes at a high cost as it removes you from any path that involves time. And time is the key because most values comes in long-term relationship - Shane Parrish
Therefore, at Epitro, we keep in mind to only invest in wonderful businesses. Many opportunities might come and go, but we believe we will never go bankrupt waiting with cash in hand until the perfect pitch lands on our feet. Ultimately, investing only in a wonderful business allows all of us to sleep sweetly at night.
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