October 24, 2023

Defining Tools For Investment Selection

This short note serves to explore the key tools (i.e., investing frameworks) with which we analyze businesses and ultimately make investments. As I was crafting this distillation of our most important frameworks, I imagined myself as an electrician or plumber collecting my most worthy tools. I imagined myself wrapping my arms around them as I collected them to depart a job. In many senses, these are my tools, which I've borrowed from great investors and developed myself, and I believe you'll likewise benefit from adding these tools to your toolkit.

Highly Replicable, Definitive Process

L.A. Stevens employs  a highly replicable, definitive process for equity research, and this process is predicated on the five tools, or pillars, that I will discuss with you today.

L.A. Stevens' highly replicable, definitive process can be easily learned, and it can allow investors to delve as deeply or as shallowly as they'd like into a business.

This process includes five pillars, listed below, and, today, I will walk you through each of these pillars.

  1. Four Foundational Investment Frameworks
  2. Key Economic Moat Analysis
  3. L.A. Stevens Valuation Model Analysis
  4. Essential Elements Criteria
  5. Inverse Bubbles Framework

In some sense, these five pillars represent the essential truth underlying value creation for all businesses distilled into five easy-to-understand frameworks.

Without further ado, let's briefly explore each of the five pillars of L.A. Stevens' investment process.

Four Foundational Investment Frameworks

Each of the businesses I share with you fit within one or more of these frameworks, and employing these frameworks increases the odds that our investments will be successful over the long run.

  1. Vertically integrated product capturing market share in stagnant mature industry: We target businesses that have created a fully vertically integrated product, within a fragmented, low NPS, and mature industry, whereby that vertically integrated product offers 10x better value; thereby, it captures significant market share rapidly. [As an example, Monday.com's platform has become more and more vertically integrated, as it's added MondayCRM, MondayDev (for developers), and its app marketplace products in addition to its core work management product, all of which sit atop Monday's proprietary, open, and configurable architecture. It's a true, vertically integrated work operating system, which, with the creation of MondayDB is more scalable than ever, the evidence of which can be seen in the company's enterprise customer growth]. My recent work on Intuitive Surgical highlighted another vertically integrated business that has been capturing market share within the 20M/year soft tissue procedure market for the last 20 or so years.
  2. Businesses that will execute a leveraged recapitalization in the coming years or are extremely disciplined with capital allocation via routine, robust share repurchase programs: These are often fairly simple businesses that have fielded one or two products, which possess defensible moats that defend their stable cash flows as they gradually expand over a multi-decade period. The stable cash flows are not employed in the purchase of value accretive acquisitions; instead, they are channeled into capital return programs for shareholders, such as free cash flow per share accelerating share repurchase programs. Notably, the capital return programs act as disciplinary forces that ensure management operates as efficiently as possible and does not engage in empire building [Examples here include Chipotle, Meta, and, in the past, Google or Apple.]
  3. Quality cultures that breed innovation within the larger conglomerate: In some sense, this framework is the foundational framework of all America's and earth's most notable franchises, e.g., Tesla, Apple, Amazon, and Microsoft. This framework details a company's ability to launch new successful line of business after new successful line of business, creating a nucleus of explosive, compounding sales and free cash flow growth. This is the idea that a business creates a culture in which its employees create new products, provide these products to the marketplace, and these products ultimately find product-market-fit. Upon finding product-market-fit, the product begins its climb on its S-Curve, which will vary in size and value for each product. With multiple products growing rapidly simultaneously, the business overall grows more rapidly and, importantly, more durably. Some of my favorite examples that fit within this framework are Axon (AXON), Monday (MNDY), Adyen (OTCPK:ADYEY), Sea (SE), Tesla (TSLA), Amazon (AMZN), and MercadoLibre (MELI). Indeed, many of our businesses possess this incredible cultural structure, and that is why we've chosen to provide coverage of these companies.
  4. Growth through quality, moat-building acquisitions: Lastly, we have the capital allocator framework by way of an exploration of Meta's (META) business. In this investment framework, a very large business materializes through prudent and judicious uses of shareholder capital via acquiring quality businesses and growing them over time within the larger conglomerate. Meta has acquired Instagram and WhatsApp, both of which have solidified its global monopoly. Microsoft has also made employed this framework masterfully, and, of course, the CPG companies, such as Unilever or Proctor & Gamble, have been quintessential examples of this framework, creating pricing power in low barrier to entry industries through industry consolidation.

Key Economic Moats

The four most common and notable economic moats are:

  1. Network Effects
  2. Embedding/Switching Costs
  3. Brand (arguably the best and most difficult to achieve)
  4. Economies of Scale

There are also regulatory moats (which I believe Meta and Alphabet have as of today), and other more nuanced, less common moats. For the sake of simplicity and brevity, we will focus on these four economic moats today.

We use these moats as a lens through which we identify the competitive advantages our companies possess. As a reminder, an economic moat is a competitive advantage that defends a company's ability to sustainably produce free cash flow and grow that production of free cash flow each year.

Here's an example of employing these moats via an Airbnb (ABNB) example:

  1. Brand moat: For me, personally, I really don't know where else to book a stay. Of course, I could think of other ways to find a place to stay, but Airbnb is so embedded into my psyche that I think of it as synonymous with travel. I start my travel journey in the Airbnb app, and only when there is no supply do I turn to a hotel. That said, I've actually been considering highlighting Hilton (HLT) as an attractive dividend growth investing idea, as I've had very good experiences with Hilton. There's 8B humans on this earth. That number is growing. The number of earthly citizens achieving levels of income necessary to travel often continues to grow. It's a very abundant universe, and I believe Airbnb is a highly customer-centric business with a robust brand moat (i.e., customer loyalty). I believe Hilton operates with a similar mindset based on my experiences with the brand.
  2. Network Effects moat: Airbnb has robust network effects that are also reinforced by Airbnb's brand moat. That is, because I associate travel with Airbnb, I use the Airbnb platform to search for places to stay. Because I use the Airbnb platform to search for places to stay, hosts use the platform to list their places to stay. Because hosts use the platform to list their places to stay, I use the platform. Because this cycle repeats consistently, I continue to associate Airbnb with travel, and, as such, my identity association with Airbnb continues to build. "I, Louis, start my travel journey on Airbnb. That's just who I am." Notwithstanding the divorce rate in the U.S., humans generally tend to dislike change. They "become set in their ways." This natural human tendency is the ally of the high character business and associated consistent product.
  3. Embedding moat: Guests build their reputation on Airbnb. Hosts build their reputation on Airbnb. These both represent embedding moats, though, to be sure, it's stronger for the business owner (for the particularly exemplary hosts, they can be given "Superhost" on Airbnb, which comes with benefits, like added trust or the ability to charge a slightly higher price). Further, Airbnb hosts manage their listings through the Airbnb app, and this creates further embedding moat. Humans appreciate a simple UI/UX that they understand well, and they will simply stick with a good one if it works. "If it ain't broke, don't fix it," so to speak.
  4. Economies of Scale: I do not believe this moat applies to Airbnb, but please let me know if I am missing something! Many businesses often have hidden moats, and an optimistic eye can identify them.

Valuation Analysis Using The L.A. Stevens Valuation Model

I often share the idea that all investors are value investors, whether they realize it or not. Ultimately, the goal is to pay less than a business is worth or to pay a price such that we're fairly compensated for the risk we assume. This latter definition is exemplified by the equation risk = return.

As I've also shared occasionally, I invented a valuation model known as the L.A. Stevens Valuation Model.

The key components of the model are not unique: Each component is based on timeless truths that underpin value creation in the stock market (and value creation for businesses in general).

In short, the L.A. Stevens Valuation Model projects the growth of free cash flow per share, which is the basis of value for all businesses in the world, including businesses in public markets.

To our shareholders:
Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share.
Amazon 2004 Shareholder Letter Authored By Jeff Bezos

Since IPO'ing and sans Amazon's recent investment cycle, AMZN has grown its fcf/share ~400,000%, and shareholders have experienced similar returns, illustrating the idea that fcf/share is the basis of all economic value creation in business.

Percent Growth Of Free Cash Flow Per Share Since Inception, Amazon

Total Returns Of Amazon Since Inception

In projecting the growth of free cash flow per share over 10 years, we can create a conservative projection of the growth of a company's share price over that period.

With this projection of free cash flow per share and the company's share price in mind, we can invest in such a way that we generate attractive returns in accordance with our investing goals.

That is, we know where we should buy a business and where we should not.

You will see the implementation of the L.A. Stevens Valuation Model in future notes that I share with you.

Essential Elements

L.A. Stevens' Essential Elements are a set of criteria that we employ to assess the quality of a business.

This list of criteria ensures that we've considered every pertinent and important aspect of the business we're analyzing.

Ultimately, using this checklist enhances our odds of successful investing.

You will see our set of criteria explicitly detailed in the future.

Inverse Bubbles

To close this brief review of our investment tools and frameworks within L.A. Stevens, I'd like to discuss my Inverse Bubbles Investment Framework, which is arguably the greatest mechanism for value creation in the world.

Indeed, the Inverse Bubbles framework has been key to Apple's evolution into the most valuable company on earth.

I will share a couple resources and real-world applications of the Inverse Bubble framework with you in a moment. To put the framework concisely, it is the idea that a new entrant builds a substantially better product for an existing industry and, using that substantially better product, captures market share within that industry over time. Graphically, our Inverse Bubble Framework looks as follows:

Coupang Capturing Market Share Within Its Massive Inverse Bubble

  • Note: It's "Inverse" Because Coupang's Value (Market Cap) Is Small Relative To The Industry/TAM In Which It's Growing; Therefore, Coupang Collapses The Bubble Into Itself By Consuming Market Share And, Commensurately, Expands As The Bubble's Collapses Into Coupang's Revenue And Profits.

Notably, Coupang has created a vertically integrated, highly differentiated, largely autonomous commerce engine, which has afforded it the ability to capture market share within the above-illustrated total addressable market, or, as I call it, Inverse Bubble.

In the interest of brevity, I will provide some resources via which you may explore this framework in even greater depth:

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