Making Sense of Understanding

24 January 2019 | by Todd Wenning, CFA

For most of my driving years, I relied on repair shops to do all the work on my cars. It wasn’t until a few years ago, after getting a $100 charge for changing a single headlight bulb, that I evaluated what repairs, if any, I could do by myself.

With the help of some YouTube videos, I figured out how to replace my headlights and filters at a fraction of the cost, with no discernible drop-off in quality. (At least not yet.)

On the other hand, there’s no way I’d tackle my car’s brakes, engine, or transmission. The risk-to-reward ratio just isn’t attractive.

This isn’t to say that I couldn’t learn how to do the repairs, but it would require extensive training and experience to become proficient. The financial payoff to work on just my car wouldn’t be worth the effort.

Circle of competence

Investors face similar challenges when we research new companies. If we just bought “what we know,” as the saying goes, our investible universe would be tiny. Learning about new companies and expanding your circle of competence is part of the fun of investing. Still, we need to know where to draw the line.

More specifically, how much effort will it take to:

  • Learn the company’s products and services?
  • Identify the company’s moat sources (if any)?
  • Explain how the business turns revenue into profit and cash flow?
  • Appreciate the customer value proposition and why they win and lose business?
  • Differentiate secular and cyclical industry themes?

On the one hand, there are businesses that, like switching headlights and filters, are easy to grasp. We call these intrinsically understandable businesses. Put another way, a good investor can relatively quickly figure out 80% of what’s important to the business without being an expert in the field.

On the other hand, there are attractive businesses that either require years of first-hand experience or a Ph.D. to reach the same 80% understanding threshold. Perhaps key information is inaccessible or the operations are complex or otherwise technically challenging. These should be tossed into the proverbial “too hard” pile, yet some investors like a good intellectual challenge and dive straight in.

Of course, there’s potential payoff for digging through complex businesses, but the return on time also needs to be considered. For us, this is like learning how to fix your car engine. Could we figure it out given enough time? Sure. Would it be worth our while, given other demands on our time? Probably not. There are more fish in the sea.

Importantly, understanding a business does not require complete knowledge of its operations. Investors can obsess over quantitative minutia and overlook valuable qualitative aspects like moat and management quality.

Two sides of understanding

The other question we ask when evaluating our overall understanding of a business is, “Is this company intrinsically forecastable?”

To be sure, understandability and predictability are two different things. For example, you might be able to quickly understand how a gold mining company makes money. It’s much harder to confidently forecast its cash flows over five or ten years.

Companies with secular tailwinds, high recurring revenues, and tollbooth characteristics lend themselves to being more forecastable, relative to the average company. We like owning these sorts of businesses. Our holdings in Mastercard and Broadridge Financial are two examples.

Now, none of our cash flow projections will be perfect, but if we can identify three to five key metrics that drive such a company’s valuation, that’s about as good as you can get as an outside shareholder from a predictability standpoint.

Bottom line

Understandability is an oft-discussed, yet poorly-defined investing term. By setting some guideposts, we hope to more accurately identify businesses worth further research and discard ideas not worth our time.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Mastercard (MA) and Broadridge (BR). This company represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

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