Recently, I had a few interesting discussions with fellow finance writers and professional investors. What struck me was that, by their own admission, it took them some years of experience to realize the value of an idea like focusing on ROIC.
Being a self-taught entrepreneur and investor, this is something I always taken for granted. So I would argue that every investor could improve by putting on the shoes of an entrepreneur.
What is an entrepreneur?
In this article, I will define an entrepreneur as a founder of a company he intends to own fully or in majority for a long period, at least 10 years, ideally for life or for several generations.
This excludes plenty of pseudo-entrepreneurs/business owners/founders, like:
Startup founders raising money, waiting for their “exit”.
Appointed CEOs, there thanks to the right connection/diploma/pedigree.
Activists, looking to use their company and money as political leverage.
Technologists, more interested in the sciences than running the business.
Interestingly, this filter should remove most "business leaders” and businesses from your potential stock universe.
Their incentives are not aligned toward building a successful company, but respectively:
Startups: to grow quickly enough, get rich, and leave the boat ASAP.
hyper-growth and quick IPO, no interest in actual profits.
Pedigree CEOs: to manage career risk.
the perfect leader for melting ice cubes and failing conglomerates.
Activists: for political influence.
for the most recent references, see Budweiser & Gillette.
Technologists: to understand better science, and develop “cool” tech.
most biotech and cleantech companies, and probably a lot of IT as well.
Not A New Idea
This is not some brilliant insight I suddenly got.
It is contained, even if in an indirect way, in the famous advice by Warren Buffett to “think as a business owner”.
The key part here is OWNER.
Not CEO, manager, founder, leader, … OWNER.
What Gets Understood
But often, I realize that investors get this advice wrong. Here is what many (most?) understand:
You need to think long-term.
You need to focus on competitive advantage (the famous moat).
You need to look at client satisfaction.
What’s Often Missing
All of these are great to have and will be the foundation of a company’s success. But this is not enough and investors often forget it.
For example here is what these ideas will fail to include, but are of crucial importance in the decision process of an actual CEO and his team:
Capital allocation. What is the future profitability of capex?
Cash flow. Do we actually have the money in the bank account? Or is it just accounting numbers?
Liquidity. A.k.a. do we make payroll next month? And the 12 months after that?
Dividends. Can I pay myself?
Acquisitions. Are the hassle and risks worth the promised growth?
How big is too big? When will it kill what makes us successful?
Unit economics. Do we even make money doing this job? If not, why are we even doing it?
How do we fail? What can kill the company or a product? What can be done about it?
As you might notice, a lot of these points are gravitating around “Show me the money.”
What (Good) Entrepreneurs Do NOT Think about.
But maybe more importantly, there are a lot of things and metrics investors look at that an entrepreneur does not really care about.
The Optimal Debt Level
I never met an entrepreneur looking to fine-tune the “optimal” debt level. You take debt only because there is an opportunity, and you do not have the cash available for it.
And you generally hate it, because it could endanger your life work in favor of the bank.
If you are an investor and ever felt like complaining that the company is not raising enough capital through debt, that’s why. A business owner thinks of survival first, optimizing ROE later, or likely not at all.
Ignoring Business Cycles
A LOT of investors talk about long-term investing as essentially ignoring volatility. There is some sense to that, as long as you speak of stock price volatility.
But real entrepreneurs are obsessed with the business cycle of their industry, recession risks, etc…
These risks can turn a shiny new factory into a dead weight that can sink the company.
It also could allow you to grab a competitor's assets for pennies on the dollar.
It will force you to fire people, a very unpleasant (and costly) task.
Investors should care a lot more about the macro context at multiple levels (industry, national, global), contrary to a popular take among value investors to ignore all macro takes.
Of course, they need to be reasonable in how much it impacts their strategy. Forever fearing a recession can kill your returns. In the same way, a too-fearful entrepreneur would never grab a good opportunity by being too paranoid.
EBITDA
I remember Charlie Munger calling it “bullshit earnings”.
Not much to add to that.
Why in hell would you ignore real costs like interests, taxes, or even depreciation+amortization (a.k.a. the accounting blah-blah for “stuff breaks and constantly need to be replaced”)?
Revenue Growth For Its Own Sake
Revenues for the sake of revenues are meaningless.
Do you know what an entrepreneur calls profitless revenues?
More work.
More people to hire and manage. More clients to handle. More products to deliver. More potential legal issues. More middle managers to turn the company bureaucratic.
If you see a company looking for growth without a clear path to the economy of scale, RUN for the exit.
Legalese
Legalese is to lawyers what the Japanese language was to inhabitants of Japan. A secret language, requiring a skilled translator for any outsider.
Legalese is 80 pages of “risk factors” in an annual report.
It is an answer in a quarterly call that is so carefully crafted, an English-language major could write a full thesis about all the possible meanings and unsaid things in it.
I personally have a liking for a management who is able to call a cat a cat. Anyone hiding behind legalese is focused on career risk and/or a liar.
Bullshit Metrics
The king of metrics LOVED by startuppers, HR, and middle managers.
The kind of metrics that will not change profit by one cent, but look good to investors or journalists/activists.
In the 1990s, it was eyeballs for Internet companies. Today it has proliferated to the point of making 70% of an annual report:
Carbon emissions.
Social activities, community engagement, …
Diversity
in all its forms but the only ones that matter: diversity of social background and thought.
Daily active users.
Benchmark performance.
Brand recognition.
Non-GAAP accounting
Adjusted-whatever.
Projected market in 5+ years.
Total Addressable Market (TAM).
and more.
The more BS metrics are used, the more risky the company is.
Not even worth reading, just a red flag if it takes over focus over real business activities.
At The Core Of Business: ROIC
If I spend $1, how much more do I get back?
This is really the only question that matters to the entrepreneur.
If the answer is $1, growth is worse than valueless. Actually, anything below $1.5-$2 in the next few years is just bad.
Most entrepreneurs would scoff at aiming for anything less than $3-$5 in 5-10 years.
Why even bother?
Entrepreneurs instinctively understand ROIC, sometimes even without knowing the concept or knowing how to calculate it.
It is a calculation they did from the very first day on the job.
If I launch X for said amount of MY money and give up years of MY life working on it, will it give me back so much more, so its worth the personal cost of all that stress and work?
The Difference Between Investors and Entrepreneurs
As investors, we nevertheless need some time to NOT think as an entrepreneur.
This is because entrepreneurs are at the helm of the ship.
They bear a very real cost in stress, work hours, missed time with their children and loved ones, and money they invest or reinvest that could have been enjoyed instead.
Alternatively, entrepreneurs also receive intangible rewards: freedom, self-respect, a sense of accomplishment, and the possibility to pass their work onto their children.
None of that matters to investors.
Ultimately you can sell at any time.
You’re just a passenger.
You will never be tied to the ship the way the captain is.
This has a few practical consequences:
You can come in and out according to the multiple cycles (business, macroeconomics, geopolitics, etc…).
Just do it rationally and patiently. “Peak oil production” fears in 2008 was the time to leave the oil sector. Negative oil prices in 2020 were the time to come back. That’s 12 long years where you should have been the business owner in other industries.
If the hull is leaking, leave the boat. Do not stay tied to degrading conditions.
The entrepreneur will try to save the company at all costs. Investors can jump to the next ship and wait and see later if the repairs worked.
Nothing personal.
Investors should not tie their ego to a stock. What was a good idea yesterday might not be today. Flexibility is key, as Soros or Druckenmiller kept repeating.
An obsessive CEO/founder is great … for the shareholders. Probably not so for his personal life, but that’s a great profile to find leading the stock you own.
The line between crazy and genius is a fine one. Just look at Elon Musk or Steve Jobs for famous examples.
Get paid.
That’s why you’re here. Not to build the company.
Growth is okay but puts you at the mercy of markets’ opinions and willingness to pay for that growth. This might take a long time, and carry a large opportunity cost during the wait.
Dividends are best. Money in your pocket is both proof of real profitability and of management's willingness to give you back your money with interest.
Buyback only makes sense if done because of a disconnect to real value. Systematic buybacks at any price are a big red flag of a pedigree CEO looking to appease the markets. No real entrepreneur would buy his own shares at twice what they are worth.
Conclusion
I can resume this article with a few key points:
Money is all.
Get Paid.
Free Cash Flow beats net income and EBITDA.
Liquidity & risks > capital structure optimization.
Key Metrics:
ROIC
Unit economics
Are purchases on a discount? (assets, acquisitions, buybacks)
Time horizon & risk.
There is no long-term if you crash before reaching it. Entrepreneurs manage their companies accordingly.
What can go wrong, not right, is the most important question to answer.
Investors are not entrepreneurs.
Get paid (yes, I said it twice)
Manage a whole fleet of entrepreneurs, never get emotional about this one stock.
Jump ship when needed, you can always come back later.
I hope this was somewhat interesting and useful.
All are simple ideas, but we all need a reminder of the basics from time to time.
Do not hesitate to tell me in the comments what you think, and how you handle debt levels, ROIC, bullshit metrics, etc…
If the hull is leaking, leave the boat.
May I ask what was reason for going to Estonia? Taxes or/and a girlfriend/wife or...?
What a Great article!