Researching Ubiquity Networks Is A Pleasure

This is my last blog post for the foreseeable future so that I can devote more time to a research project: in-depth interviews of directors, former directors, major shareholders, and management of ten companies that combine high five year profitability, low debt and low capital expenditure requirements.

I selected those ten from 200 companies with the follow characteristics:

• market cap of over $5 million
• top five percent of all US-traded companies in terms of five year return on equity
• top five percent in terms of financial strength as measured by debt in relation to equity, interest coverage by operating income and balance sheet liquidity

from there, I sorted by capital expenditure requirement in relation to cash flow. Low capital expenditure requirements can indicate both competitive advantage and high quality of earnings. Finally, I sorted by price in relation to earnings, earnings growth and free cash flow.

Ubiquity Networks (UBNT) immediately stood out in this preliminary analysis. As I've been digging into the company, which I haven't yet gotten to the point of recommending, it has repeatedly occurred to me what a pleasure it is to study.

The company has a five year return on capital of 38% and a return on equity of 53%. Cash exceeds debt by a ratio in excess of three to one. Last year it repurchased $50 million of its own stock and has approved a similar level of share repurchases this year.

CEO Compensation Including Salary, Stock Options, etc. Versus Insider Ownership

• most companies pay their senior executive millions of dollars a year, and management and the board of directors own minimal stock. The lavish compensation often bears little relationship to company performance or shareholder returns
• Ubiquity's CEO takes no salary and receives no stock options. He owns just under 70% of the company

Ubiquiti's CEO is an entrepreneur (rather than a bureaucrat). Click here to read an article written by the CEO's blog, including a post from a month ago about developing the company's product line.

Here's a video of the founder talking about the founding and culture of Ubiquiti when he introduced himself to fans of the NBA team the Memphis Grizzlies, which he purchased.

I have also noticed an extraordinary level of board turnover. I need to look into that, try to talk to some former directors as well as management. And there have been a number of sales of stock by insiders, not including the CEO. The company is regarded suspiciously by many analysts for a variety of unorthodox practices including minimal administrative, maximum R&D staffing. 

Based on reviews and comments I've read, the company seems to have an unusually devoted customer base, bordering on extreme. 

In terms of quality, Ubiquiti seems to be an exceptional company, and a pleasure to research. I've identified ten companies which appear to have similar characteristics and look forward to publishing the results over the next few months.

This publication is in its early days. I don't yet have many subscribers. I've decided to change the name of the publication from Master Investor Portfolio Insight to Quality Company Analysis in recognition of the emphasis of this research on quality above all else. And of course, companies like Ubiquiti tend to be held by Master Investors. For example:

• Akre Capital Management
• Disciplined Growth Investors (by the way, the founder of DGI wrote an excellent book on investing entitled Benjamin Graham And The Power of Growth Stocks by Frederick K. Martin)
• Renaissance Technologies

Time Allocation In Investing

In business, time allocation is central to success or failure. In investing, the decision of whether to know a little about a lot of companies, or a lot about a few companies, is crucial. Peter Lynch, the former highly-successful manager of Fidelity's Magellan Fund, once wrote, "The person that turns over the most rocks wins the game."

Turning over rocks is one way of looking at it. Another: when trying to find water, one thirty-foot hole is likely to get better results than thirty-one-foot holes.

I used to screen all US companies -- about ten thousand with a market cap of over $5 million - every two weeks. I now screen every quarter to identify the 200 that look at least somewhat interesting. I spend the next three months studying the sixty that look most attractive on the surface - the most I can know in any kind of depth. I read other analyst's reports, SEC filings, management conference call transcripts, study charts until the next 10Qs or 10ks come out, at which time I screen again.

I look for two hundred each quarter with these characteristics:

· high average return on capital (or equity in the case of banks and insurance companies)

• low debt
• low capital expenditure requirement in relation to earnings plus depreciation,
• stable or improving margins and capital turnover over the last two years.

I then sort by financial strength and financial statement trends looking for the most interesting sixty:

• debt in relation to equity
• interest coverage by operating income
• liquidity trends (inventory, receivables versus sales; cash and receivables versus payables, total current liabilities, debt)

Knowing a little about a lot of companies, an investor can get a pretty could handle on relative value - what, for instance thirty different companies with annual growth of 10%, no debt and an average return on capital of say 20% trade at in relation to TTM earnings and free cash flow. Knowing a lot about a few companies, you can know why for instance return on capital has gone up 25% over the last two years - expansion into new markets maybe, or pruning mediocre products or new management.

Or think you know. From there the subject quickly gets into whether or not the impact of personal bias and judgment rather than strictly facts - a personal relationship with management versus a thorough understanding of the margins, capital turnover and relative value for instance - is positive or negative in investing. I've encountered investors who think because they are friendly with management the numbers don't matter. I've become buddy-buddy with CEOs a couple of times myself and gotten my head handed to me.

I don't do that anymore, but more out of concern about how it will affect the quality of my decision-making than a desire to protect time, although both are of course important.

This blog was inspired in part by an article by Mike Schlesinger Turning Over The Most Rocks on the MicroCapClub website.

Profitability, Competitive Advantage and Focus

The single most important element in sustainable, exceptional profitability is a focus on doing something different, rather than something better, than your competitors. Every leading writer and thinker on business strategy has emphasized focus over efficiency, including Peter Drucker and the pre-imminent author of our time on the subject, Michael Porter of the Harvard Business School.

Some quotes from Porter's writing (his best known book is probably Competitive Advantage) and from the work of one of his students, Joan Magretta, (author of Understanding Michael Porter):

The essence of strategy is choosing what not to do. You can't be all things to all people. 

Strategy is about making choices, trade-offs; it's about deliberately choosing to be different. Strategy is about setting yourself apart from the competition. It's not a matter of being better at what you do - it's a matter of being different at what you do.

Unhappy customers are one sign of a good strategy. Make some customers really happy, and let others be unhappy.

Make it clear what you will not do. Trade-offs allow you focus resources to create something unique. Trade-offs create and sustain competitive advantage.

Human nature makes it really hard to make trade-offs. The tendency is always toward more customers, to offer more features. You have to decide which specific customers, and which needs, you want to meet, and not worry about other customers.

“The difference between successful people and really successful people is that really successful people say no to almost everything.”
          - Warren Buffett

Fundamental Trend Analysis: Buffett, Coca-Cola, American Airlines, General Motors and Apple

In investing, everything is simple in concept, difficult in execution. There's too much money involved, and too many intelligent and hardworking people competing against one another, for it to be easy.

In fundamental analysis, and investing, there are three major considerations.

• Long term trends in profitability and balance sheet strength.
• Short term trends in profitability and balance sheet strength: latest quarter versus prior quarter, TTM versus prior twelve months
• Intrinsic value. Very difficult to estimate exactly, but very possible to estimate relative to hundreds or thousands of publicly-traded companies.

I deliberately omit considerations like management integrity, in part out of personal experience, much of it not good. Steve Jobs was legendary for his dishonesty and yet he may have been the best CEO of his generation. My investment strategy has evolved out of a realization that I'm not good at separating the wheat from the chaff, at least as far as it relates to management.

In 1988, Buffett took a major position in Coca-Cola at fifteen times earnings, twelve times cash flow, and five times book value. Right around that time a client hired me to research the net asset value of Anderson Tully, a major owner of hardwood forest land along the Mississippi River. I flew out to Vicksburg Mississippi to interview former executives of the company, former directors and customers.

When I tried to figure out why Buffett took that position in Coca-Cola -- which seemed an anathema to a value investor, as Buffett was widely described in those days -- it became clear that it was a highly-profitable company with a strong balance sheet and income statement trends in transition from an above average company to an exceptional company. It was meeting with real success expanding into foreign markets and it had also shed several mediocre businesses. I like to think that I could have reached that same conclusion myself had I not been spending all my time flying all over the country to interview people about mediocre, undervalued businesses.

That was thirty years ago. I've been working off and on since then developing financial statement trend analysis techniques (and software) that allow me to identify situations like Coca-Cola was in the late 1980s. As I've developed these techniques, I've become increasingly aware of the role of emphasis on length of trend. Does an analyst emphasize latest quarter versus year ago quarter, TTM versus prior twelve months or last five years versus prior five years, or some combination of the above? My conclusion: this analytical method, centered as it is around financial statement trends, works best according to how predictable a company is. Like, for instance, KO. Companies that have no real competitive advantage, such as the vast majority of public companies, give constant false signals. It is probably best to buy those when their trends are weakest, but of course you never know when they've reached a nadir. It is always possible that tomorrow will be worse than today, no matter how bad today was.

So if these analytical techniques are most effective in identifying highly-profitable companies with strong balance sheets and a sustainable competitive advantage does requiring, in addition, that these companies be held by investment managers with highly-successful long-term records add or subtract from overall performance? I added the Master Investor requirement for three reasons:

• it reduces the risk that there is some major flaw in an investment that is not yet exposed -- these investors tend to do rigorous due diligence. Paying a premium for quality doesn't work well if that quality deteriorates 
• it allowed me to develop connections with Master Investors, and benefit from their feedback on my research, which has been important and appreciated
• it has marketing value -- we are all curious about what the best among us are doing

In practice though it has had a disadvantage. Very few of the companies in Master Investor portfolios are exceptional in terms of profitability, balance sheet strength, etc. Lots are good, lots are improving -- in other words the Master Investor is betting on positive change, which even Buffett was doing, I think, to some extent in Coca-Cola.

My conclusion: to focus on the top one percent of US public companies in terms of competitive advantage and balance sheet strength, look first for which companies have the most favorable combination of long term profitability and balance sheet strength, and from there look at who owns them. Rather than start by first examining the portfolios of Master Investors.

As a result, through three screens, I have identified the top 200 US companies in terms of profitability, etc. and then completed intrinsic value analysis of those versus two thousand other companies held by Master Investors. I'm now studying the most interesting sixty of those -- sixty is the maximum number I can develop a real knowledge of -- as the basis of this research going forward.

All of this is taking a little time as I sort through the two hundred. And first I'll publish my thoughts on which of Buffett's current holdings appear most attractive. There is, by the way, a very substantial difference between the investment criteria Buffett has outlined in his numerous writings and interviews, and the companies currently in Berkshire Hathaway portfolios. There are, for instance, now four airlines and two technology companies (Apple and IBM) in the Berkshire portfolio. And General Motors.

The net wealth creation in airlines since Orville Wright has been next to zero. If a capitalist had been at Kitty Hawk and shot him down, he would have done us a huge favor. 

There’’s a big difference in making a lot of money and spotting a great business. At the turn of the century there were two industries that had never existed before but changed the entire twentieth century: the airlines and the autos. They’’ve been wonderful industries but lousy investments. There have been tons of capital lost in those industries . . .

 I have avoided technology sectors as an investor because in general I don't have a solid grasp of what differentiates many technology companies. I don't know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don't overpay for them. Technology is based o­n change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles.

I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.

- Warren Buffett