Do You Have Edge? (Part One)

I know - I hate the term as much as you do, but it's real and it's damn near impossible to explain: the phenomenon investors call "edge." In its most basic form, edge is the ability of an analyst to identify, at first glance, what the key issues and concerns are in evaluating a business. Edge is being able to point to what matters, it can be the gut instinct to know what's truth and what is management bullshit, and it's the ability to ask the right questions to understand the one thing that will make or break an investment... and edge is figuring out what the rest of the street is missing.

Whether or not you think you have it yourself, it's hard to deny that some people are just able to shoot at targets nobody else can see, and they tend to get generously rewarded for it. Hell, if you ask me they're probably underpaid.

Unfortunately, the concept is so abstract and difficult to quantify that any attempts to teach it to others usually don't end well... especially when you consider most of the people who truly have "edge" probably aren't teaching it, and people that are trying to share it with others usually don't have it at all. But screw it, my job with this post is to try and do it anyway, and if you believe what I just said, then I should fail miserably. Every analyst thinks he has a unique thought process, and chances are I don't actually have one, but I'll do my best, so if you can take even one thing away from this post that helps you think like a better investor, I've done my job. This is Part One, where I'll focus on the broad strokes of figuring out what the right questions to ask are... Part Two will focus on where to ask them and who to ask them to. Have fun with this one, kids.

Comment: Looking back on this, I re-read it and worry that it's absolute shit. There's no way to quantify this stuff and any attempts to do so feel obvious for anyone in industry and maybe even most kids in college... and while I would have just scrapped the whole thing I'll post it anyway with this qualifier: There's too many "it depends" answers to this stuff for me to feel comfortable saying it's legit. Still hope it's helpful to some people though...

So you're interested in a new company... you've read the annual, recent transcripts, and any other relevant information to get you acquainted with the business. Now what?

Believe it or not, no matter how complex or ground-breaking the business is, it probably falls into a small category of ways to make money. Just about every company can be boiled down to some classification of productive asset... and I can't effectively describe the different categories of businesses as productive assets, but I'll provide a rudimentary checklist for the ones I can think of:

1) Do they generate their cash through service-based revenue streams like long-term subscriptions, non-cancellable contracts, or other highly visible periodic revenue payments? And what level of dependence do these services come at, meaning how easily can the business lose a revenue stream (switching costs)?

2) Do they manufacture products with significant supply-demand dynamics that change drastically with broader industry or economic conditions, like commodities or capital equipment?

3) Do they sell a basic good in a price-taker's environment where competition is mainly managerial and along the cost curve? Is product differentiation possible to mitigate this, such as innovation or brand equity?

4) Are they reliant on periodic large inflows from heavy investment/development products, like tech companies releasing new versions of their technology or pharmaceuticals developing new drugs?

5) Is it a hybrid of more than one of these? [Most things are]

Who Cares?

Whether or not my attempt at categorizing different businesses is even remotely accurate, the point is to understand what sustains a business and what threats are going to put sustainability in jeopardy going forward. Economically speaking, the right combination of traits from the above should make a business have a near impervious moat, while other combinations would make it an absolutely terrible, perfectly competitive business.

Anyway, like I mentioned in my previous installment on how to parse a 10-k, after we've identified what kind of income/value generator we're dealing with, we want to identify the "crown jewel" and the "growth engine." Recall that sometimes these can be the same thing, but the basic rules of economics typically force them to be separate.

Case Study...Maybe

It's not easy to explain this in generic terms so I'll use an example from here on out. Suppose we've found a company that primarily provides servers and maintains databases for its customers. The company signs 10 year service contracts that give them fixed quarterly payments (with, let's say, a variable provision for increases in costs and inflation) and in return they maintain the hardware and back up databases for customers' operations. This has been their primary business for a long time and they are a market leader. Revenues in this segment have grown 3-4% organically, as new account wins are few and far between but contracts provide for revenue growth from pre-existing customers with very high switching costs. These payments also account for 80% of the company's operating cash flow. Not hard to figure out that this is probably the company's crown jewel. If they lose this business, if it starts to comp negatively, etc. then they may be in some serious trouble.

Businesses like this that look like they've hit maturity generally have a buyback focus to generate future growth. That's all well and good if the contracts stay in place, prices keep going up, and people keep using huge data centers for their IT operations. However, that doesn't seem all that likely now does it? Right off the bat you can imagine something like that could weigh the company's shares down.

Fortunately, this potentially endangered crown jewel isn't alone, as this company has a burgeoning online data service as well. Like good managers, they realized years ago what the market is just now worrying about, and they invested heavily in the cloud on the off chance that it would one day be the "next big thing." The investment is just now paying off to the tune of 12-15% revenue growth per year. The company has leveraged their customer base on the database side and started to cross-sell them cloud-based storage and backup services as well as an outlet for outsourced IT support. While this is only 20% of OCF at this point and has plenty of volatility, it's the only promising part of the business if we want to see a substantial return.

Writing a Game Plan

So you've categorized the business, you see what they do well and what they need to do better. Unfortunately most everyone else who's been on this name for a while knows the same stuff. Research becomes an art from this point forward, and the way I'm going to generalize isn't really fair but it hopefully gets the point across. The debate among all the analysts on this name is going to be what kind of a multiple are we going to assign to the growth engine and is it enough to offset our concerns that it might fail and/or the chances that the business falls apart if the crown jewel dies. The sell side is going to spit out something +/- 10% of management because they don't want to get on anyone's bad side but they still want to have an identity, and they aren't incentivized to go out and dig into things any more than what guidance they're given. Thus, sell-side tends to be a great mouthpiece for management, but it's not going to be what gets us to something actionable...

Effective research is proprietary, and things like channel checks and scuttlebutt are often the difference between hitting the mark and being completely wrong on a name. Most of Wall Street doesn't get paid to get the right answer, just an answer that doesn't get them fired, so Part Two will cover how to think about finding the RIGHT answer...