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Three Ways to Analyze an Investment's Potential

Frameworks help evaluate a businesses’ potential. Whether their stock will be a good investment is another question. Good companies can make bad investments if the price paid is too high.

Important: Frameworks help evaluate a businesses’ potential. Whether their stock will be a good investment is another question.

Good companies can make bad investments if the price paid is too high.

Warren Buffett’s Framework

Are you investing in a “business” or “economic franchise?”  We want to invest in the latter, but how can we know which companies have the potential to become an economic franchise and deliver outsized returns?

Warren Buffett wrote in his 1991 shareholder letter the characteristics of an economic franchise.

An economic franchise arises from a product or service that:

  1. Is needed or desired (product/market fit).
  2. Is thought by its customers to have no close substitute.
  3. Is not subject to price regulation.

The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

Moreover, franchises can tolerate mismanagement. Inept managers may diminish a  franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if  the supply of its product or service is tight. Tightness in supply usually does not last long.

With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

This framework helps us answer the question: Does this company have a moat, and how durable is it?

Bottom line: We want to find, invest in, and hold onto businesses that have the potential to become economic franchises.

Peter Thiel’s Framework

Peter Thiel wrote, “Zero to One.” The book discusses the four characteristics of a monopoly.

  1. Proprietary Technology–Is your product or service difficult or impossible to replicate? How hard would it be to build a better search engine than Google? Or offer more products at lower prices with faster delivery than Amazon?
  2. Network Effects–Does your product or service become more useful as more people use it? If all your friends are on Facebook, does it make sense to choose another social network?
  3. Economies of Scale–Does your business get stronger the bigger it gets? The fixed costs of creating a product can be spread out over greater quantities of sales. Software companies are good examples because the marginal cost of  replicating software is zero.
  4. Branding–Built overtime by the ability of a company to deliver a product or service that, in the customer’s mind, is special and consistent.

Most businesses will not have all these characteristics, if any. However, the ultimate winners in a given vertical will have multiple.

Geoffrey Moore’s Framework

Geoffrey Moore wrote, "Crossing the Chasm." The book explains how technology companies should market their products and how some companies with promising starts, fall prey to the chasm.

His framework is useful when estimating market size and penetration rate for a product or service.

For example

iRobot's estimation of addressable market

This chart is from iRobot’s 2018 analyst presentation. It’s their view on how much room their product has left to run.

As investors, we can assign a likelihood for them penetrating the rest of their addressable market. And sometimes, there’s a gap between our estimate and what the market has priced in. Hence, an opportunity!

Sustaining vs. disruptive innovations

Another important concept from the book is distinguishing between sustaining and disruptive innovations.

Sustaining innovation: The normal upgrading of products that does not require us to change behavior.

For example: Warby Parker made better-looking eyeglasses and the experience of buying them more enjoyable.

Disruptive innovation: Products that require us to change our current mode of behavior.

For example: Before Uber, we stood on the street and hailed a taxi. With Uber, we  press a button, and a car shows up. The Kindle made visiting book stores  unnecessary by letting us upload books on a portable device.

Understanding which products have the potential to be disruptive is key to estimating which companies have a chance at becoming the next Facebook, Netflix, or Amazon. Those are the companies we want to find early and hold onto (the hard part).

Putting it together

Putting multiple frameworks together can give your analysis superpowers.

We combined Warren Buffett and Peter Thiel’s framework in our Zoom ($ZM) analysis.

Check it out.