Weeding Out The Best Investments | The Acquirer's Multiple®

During his recent interview with Tobias, Kyler Hasson, Portfolio Manager at Delta Investment Management discussed Weeding Out The Best Investments. Here’s an excerpt from the interview:

Tobias: So, besides valuation, what’s important? What’s your process for assessing a company when you–? You first come across it however you find it, how do you think about it?

Kyler: Yeah, I would say I spend– if I’m looking at a company, I probably spend 95% plus of my time on the qualitative stuff. And then the numbers, I’m pretty quick with, like I said, no complicated models. I think it’s hard. I think investing is really unique and really difficult in that there’s not a lot of what I would call– it’s very hard to learn anything sort of positively, I think you can learn what doesn’t work. I think it’s really hard to just say, “Oh, well, look at what’s done well recently, and I’m just going to do that,” and as you know that, can blow up on you. So, I really just try to weed stuff out first and foremost. What I don’t like, first of all, you can weed out a lot of companies by just, is that return on invested tangible capital high enough, that they’re actually creating value, that weeds out a lot.

Number two, most companies that exist don’t exist for a long time. Their profitability is competed away. The returns on capital are competed away. So, there’s got to be some sort of competitive advantage, obviously. Those are probably the two biggest ones. Can I be comfortable that this business is going to exist and be better than it is in 5 or 10 or 20 years that it is now? It’s a rare business that you can be confident in that, I think, truly confident. You can say whatever you want, but if you’re being honest with yourself, that’s a tough bar to clear. Then, I usually look for that– I think, who’s buying their products and are they solely focused on price. Obviously, you can have some price-based moats but any business where people might say, “I’m going to buy the cheapest one,” I want to stay away from. So, those two things.

And then, assuming it checks that, I think the three ways you can get yourself in trouble the most are lots of operating leverage, and there’s plenty of good businesses that their margins are going up over time because they have pricing power. And I don’t mean that. I mean like airlines. There’s a lot of operating leverage in that business and if your load factors go down just a bit, you’re not profitable. Two companies, we own TransDigm and Heico, in April, I think, rev passenger miles were down something like 90%, across the globe. And those two businesses were still profitable. EBITDA or maybe operating income was down, sure, but still free cash flow positive, so they can survive distress a lot better than something like an airline with a lot of operating leverage. So, I try to avoid that.

I personally try to avoid things that are too cyclical. I think it’s really hard if you have a really cyclical business to have any idea with earnings power is, honestly. I was looking at a Vulcan Materials other day and that’s not horribly cyclical, but they did this deal in 2007. Florida Rock was what they bought. And if you look at the graph of aggregates demand from– I think it was 1960, or something up until 2007, it’s up until the right and there’s a couple little wiggles. And so, you can read the transcript for this acquisition, and the analysts are getting on and they’re literally saying, “Hey, congratulations, this is a deal made in heaven. You guys are going to make so much money.” And management saying, thank you, thank you, thank you. And sure enough, the next year, aggregates demand was down. I don’t know the number, maybe it was a third or something. But volumes were down, EBITDA cratered. They had done a lot of debt to do the deal. And they were in some pretty serious trouble.

So, obviously, that one sort of looks not too cyclical, but when you have cyclicality, I find there’s risk obviously just in and of itself, but then it’s hard to predict what’s going to happen, I think– [crosstalk]

Tobias: What drove the cyclicality in that instance? Was it homebuilding just stopped for a period?

Kyler: Yeah, homebuilding and construction, and then there’s some public sector construction as well. We went it from really hot to not hot, and it was a problem. So, yeah. And then, I’d say the last thing, and this is sort of an obvious one, is too much financial debt. Especially, I would say– I own a couple things that have some debt on them. But if the debt’s not structured right– there’s some companies that need debt just to make it through a cycle or to operate, I really try to avoid that.

Some companies that use that to make their returns to equity holders a little better, I mostly avoid that, unless I’m really, really sure that the company’s going to be solid. And even then, I want to make sure that it’s termed out and there’s no new term maturities. And usually, that it’s a good organic grower because a good way– if you have good organic growth and then you have some debt, your debt to income ratio will drop over time. If your earnings go down, then you’ve got a problem. So, I do that in limited certain circumstances. But most of the time, I’m trying to avoid things with too much financial leverage as well.