Over a decade ago, investor Brent Beshore founded adventur.es, a firm that invests in family-owned companies. His aim is to cultivate portfolio of sustainable, boring, disaster resistant companies.
Here are some of the parameters he keeps in mind.
1. Determine intrinsic value.
Successful investing boils down to buying assets at a discount to intrinsic value. The greater the discount, the more likely the investment will perform. Benjamin Graham, the father of value investing, called this “margin of safety.” The concept is simple in theory and extremely challenging in practice, with the valuation process anything but straightforward.
Two educated, emotionally stable, and reasonable people can view the same information and come to very different conclusions. People weight information differently based on their preferences, values, and experiences. Some are comfortable tolerating certain types of risk. Predictions differ and forecasts can be wildly divergent. Those differences create the market.
I start by understanding what I call owner earnings, which I define as:
Owner Earnings = Net Income + Non-Cash Expenses (Depreciation, Amortization, Depletion) + One-Time Charges – (Maintenance Capital Expenditures + Working Capital Needs)
Said another way, owner earnings are the profits left over after necessary expenditures that owners can discretionarily spend, save, or reinvest. Blindly following the formula can easily provide false precision and a false sense of security. It’s merely a simplified starting point.
Valuation is a process that is best learned through experience and study, and each investor has his/her own method. It is hard and complicated. A business isn’t simply worth some multiple on its current cash flows; there are all kinds of other variables that go into building up to a number.
2. Look beyond the owner.
We acquire firms with $1 million to $10 million EBIT and a regional or industry-specific competitive advantage. In any given year, there are thousands of companies for sale in our financial size range.
When it comes to small businesses, most of the time it is pretty easy to see that there is nothing differentiated about the business. I mean, there would be a product market fit and they would be providing value to their customers. But most are an extension of the owner. There are businesses where almost all of the value is tied up with the goodwill of the owner. The questions I seek to answer are, is it solely the ownership that is driving the business? If not, then where is the advantage of the company?
Small businesses don’t stay small on purpose. So we try to comprehend why the business is smaller, and I don’t mean it in a derogatory fashion. I mean if a business is generating around $10-15 million but has been around for, say, 30 years, that is a question I would want answered. Why is it still small? Is it doing something wrong? Is it misallocating resources?
How much money do they actually make? What are the owner earnings? (see above point).
We once looked at company that was making $6 million a year EBITA, but the owners could really only keep around $2 million. That is not a fantastic number.
Look at earnings. Stability of earnings. Visibility of earnings. Future earnings. And how much of it is tied to the current ownership.
3. Culture is probably the biggest non-financial indicator.
As Peter Drucker once wrote, “Culture eats strategy for breakfast.” We like to say that culture is nothing more than what you reward and punish. We’re looking for cultures that respect employees as valuable partners, and not merely as faceless cogs in a system.
We love to see how conflict is handled, how decisions are made, and how new ideas get treated. Ultimately, the tone is set at the top, and so we spend considerable time trying to understand company leadership.
4. Search for boring businesses.
All businesses have a shelf life: Competitive advantages erode, economies cycle unexpectedly, and life happens. But there’s an interesting theory called the Lindy effect, which asserts that some things, like ideas or books, actually get more durable over time. The chances that Plato will still be read in a thousand years are higher than the chances that the latest management book will be. We think the same principle holds for certain companies. The longer they’ve been around and weathered storm after storm, the greater the likelihood is they’ll continue to operate.
Boring businesses endure because they consistently solve a meaningful problem and were patiently built over decades. Their clients, communities, and employees trust their reliability, integrity, and craftsmanship. They won't disappear with trends, or fads. The problems they solve existed two decades ago, and will exist two decades from now.
Boring businesses aren't stagnant; they're specialists. They’re not looking for quick PR hits, a flashy new product to “save” the company, or to make a move merely to create the illusion of progress. They are perfectly fine to do the same thing day in-and-out, refining their expertise, systems, and service. And, through that commitment to excellence they profit.
5. Get familiar with risk.
Everyone likes to talk about returns; but risk is of equal importance.
Risk is tricky. It’s always in the background and underneath the surface, lurking and waiting. Ignore it and you’ll probably be fine – until you’re not. And when that happens, watch out, you’re likely in a world of trouble. Embrace risk mitigation and your upside will necessarily suffer. Eliminate risk and you will get between almost nothing and literally nothing.
Risk is not uncertainty. It is not volatility. At its core, risk is the likelihood and magnitude of permanent loss. It is the probability of a collision between a detrimental event and a lack of planning, resulting in a permanently negative outcome of some potential size.
While returns are easy to measure, risk is elusive. Economists and financial gurus constantly attempt to quantify it, but its estimation is more art than science. If you took a piece of real estate and asked 100 investors to gauge the risk of owning it, you might get many of the same risk-related topics, but few, if any, would agree on a precise score. Risk represents a rough approximation because the permutation of each actor’s circumstances are indefinite and constantly changing. Plus, each participant’s actions influence the system’s outcomes. What is high-risk to one, may be de-risked to another.
The path to managing risk is to understand yourself, your situation, and the controlling factors that might lead to negative outcomes. The goal is to operate responsibly, allowing for enough risk to gain rewards, while not playing financial Russian Roulette. Think Goldilocks. Not too hot, yet not too cold either. But only you know the appropriate temperature.
The less risk equity investors feel, the more they’re willing to bid up assets and as long as everything is up-and-up, the game continues. Risk taking in good times leads to outsized returns. But assumption of risk alone won’t drive long-term gains. It results in an opacity between being lucky and being good, or what Nassim Taleb would call “lucky idiot” syndrome. Every bull market produces a class of lucky idiots who won (temporarily) for all the wrong reasons.
Elevated valuations, aggressive transactions, and a general feeling of financial FOMO (fear of missing out) should give you pause, lead you to take inventory, and provoke a plan for the future. Cycles happen and the good times don’t always roll. So when the music stops, or gets inaudibly quiet, how quickly and easily can you find your seat?
The most glaring source of risk I see time-and-again for businesses of all shapes and sizes is financial.
- How do you monitor and maintain cash flow?
- How have you structured equity and debt?
- What are the likely outcomes from growth or shrinkage?
Risk doesn’t only manifest in bad times. Loading a company with debt, maintaining small cash reserves, and not closely monitoring the results from the business’s trajectory can all prove disastrous.
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