[vc_row equal_height=”yes” row_type=”row” type=”full_width” text_align=”left” css_animation=”” el_class=”top-round deskpadd process-header” css=”.vc_custom_1506772833548{padding-bottom: 40px !important;background-color: #ffffff !important;}”][vc_column][vc_empty_space height=”60px”][vc_custom_heading text=”We build a lot of models: hundreds every year” font_container=”tag:h2|font_size:46|text_align:center|color:%2324323f|line_height:46px” use_theme_fonts=”yes” el_class=”uppercase antonio heading”][vc_empty_space height=”30px”][vc_row_inner row_type=”row” type=”full_width” text_align=”left” css_animation=””][vc_column_inner width=”2\/3″][vc_column_text el_class=”modal-text” css=”.vc_custom_1510531593103{padding-right: 0px !important;padding-left: 0px !important;}”]Our investment process is both qualitatively and quantitatively intensive. Throughout the course of a year we look at hundreds of companies. Most of them receive only a cursory look \u2013 we don\u2019t like the business, the valuation is too stretched, or we simply have no insight into the business. We usually glance at them and move on. But if we really like the business and\/or its valuation, we build a model.<\/p>\n

Often, just from a cursory look we know that the stock is not cheap enough, but if we really (really!) like the business we\u2019ll invest the time to model it so we can understand it better and set a price at which we want to buy it (and then wait).<\/p>\n

We build a lot of models: hundreds every year. Building models is important for us. Models help us to understand businesses better. They provide insights as to which metrics matter and which don\u2019t. They allow us to stress test the business: we don\u2019t just look at the upside but spend a lot of time looking at the downside \u2013 we try to \u201ckill\u201d the business. We look at known risks and try to imagine unknown ones; we try to quantify their impact on cash flows.<\/p>\n

This \u201ckilling\u201d helps to us understand how much of a discount (margin of safety) we should demand to what the business is worth. By applying this discount to fair value, we arrive at a buy price. For every stock we buy we probably look at a few dozen (at least).<\/p>\n

We usually try to drill down to essential operating metrics. If it is a convenience store retailer, we\u2019ll look into gallons of gas sold and profit per gallon. If it is a driller, we look at utilization rates, rigs in service, average revenue per rig per day, etc. If it\u2019s a pharmaceuticals company, we\u2019ll have revenue lines for each major drug it sells and model the company for the eventuality that patents will run out (Revenues usually decline 80-90% when a patent expires).<\/p>\n

We looked at American Express before the crisis, which gave us insight into inflated profit margins of the financial sector, and thus we avoided for the most part the carnage in the financials. We thought American Express stock was not cheap enough at the time, but we learned that Amex\u2019s high swipe-fee revenue provided an important buffer to help the company absorb significant loan losses. Amex could have withstood over 10% loan losses on its credit card portfolio and still have remained profitable. This insight gave us the confidence to buy Amex during the crisis.<\/p>\n

We usually build two type of models. We start with what we call the \u201ctablecloth\u201d model. This is a very detailed, in-depth model that zeros in on different aspects of the business. But the risk we run with a tablecloth model is that we get lost in the trees and forget about the forest.<\/p>\n

This brings us to our \u201cnapkin\u201d model. It\u2019s a much simpler and smaller model that focuses only on the essentials of the business. It is easier to build the tablecloth model than the \u201cnapkin.\u201d If we can build a napkin model, that means we understand the drivers of the business \u2013 we understand what matters.<\/p>\n

Models are important because they help us remain rational. It is only a matter of time before a stock we own will \u201cblow up\u201d (or, in layman\u2019s terms, decline). We can go back to our model and assess whether the decline is warranted. The model then gives us the confidence to make a rational (very key word) decision: buy more, do nothing, or sell.<\/p>\n

Models are frameworks that help us think about the businesses we analyze. We are always aware of John Maynard Keynes\u2019 expression, \u201cI\u2019d rather be vaguely right than precisely wrong.\u201d Models are not a panacea, but they are an important and often invaluable tool. However, models are only as good as their builders and the inputs to them.<\/p>\n

Side note: As an advisor, I feel it is one of my great responsibilities to be an honest and clear communicator. There is an asymmetry of information between us and our clients. We have invested weeks and months of research into the analysis of each stock; therefore, we have a good idea what each company is worth. Our clients have not done this research, and they should not have to \u2013 that is what they hired us to do. This is why we pour our heart and soul into our quarterly letters \u2013 we want to close this informational gap and so we try as hard as we can to explain what we think the companies in our portfolio are worth. Our letters are often 15-20 pages long.[\/vc_column_text][vc_empty_space height=”50px”][\/vc_column_inner][vc_column_inner el_class=”form-column” width=”1\/3″ el_id=”stikuj”][vc_single_image image=”16421″ img_size=”full” qode_css_animation=”” el_id=”modalFormBg” el_class=”modalFormBg”][vc_custom_heading text=”How we do turn our principles into an investment process?” font_container=”tag:h3|font_size:23|text_align:left|color:%2324323f|line_height:32px” use_theme_fonts=”yes” el_class=”form-title”][vc_column_text el_class=”modal-text”]Check out the 6 Commandments of Value Investing, Vitaliy\u2019s detailed look at value investing fundamentals and how they\u2019re turned into a real-world investing process at IMA:<\/p>\n