The Quality Series · part 11 of 13
The best entry points come when a great business stumbles. The hardest judgement is whether the stumble is temporary or permanent.
Nobody has a crystal ball, so this is a judgement, and I will sometimes get it wrong. The primary question I ask myself is whether the characteristics that made it a quality business in the first place are still intact: the predictability, sustainability and linear growth of its free cash flow per share, without a material loss of margin or market share, or any weakening of the balance sheet. If they are, the setback is a temporary one and the market is likely misreading the situation. In that case, armed with conviction in my thesis, I see a falling share price as a chance to buy more. If, however, the thesis has been damaged, or the business has simply become too hard to project, I would rather stay away.
In 2018 Lam Research was being sold with the whole semiconductor industry. Memory makers were cutting back their spending, Lam had guided lower for the coming quarter, and the shares had fallen by about 40%. The market was treating it like a chip maker, and so as cyclical as the boom-and-bust memory companies it sold to, such as Micron. That was not the case. Its services business, covering spares, upgrades and consumables and then a quarter of revenue, was high margin, far less cyclical, and grew with equipment that lasts around twenty-five years. That made Lam much more stable than a typical semiconductor stock.
That was my variant perception, the point where I differed from the market: Lam was an equipment maker, not a chip maker, and did not deserve to trade at about five times EBITDA (operating profit before depreciation). The evidence was all in public filings, and the two charts below show it. I also tested the one risk that could have made the problem permanent, asking the leading analyst covering the sector whether a competing technology threatened Lam’s equipment. It did not; the two were complementary.
Gross margin, 2013–2018: Lam held a tight, gently rising band while Micron, its customer, swung from about 20% to 33%, back to 20%, then to nearly 59%.
Operating margin, 2013–2018: Lam’s rose every year, from 3% to 29%, while Micron’s went from about 3% to 19%, down to 1%, then up to 49%. Steady against boom and bust.
Coach, in 2013 and 2014, was the opposite case. In 2013 the numbers still looked healthy: cash flow was strong and sales were still growing. Then gross margin, the share of each sale left after the cost of making the goods, fell from about 73% to under 69% in a single year. The questions on the earnings calls showed why: sales were being held up by pushing more product through the discount channel. An aspirational luxury brand cannot be discounted harder and harder without brand impairment, and that damage is very hard to undo.
In both cases, the answer was there for anyone willing to look beyond the headline numbers. It was in the filings, on the earnings calls and in what management was saying. The job is to do that work, and then decide whether the setback is temporary or a permanent impairment.
Next: when I sell — two reasons, the warning signs, and where macro fits.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
- Part 5: The secret sauce
- Part 6: Why return on capital decides it
- Part 7: A moat is the power to raise prices
- Part 8: Three engines, and the people driving them
- Part 9: What I won't own
- Part 10: Am I overpaying?
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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