Part 3 – Drivers – The Where, as in “Where to focus attention and resources”
 
In Part 1 and Part 2, we addressed creating a Vision and a Strategy to grow a business.  In Part 3, we will address the Drivers to grow a business.

What are drivers?  A simple, important yet challenging question as there are many potential answers.  In our experience, drivers are the parts of the business that a management team has control over, when managed effectively, will deliver the greatest impact to the business’ profitability.  It’s the Where to focus time and resources to have the greatest impact.  Often it is the How behind strategy’s How. 

Part 2 – Strategy – The “How,” as in, How do I execute my vision?
 
Strategy – strategy, as a concept, carries a sexiness to it.  It conjures images of intellectual battling, thinking moves ahead and out-smarting opponents.  Companies and governments pay top dollar to premium consulting firms, such as McKinsey, Bain and the Boston Consulting Group, to help them devise the appropriate strategy. 
 
Yet we would argue that the process of building a growing company is comparable to that of constructing a building – if the vision is what the building will look like when completed, the strategy is the architectural blueprint of how it should be constructed.  Strategy needs to serve the vision, not lead the discussion.
 
The Harvard Business School professor Michael Porter noted that a company’s strategy should be tied to either 1) cost leadership, 2) differentiation or 3) focus in order to develop a competitive advantage relative to its competitors.  Without one of these three positionings, it is difficult for a company to earn profits greater than the industry and/or its peers.  A CEO/owner needs to determine which path to head down that would most likely reflect the previously defined vision.

• Cost leadership – providing a product/service at a lower cost to a customer.  This enables greater profit generation as the company can charge less for its product/service while maintaining margins and sell more products/services or price at the same level as competitors but make more money for each product/service sold.  The challenge is that a company that pursues cost leadership must be structured differently than competitors – we have seen this most often in a company having better access to a critical input/resource (e.g. a mining company closest to a customer), with lower cost of distribution (e.g. GEICO and its direct sales model) or scale in production (e.g. Intel and chips).

• Differentiation – this is a focus on devising a product or service with a different set of attributes that better match what a target customer segment desires.  Frequently this enables a company to charge a premium for its product/service, such as through the trust that a brand provides.  For example, consumers are willing to pay more money for a commodity product because it arrives in a light blue box (Tiffany’s for jewelry) or tools because they come with the label Snap-On. 

• Focus – is the ability to limit a product/service to a particular customer segment and to serve it more effectively by developing internal capabilities that better enable the company to satisfy the customer demand.  A classic example is Southwest Airlines that created a business model around a customer segment that was highly price sensitive – this included avoiding hub-and-spoke networks in favor of point-to-point routes, standardizing on a specific airplane type to reduce operating expenses and working capital needs and avoiding the traditional distribution channels.  Another example of focus is the aerospace company Heico, which has concentrated its business on aftermarket parts that cost less to its airline customers. 

“How do I grow my business?”  It’s one of the most fundamental questions that a business owner or chief executive considers; it can also be one of the most confounding given all potential answers.  At its core, there are questions of whether to:

• Do more of what a business is currently doing
• Find new customers
• Enter new geographies
• Develop new products/services

All of which may require additional expenses before revenue comes in the door.  As a result, we have found that many business owners and CEOs tend to be more reactive to the existing market rather than proactive in deciding where to allocate resources for the greatest growth. 
 
In his seminal book, The E-Myth Revisited (Amazon here), Michael Gerber popularized the importance of “working on the business, not in the business.”  The idea is that business leaders need to step out of the day-to-day managing of the operations, which are often reactive, and devote time to thinking through what needs to be accomplished to develop a growth engine. 
 
For example, at ValorBridge, we work with our CEOs on developing “VSD Plans.”  VSD plans define the Vision – Strategy – Drivers for a business so that a growth path for the medium to long term can be charted.  Or, as we consider it, if you don’t know where you’re going, how will you get there?
 
We actively work with our business owners/CEOs on answering the question “How do I grow my business over the next 10 years?” using the VSD plan framework.  Digging into the three VSD components
 
Vision – Vision is “The What,” as in, what do we want to be in 10 years? 
 

In the first two pieces in 3 Keys to What We Look for in an Investment (Part 1, Part 2), we highlighted what it is about the business and people that are critical to what we look for.  In this post, we’ll focus on the third – valuation, or the price we pay. 
 
Price
The third of the 3 Keys We Look for in an Investment is price paid relative to what we believe the business will be worth in future years, typically 5-10 years.  We measure whether the price is right by focusing on the internal rate of return (IRR) of the cash we invest over our long holding period.
 
No valuation tool is perfect and we attempt to keep our valuation approach simple.  What we like about IRR is that there are only 3 variables we must make assumptions about to determine whether the valuation to buy an ownership stake in a business makes sense to us.  Those 3 variables are –

1. How fast the free cash flow of the business will grow during the period of our ownership?
2. How much of that free cash flow will be distributed back to the owners vs. how much will be retained and reinvested in the business?
3. What a reasonable multiple of free cash flow in a normal environment a business with this quality, free cash flow characteristics and growth opportunities would be valued at by a rational private investor?

From our assessment of these three variables, we are able to estimate an IRR based upon different prices paid today for the business.  If the IRR is high enough to meet our standards (i.e. above our opportunity cost), then it is an investment that has a compelling price.

In Part 1 we addressed the first of the 3 Keys to What We Look for in an Investment – the structure and nature of the business.  In this post, we’ll focus on the second, the people who will be managing the business.

People
The second of the 3 Keys to What We Look for in an Investment is management.  It is a cliché, but there is often truth in clichés – people matter.  This particularly true for us at ValorBridge as we look to have the executives who build our operating companies as long term partners with significant personal net worth invested alongside us.  We are looking for those with the mindset of owners, not managers.
 
Which begs the question, what is an owner’s mindset?

1. Thinking about what are the critical attributes to focus on in order to build a business for the next 10-20 years, not the next 1-2.
2. Making decisions that optimize the long term over the short term.
3. Understanding the importance of culture to the sustainability of growing a business.
4. Frugality.
5. Understand the power of incentives to drive results.
6. Approaching decisions from “opportunity cost” and “unit of effort” perspectives

An opportunity cost perspective is one where a decision is evaluated relative to the gain from an alternative choice that is unattainable once the decision is made. 

A “unit of effort” perspective is “how much more product do I have to sell at my current gross profit level” to justify an expense.

We are seeking partners who are business builders – this means they are willing to slog through the challenges that arise when building long term

• We prefer to retain management, so we are looking for managers who want to roll most of their ownership into the business as part of our investment
• We want managers who think about a culture where their employees can grow, provide incentives and measure productivity
• We seek partners who are open-minded to considering advice from their partners.  To quote Ryan Holiday, “Ego is the Enemy.”  We look for people who are humble enough to ask for help and perspective as we have great depth of entrepreneurial and operating experience on our investment team.  These experiences is a core differentiator for ValorBridge.

Hindsight provides valuable examples that can be role models.  We’ve spent time recently evaluating the history of Amazon after reading Brad Stone’s outstanding The Everything Store.  In his first shareholder letter in 1997, Jeff Bezos followed Warren Buffett’s lead in Berkshire’s Owners’ Manual [pdf here], with a candid overview of his perspective in building Amazon [pdf here].  It’s a great read.  

To be continued in 3 keys to what we look for in an investment, Part 3

VB Blog Post – 3 Keys We Look for in an Investment
 
In complex pursuits, it helps to simplify.  At ValorBridge we reduce our investment opportunities down to 3 Keys We Look for in an Investment – Business, People and Price. 
 
"Business, People, Price" is borrowed from the writings of Fielder Capital and the legendary investors Southeastern Asset Management (a nice profile from Value Investor Insight here).
 
Let’s start specifying what we focus on in the 3 keys that we look for in an investment in part 1 of our 3 part series.  We believe that the "BPP" framework can be applied to investments in public and private companies.

Business
Our focus is on the attributes of the business – the business model, how the company makes money, how the industry is structured, is the industry in secular growth/secular decline/cyclical and are the returns on capital sufficiently high to meet our minimum standards.  A solid understanding of these attributes will help visualize what the next 5-10 years of an industry and potentially our investment will look like. 
 
The equation that we are solving for is how large can this business be in 5-10 years.  We are seeking businesses that can double in size every 3-5 years for the foreseeable future. 
 
This is a reflection on how much free cash flow the business can generate and the opportunities to reinvest those future free cash flows either in organic growth or tuck-in acquisitions. 
 
In terms of how much free cash flow a business can generate, that is a reflection of how much free cash flow can be produced relative to the tangible assets in the current business.  The higher that ratio, the better.  This tells us how good a business is today and we can compare this ratio to that of prior years to determine the consistency of free cash flow relative to the tangible assets that have been invested in the business.  The more consistent this ratio, the more conviction we have about what the future may look like.
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