10 factors to judge the quality of a business

From an investing point of view, “high quality” is subjective. Subjective to your risk appetite, time horizon and your own biases. But it would be fair to say that, a company that can assure a certain amount of return over a period of time can be considered as high quality. The quality coming from the certainty to which we can look into the future.

That said, there are countless ways in which the future can unravel. Hence, we need to have a margin of safety in our thesis about a company and it’s future.

The analysis can be divided into a qualitative and quantitative parts.

The 5 main qualitative perspective are

  1. How does the business make money? What is it’s business model? What are the core features of the business that customers are paying continually paying for?
  2. Does it have a competitive advantage? Will that advantage strengthen or weaken as the business expands?
  3. Are they innovating with changing times? This shouldn’t be read as, are they jumping on the hype wagon every couple of years to prop up investor sentiment. Rather, is the business having a good balance of exploring new avenues and maintaining it’s core business.
  4. What are the major risks for the business? Are there any other businesses that can take its place easily?
  5. How are the people running the business? This is hard to judge without having any kind of contact with the management. Have they been on the news lately? And was it for a good or a bad reason?

The 5 main quantitative aspects to figure out are

  1. How has the returns been historically? What drove them over the years?
  2. What are the costs for running the business? Are the costs growing or dropping and why? How will the costs change as the business expands?
  3. How much debt does the company have? Is it good debt or bad debt? Will it be able to payoff most of it’s debt if an adversity occurs?
  4. What are the margins in the business? How much pricing power do they have?
  5. These metrics alone are not that helpful in itself. The key step here is to compare it with that of it’s competitors and against the backdrop of the industry the business is in.

Greenfield vs. Brownfield

Greenfield and Brownfield investments are ways in which a company can expand into other countries. They are 2 different types of foreign direct investment.

Greenfield investment is when the company builds necessary resources from scratch in the new country. This could include building new plants, distribution centres etc. Greenfield option makes more sense if the business operations are unique and custom made for the company. It is more risky as it is the more expensive option of the two. If the operations are near one-of-a-kind, it would be cheaper to build it from scratch and operate it like existing parts of the business. A good example of this is the Gigafactory tesla is building in Germany.

Brownfield investment is when the company relies on acquiring existing companies and facilities. This makes sense when business operations are rather existing. In some cases, facilities are leased instead of purchasing. This could be an interim solution before companies can take the leap to build their own facilities in a new market.

This way of thinking can be applied to personal projects as well. Would it be easier to update your personal website by making tweaks or to rewrite it from scratch.

The Business of Spawning

Every successful business has done at least a few things right if not many. They have to find a product or service that they are good at. Possess some characteristic that differentiates them from their competitors. Find a market to sell to. And be profitable at the same time.

Businesses in itself are a beast of an animal.

Then there is this special breed of businesses. That can not only do all of the above, but can spawn off other businesses at the same time. By spawning off, I don’t mean extending an existing product line or expanding into nearby verticals. But building entities that are not in their primary field of expertise and building them into independent businesses.

Amazon is a good example of this. Starting from selling books online and expanding that to other verticals is quite logical. But the spawning off of businesses like Amazon Web Services, Amazon Prime, Kindle, not quite. But that did not come for free.

There were 2 major factors that enabled them to do this. Access to capital and ideas for businesses that have the possibility to return high ROI. Internet based businesses have a very high ROI, given the low investment required.

Having both access to capital and serially trying one idea after an other is a deliberate effort for sure. And the more tries you get, higher the chances of success.

Pricing Power

Pricing power allows businesses to price their product or services higher than the rate of inflation and that of the competitors without reduced sales. Pricing power can come from a few ways. A very high quality product. A patented efficiency or feature of convenience that competitors cannot match. Or when a business is operating as a monopoly and barrier for entry is quite high.

A key indicator of the strength of a business is its pricing power That said, it does not mean that if a business does not have good pricing power it is a bad business. However, the opposite has a much higher probability to hold true.

In some businesses untapped pricing power is a good indicator that it is mispriced by the market. To reach such a conclusion one must have an idea on the costs and margins of that particular business against the backdrop of it’s competitors.

High pricing power can materialize as high ROIC over the years. But keep in mind that, high ROIC can be a result of many other factors. Operating and gross margins also provide an indication of the pricing power a company has.

Genetically Engineered Products

All products that are aiming for a sizable market has to be generalized to some extent. To make it efficient to create, distribute and market the product it was essential that the product appealed to the masses. Having minimum variability was key to optimise the business as a whole. Take Apple for example, Back in the 2000’s they were successful partially because of their relatively small product line. Less options for the customers to choose from but why would they need options if the product was just so good.

On the other end of the spectrum are products that are bespoke to an individual. A good example are tailored outfits. By definition there is a need for the product to be unique and match a person’s style. Usually these kind of businesses rely on physical and more tangible parameters of a customer to make a customised product. With the reduced cost of doing a DNA test, there is a new vertical altogether that opens up a possibility for a business to create hyper-customized products.

23AndMe is a company that helps you map out your ancestral lineage using a sample of your DNA. As more and more customers use the service, the better their data and reach will become.

GenoPalate is a business that aims at creating a specialized diet plan based on your DNA. Based on the combination of genes that a person has, Genopalate can come up with an optimal nutritional plan. It can provide analysis on how our body digests various types of food and substances(caffeine, alcohol etc.).

Internet and Localization

What the internet together with the smartphone has now done is that it democratized accessibility. Any website, article, tweet, video, image, product, service on the web can be read by anyone in the world. But this has taken out the geographical localization from the experience of buying something or experience a product.

In most cases it is more efficient to just order for food in an app rather than to physically go to a restaurant and pick up an order. The same applies to e-commerce, flight and hotel booking etc. Businesses that rely on the hyperlocal aspect for its business still need a network of employees to run its operations. Whether it is a delivery/logistic arm of Amazon or distributed pockets of people who are ready to rent out a space to strangers.

The scalability of such systems on top of a stack like the internet is huge. Nothing new here. But what that means is that, for a given reward structure, a biggest fish WILL have to emerge in almost every pond. Not completely extinguishing it’s competitors. But leaving enough room for bespoke peers in the market.

An example is Amazon followed by all these niche e-commerce websites. Like Google followed by the rest.

Supply Chain Traceability

A supply chain is a system of activities that is required to convert raw materials to the final product spread across in time and geography. Traceability in such systems make it easier to understand what is happening at each step of the process. This is critical especially in the Food and Pharmaceutical industry, where they are trying hard to trace each component that goes into their products.

With better traceability, it will be easier to enforce regulations. Regulatory authorities can more easily make sure that there are no banned substances used in any product or if any banned processes were used.

From a business point of view, it will be easier to optimize value chains for each product and find possible synergies. Currently all businesses do this, but at a higher level. Not every company is interested in raw materials right from the ore to the form they use. But traceability would make it more transparent for businesses to see the history of each delivery and the complete chain.

Within the food industry, there is a growing need and market for products that are ethically sourced. Big companies want to be seen on the right side of history when it comes to sourcing from local farmers and institutions. Traceability in supply chains is one way to improve their overall brand image. For example, the Fairtrade initiative. Which is then used by downstream companies like “Ben & Jerry’s” who source cocoa, sugar etc. under this initiative.

There are a few ways traceability can been introduced to a supply chain. Subway has 98% of their products traceable by using barcodes. RFID tags, alphanumeric codes are possible solutions as well. Blockchain is a relatively new technology that is being used for this purpose. A distributed ledger that cannot be tampered with keeps track of the supply chain. And all stakeholders are free to check the validity of it themselves. A drawback with using blockchains is that these chains become stronger and more viable when the size of the information is huge. For smaller amounts of data, a centralized approach would suffice.

Usually supply chains include contracts between different parties right from the start until the product reaches the customer. Blockchain maybe is a more viable solution to manage these smart contracts in one of its ledgers. These agreements are usually repetitive in nature and can span across different geographies, time-zones, currencies etc. A distributed ledger in this case could act as a common protocol used by all stakeholders to manager and maintain contracts.

Unit Economics

Unit Economics is a neat way to look at the fundamental economics of a business. A sanity check. It starts with defining a “unit”. A “unit” could be a product sold or a customer acquired depending on the kind of business and business model. Unit economics would then describe how much value is created from this “unit”.

Unit economics help you understand how much has to be given to perform a unit transaction that is core to the business. Especially when analysing a business, unit economics provide a quick way to check the feasibility of the business. It would be quite clear if an insane amount of money has to be put into for acquiring one customer. Or if the charges on logistics were eating up too much of the margins.

The unit economics and it’s various components can be projected out in the future. This will give you a fair idea as to how the business would have to perform to stay solvent. Whether that is realistic or not is another question. Comparing figures in a per-unit basis eliminates the possibility of comparing different things all together. We do not want to compare apples to oranges.

An example of a unit economics for a restaurant would look like this. From a basic sense, a restaurant cooks food for their customers with a marked up price to earn a profit for the product(the meal) and service. So the margins of a restaurant meal would be the difference between the price of the meal and the cost that it took for the restaurant to make it. The cost can then be broken down into the hourly wage of the workers, the cost of running a kitchen, the cost of the ingredients etc. This would give us an idea as to how much would have to be spend and what each dish has to be priced to obtain a margin that would justify running a restaurant business.

Ultra-Niche

An ultra niche is a niche within a niche. A minority within a smaller group. The outliers of the pack. The internet makes it possible to cater to such ultra-niches in a viable manner.

A piece of software that solves a particular problem for 100 people. Only 100. They would be ready to pay for the product since it is the only product or the best product that solves their exact problem. The amount they would be willing to pay depends on 2 things. First, how much of a pain the problem is for them. Secondly, how much value can be created for our users by solving this problem. What “potential” is being unlocked by solving this problem and how big of a “potential” is that. It can be in the form of freeing up their time or helping them do something more efficiently.

If the problem is recurring, they would be willing to pay in a recurring way.

Finding the exact 100 people with this problem is the hard part. Maybe forums, reddit, fb groups, twitter all are ways to find people within a niche. Of which to filter again to find the 100 in our ultra-niche.

Super Apps

Super Apps, a term that became mainstream thanks to a 2015 podcast by Andreessen Horowitz. A super app is a closed ecosystem with multiple apps and services that work together seamlessly. They offer a wide range of options to users within this ecosystem.

WeChat is the classic example of a super app. WeChat started out as a messaging app. Which then branched out to be a social media app. Eventually, they integrated financial services that allowed users to send money to each other, order services, order in restaurants and use WeChat as a default payment method.

AliPay took a different path. They began as a payment app. And then integrated other features.

Why are they becoming more popular? From a user point of view, super apps can tie in different services and offer user experiences that other conventional apps just cannot. A single app is perhaps better at keeping the attention of the users. Less context switching.

Super apps by definition is a suite of apps. More often users can find features that they didn’t know that they wanted. It provides a good imperative to easily get hooked on these features simply because of its convenience. Super apps benefit from the amount of data it has access to. The users still only see one company and one set of privacy policy.

This is also a direct outcome of API’s fueling digital growth. Most companies would like to build a brand and business around a service or a product. Some companies are better off with just offering an API and letting other businesses figure out the rest of the value chain. Getting features/integrated to a super app is like getting featured in the front page of reddit, but for API companies.

Even though these kind of apps are most common in Asia, there is growing interest for super apps globally. Google is probably at the right place at the right time to capitalise on such a service. They already run a tight ship with their suite of apps. But packaging them into a coherent set of features of a super app might not be that far away.