Perspective

Four Pillars – The TDM Investing Framework

At TDM, investing is a team sport. As our investment team grew over the first 10 years from two people to eight, conversations about businesses and investment decisions became less clear and less productive. In circa 2015, it became clear that we needed a more definitive common language and methodology to assess the quality of the businesses we might invest in.

We called this common language and methodology our ‘Four Pillars’.
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Why We Needed the Four Pillars

Assessing the quality and value of a business is highly subjective in nature. As an investor, the quality of a business always needs to be considered compared to the price you are paying for it. There are always incredibly high-quality businesses selling for expensive prices. There can also be low-quality businesses selling for cheap prices. 

These subjective and relative conversations are the types of discussions we have at TDM every day. But, given their nature, it is easy for these types of discussions to deteriorate in quality and productivity. They can degrade into unresolved opinion-sharing quickly, especially around contentious topics.

Our Four Pillars were implicitly our investment framework prior to 2015 – the big-ticket issues we cared about in assessing an investment opportunity. But, as the team size grew, the weakness in our process became apparent. More people around the table. Varying levels of experience. Different backgrounds. More points of view. Conversations became less productive. We would have long debates about ‘the quality’ of a business without being precise enough on the points where we disagreed. We needed a much clearer, unifying framework and language to harness the power of the diversity of views.

It was around that time we developed our Four Pillars framework. It was designed to help us break down the complex problem of assessing business ‘quality’ into its component parts. It also enabled more precision around working out where the differences of opinion are and, consequently, allowed for a much better conversation. The framework transformed team debates and discussions into a much richer, granular conversation. It also helps us control the influence of biases and noise in decision making, both of which can lead to wrong conclusions, and ultimately bad decisions. Most importantly a clear framework helps us to make decisions that more clearly balance the risks and rewards. And in TDM terms, it helps us to ‘Align and Commit’ as a team to any decision we make. 

Overview of Our Four Pillars

Assessing business quality involves the first three pillars—Growth Opportunity, Structural Competitive Advantage and People & Culture. Assessing a business as an investment opportunity requires all four—the first three, plus the Valuation pillar. A high-quality business can be selling for a very high price which means it will probably not be a great investment.

When TDM started, the quality of businesses we were willing to invest in was much lower. Back then, we were happy to buy lower-quality businesses for very cheap prices. As the years rolled on, our quality threshold has consistently gone up. The ‘why’ behind that is a whole other topic. But suffice to say, nowadays we only invest in what we consider to be world-class, category-leading businesses or very good businesses that are on the trajectory to be world-class and category-leading.

All pillars are equally important to us. In fact, they are all tightly intertwined and need to be viewed as interdependent variables. For example, the quality of a business’s Growth Opportunity is dependent on the ability of the organisation to build a Structural Competitive Advantage and execute on the strategy (People & Culture).

Despite the equal importance of the Four Pillars, the amount of time we spend on each pillar can vary significantly. At a high level, the vast majority of our time (95%+) in due diligence pre- and post-investment is spent on the first three pillars. 

Finally, we care deeply about People and Culture. We believe it is the most important competitive advantage over the long term. It has been the differentiating factor between our good and great investments and the key reason for our most disappointing investments.

Pillar 1 – Growth Opportunity

We break this down into four clear vectors:

  1. Total addressable market (TAM): The current size and future expected growth of the market for which the company has products or services today.
  2. Experience market fit: To what extent the company’s product(s) or service(s) experience satisfy the addressable market. The concept of ‘product market fit’ is used much more broadly. We prefer ‘experience market fit’ as we believe the entire customer journey from the first interaction with a brand to the after-sales service is critical to consider.
  3. Friction of adoption: To what extent there is friction in adopting a product or service. For example, is there a big upfront cost to buy a product? Or is there significant organisational change required to adopt a new service?
  4. Vitality: Inspired by BCG’s work on the topic, this is probably the component of Growth Opportunity that people are less familiar with. We define it as the extent to which a company can successfully extend its TAM over time by developing new products and/or services. For example, Apple started with the personal computer, then the iPod, iPhone, iPad, App Store, etc.

Similar to the Four Pillars themselves, these components of Growth Opportunity are interdependent. Many companies have a large TAM but don’t nail the experience market fit. Some can have a large TAM and possess experience market fit but friction of adoption is too high to truly capitalise on the growth opportunity.

In TDM’s case, we care about all four components, but Vitality tends to be the most important characteristic for driving sustainable, long-term returns. We have invested in companies with relatively small TAMs but the team develops incredible Vitality, opening up new market opportunities and extends the growth runway well beyond our original assessment. There is no better example of Vitality than Amazon which as we all know – and it is hard to believe – started as a simple online bookstore…

Pillar 2 – Structural Competitive Advantage

We call this pillar structural competitive advantage as we see competitive advantage as a structure that can both strengthen or decay.

While it is best to read the book, Helmer has also recorded many podcasts on the topic that are rich in insights and case studies. With this in mind, it is only worth briefly outlining the 7 Powers here and touch on the importance of defining what ‘power’ actually means.

Firstly, ‘power’. This is a critical concept because for any competitive advantage to be meaningful it has to have power. Helmer describes power as giving a business the ability to generate ‘persistent differential returns’. Examples include charging higher prices, having lower costs or lower investment requirements. Helmer calls these the ‘benefits’ of the power. There also must be some obstacles to competitors replicating them easily. Helmer calls these the ‘barrier’ of the power. It must be durable and not fleeting.

When applying the 7 Powers below to any business, the key questions are: ‘Is there a significant benefit derived by the company in having the power?’ and ‘Is there a significant barrier for competitors because of the power?’

This is a competitive advantage most would be familiar with. It is defined by Helmer as the quality of declining unit costs with increased business size. This can lead to higher profitability, more competitive pricing and increased market share.

The barrier for competitors is the large investment or losses required to build the infrastructure or technology to get to scale economies, therefore becoming very unattractive for them to try.

Costco is a wonderful example of scale economies. It uses massive scale with huge warehouse stores and its membership program to drive the lowest prices. Its gross margins are about half of its competitors.

This one is a little more complex than some of the others. So much so, we have produced a video for portfolio companies further exploring our views. 

In its purest form, network effects occur when the value of a product to a customer is increased by the use of the product by others.

Networks are difficult to build and maintain, especially in industries where establishing critical mass is challenging. The cost/benefit therefore is unattractive to competitors attempting to gain market share.

Networks can come in many forms, be it direct networks (WhatsApp), two sided (Ebay or other marketplaces) or hybrid (Facebook).

You’ll tend to see this power in earlier stage businesses and it is often the most disruptive power to industry structures. It occurs when a newcomer adopts a new, superior business model which the incumbent does not mimic due to the anticipated damages to their existing business. The business model counter-position allows for lower costs or the ability to charge higher prices (the benefit). The incumbents are typically unwilling to respond to the disruption caused by the new business model as it would cause damage to their existing business (the barrier).

The classic example is the Blockbuster versus Netflix battle in the 2000s. Blockbuster was the giant incumbent with $6bn of revenue renting videos from its thousands of stores. Half of its revenue was derived from late fees. Netflix came along with mail-order DVDs, no stores and no late fees. Blockbuster was too slow to react—probably in large part because of the fear of losing its late fees revenue. Blockbuster subsequently went broke in 2010 and Netflix has flourished (and shown incredible vitality in doing so!).

They are usually most relevant to more established businesses and can be incredibly powerful. Switching costs refer to the costs incurred by customers when switching from one product or service to another. The true benefit is the ability to increase prices or upsell to a captive customer base. High switching costs can create customer lock-in and reduce churn, leading to greater customer loyalty and recurring revenue. This power forces competitors to either have a 10x better product or be willing to engage in significant pricing discounts.

At a personal level, think about moving from a Microsoft PC laptop to an Apple device. At an enterprise software level, moving off a system of record or source of truth – there is a reason Salesforce has been able to grow at such a high rate for such a long period of time. 

Probably the power most are familiar with, yet remains the most difficult to gauge in terms of magnitude and durability. A strong brand does not mean necessarily that the business possesses the brand power to charge higher prices for an equivalent good.

Great, enduring brands that do possess this power take a huge amount of time to build, and can only be created with consistent actions throughout this duration. We often talk about ‘drips in the brand bucket’ taking decades to fill.

A classic example of brand power is Tiffany’s ability to charge higher prices for essentially the same commodity (in its case, diamonds or gold) due to the brand association and overall customer experience. 

This is probably the rarest power for businesses in most industries, but incredibly valuable. It is defined as the preferential access to a coveted asset that can independently enhance value. If you hold the asset, by definition it is exclusive and your competitors do not.

Common examples would be mining tenements or patent rights in technology for the pharma industry. In the modern world of AI, it would be large proprietary data sets to train models.

Process Power can be the most challenging to define, understand and identify. Helmer describes it as embedded activities within an organisation that enable lower costs or superior products. It is the cumulation of countless small and large changes, iterations and improvements to process over time. These can’t be replicated by competitors easily. To have real power, the processes need to have been developed over many years and can only be matched by an extended commitment.

A great example of this power in action is SpaceX. 

Putting This Into Practice:

As a team, we rely on the 7 Powers Framework in both assessing potential opportunities as well as evaluating our current portfolio. While determining the initial competitive advantage and its relative strength is certainly always hotly debated, given our long-term investment horizon, we are often more interested in direction than the magnitude. We know over this horizon competitive dynamics are fluid, and we need to be aware of change of directions over time. This is particularly pertinent for our current portfolio – when presented with new information (usually around the reporting of public companies), we will revisit the framework and debate accordingly.

Below is a real example from the initial diligence of a private vertical SaaS company we recently conducted. While crude and perhaps not perfectly in line definitionally with how Helmer may intend, the framework provides a tool to focus discussion and debate.

Pillar 3 – People & Culture

We believe that Helmer is actually missing one power – People and Culture. We break this out into its own pillar (given its importance) to assess and debate as a team. We define it as:

The embedded culture within an organisation that enables structurally lower costs or consistently superior products or services. 

It is similar to Process Power in that it is the culmination of countless iterations, improvements and adaptions over time. It is extremely difficult or even impossible to be replicated by competitors. To have real power, the culture needs to have been developed over many years and needs to be enduring. 

TDM was built on the foundation of Buffett’s and Munger’s investment philosophies. But we have come to disagree with Buffett on one idea; if you combine a poor business with a good manager, it is the business that maintains its reputation. This is no doubt true in many instances. However, we have seen great leaders build great businesses despite the business being much lower quality at inception.

We have one business in our portfolio, Mineral Resources, which we have owned for 18 years. It has returned 100x our money. It was a relatively low-quality business when we first invested in 2005 in one of the toughest industries in the world. It has grown to be an outstanding business with a wide moat and a great Australian success story. How? We believe the foundational and durable ‘power’ is its People and Culture.

Mineral Resources has proven over the last 20 years as a listed company that its People and Culture power has resulted in structurally lower costs and lower investment requirements (clear ‘benefits’ as required by Helmer) and time has also shown that competitors have been unable to replicate the power (i.e. a demonstrable ‘barrier’).

We have previously written blogs on how we assess culture, as well as what we think makes a great CEO.

Ultimately, we believe a great culture is defined by a great leadership team, and we are constantly and closely analysing data points that both enhance the conversation as it relates to both the character and competence of the leaders of a potential or current portfolio business. 

Pillar 4 – Valuation

All the qualitative due diligence we do on the first three pillars is to answer two questions:

  1. Is the business of sufficient quality for us to own?
  2. What is the fair value of the business?

Answering the second question is our fourth pillar. It is the quantitative outcome of all of the qualitative due diligence. Whilst we only spend a proportionately small amount of time on this pillar versus the others, coming up with our estimate of fair value is the reason for spending so much time on the others. They are the inputs. Valuation is the output. It’s akin to Albert Einstein’s adage: if he had an hour to solve a problem, he would spend 55 minutes thinking about the problem and five minutes thinking about the solution.

Valuation First Principles

The maxim ‘simple but not easy’ is very much applicable to valuing a business. The simple truth is: the value of a business is the sum of its future free cash flows (FCF) discounted back by the time value of money.

If both of these two concepts are relatively ‘simple’, why isn’t valuing a business ‘easy’?

The problem is – no one knows what the future cash flows will be. The purpose of spending so much time on the first three pillars is to come up with an informed view of the range of likely outcomes for the future FCF of the business. This is the hard part!

Three Key Concepts for Valuing a Business

The three key concepts to consider when valuing a business are its ‘true value’, its ‘fair value’ and ‘margin of safety’.

  1. True Value: If you had perfect foresight into the future, you would know the future FCFs of a business and, therefore, its true value. However, as far as I am aware, not many people have this ability. In fact, the future is uncertain. There is an infinite range of outcomes that could play out for any business – from really good to really bad. That introduces the next concept…
  2. Fair Value: The concept of fair value captures the fact that the future is uncertain. Given the uncertainty of the future FCFs of a business, what’s the ‘fair value’ a reasonable investor should be expected to pay for a piece of ownership at that point in time? Fair value isn’t a precise number. At TDM, it is usually a range of plus or minus 10%. The fair value of a business can change over time, up or down, depending on the future prospects of the business.
  3. Margin of Safety: These are the three most important words in investing. Occasionally we will invest in wonderful businesses at a fair price. We will do this when we have high conviction that the fair value will increase at a rapid rate, 25%+ per annum, over the next 5-10 years. But for the most part, we will look to invest in wonderful businesses at a cheap price – a price that gives us a margin of safety in case we get something material wrong to the downside. This does two things: (1) it limits the losses when we do get things wrong and (2) when we get things right, it supercharges our returns.

This video describes how we think about fair value and margin of safety at TDM.

Whilst the definition of the value of a business is its discounted future FCFs, on a day-to-day basis we much more freely use valuation heuristics (short-hand approximations) to discuss the fair value of a business, be it a P/E or EV/pre-tax earnings or revenue multiples.

Applied to our Portfolio

Listen in as Investment Team members Ed Cowan and Fraser Christie share how the Four Pillars apply to two of our portfolio companies: Rokt and Guzman y Gomez.

About the author

At his core, Hamish loves helping people create futures they never thought possible. As a coach, mentor, and co-founder of TDM Growth Partners, he brings experience from multiple top-tier investment firms as well as from his hiatus as a school guidance counsellor.

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