“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the right one in your sweet spot.”
Warren Buffett is a big baseball fan, as am I, and he uses baseball analogies throughout his writings. He likens baseball to investing in the manner that we can take our time and don’t have to swing at every pitch.
Finding the best companies and waiting for our pitch remains one of the biggest challenges in investing.
Baseball scouts have long searched for five-tool players; they are the unicorns. Players who excel at all aspects of the game display such prodigious talents that they can’t miss. Players such as Willie Mays, Hank Aaron, Babe Ruth, and Barry Bonds come to mind as five-tool talents who went on to tremendous success.
The same idea can translate to investing. We can search for these five tool companies and, once we find them, take our swing.
In today’s post, we will learn:
- What is a Five Tool Company?
- What Are the Components of a Five Tool Company?
- Example of Five Tool Companies
Okay, let’s dive in and learn more about five tool companies.
What is a Five Tool Company?
According to MLB.com, baseball scouts have graded position players on five tools, which are integral to success in the game. When we think of position players, we refer to outfielders, infielders, and catchers. These positions can field, run the bases, and hit.
The five tools they refer to are:
- Hitting for power
These are the five tools that all scouts look for, and it is rare to find all of these in one player. For example, it is more common to find players who excel at running, fielding, and throwing.
But to find that unicorn can make or break a team because of the money involved.
Scouts will rate all players on these five tools and give them a numbering system. The numbering system ranges from 20-80, with 20 being the lowest and 80 the highest. The rating system has some arbitrary rules, much of which is subjective, which led to the rise of numbers in baseball, i.e., Moneyball.
So how does this all relate to investing?
We can implement the same idea into investing by creating our own five-tool system. We can narrow down the companies we analyze and buy by using a system like this. For example, we can pass if we find a company with great revenue growth but nothing else. Or if they have an amazing balance sheet and moat but zero growth, we can pass.
The system includes all the important ingredients we need in any successful long-term investment.
The five tools are:
- Long-runway or scale
- Great management
- Capital allocation
- Strong balance sheet
Considering some of the best investments over time, they all have these five tools.
For example, Berkshire Hathaway has returned 20.1% CAGR returns since 1965, compared to the S&P 500’s 10.5%.
According to Kiplinger.com, below is a list of some of the best-performing stocks over the last 30 years:
- Nvidia – 27.5%
- LVMH Louis Vuitton Moet Hennessy – 12.4%
- Microsoft – 19.2%
- United Health Group – 21.2%
- Mastercard – 33%
- Google – 19%
- Amazon – 31.1%
- Apple – 23.5%
There are not many surprises, but we could argue these companies offer the most complete five-tool categories.
Who wouldn’t have wanted to own Amazon? In hindsight, all of us. But at the time, it would have been challenging to identify Amazon’s strengths.
This is why having a complete understanding of the companies, leaders, and future growth prospects will help us.
Understanding the components of the five tools will give us a well-rounded idea of each company and helps us determine if they meet our criteria, and we can swing at our pitch. Or if they don’t quite fulfill all the criteria, we need to wait.
What we are attempting to do with this idea is identify quality companies. The quickest, easiest way is to understand the business and any competitive advantages it might have.
As evidenced above, we can build long-term wealth by finding and holding long-term quality companies.
The idea behind the five-tool checklist remains to find quality companies with competitive advantages and hold those for as long as possible.
A company’s competitive advantages filter down into the moat, scalability, capital management, and management, to name a few.
For example, companies with network effect advantages create moats around their product and service, allowing them to allocate capital to grow and help them protect their moat by introducing new and updated products. Great management understands these competitive advantages and works to widen or defend the moat.
What Are the Components of a Five Tool Company?
Let’s take a few minutes to explore the five tools. The better we understand these tools, the better we can deploy them.
Again, the five tools are:
- Long-runway to growth
- Great management
- Capital allocation
- Strong balance sheet
A competitive advantage makes a company’s products or services superior to the customer’s other choices.
The most classic example of a moat stems from Apple’s development of the iPhone. With Apple’s creation of the iPhone, they put the power of a computer in everyone’s hands. Now, across the world, we all can communicate and find answers to everything.
Think of the power this unleashes across the globe as more “underdeveloped” companies acquire and adopt these devices.
Apple’s introduction of the iPhone spelled the death of Blackberry, the leader at the time.
Moats, or competitive advantages, have three main components:
- Benefits – what benefits does your product or service provide? The company’s product or service must offer tangible value that the customer can recognize.
- Target market – If the company doesn’t define its customers or needs, it will struggle to succeed. For example, if they don’t create their service with the customer in mind, no matter how cool, they will fail.
- Competition – Each company must define its competitors and how they plan to compete against them. Sometimes a company might not have direct competitors but other outside competition across sectors. A great example from recent history is the newspaper industry. Until the arrival of the internet, newspapers considered other newspapers their competition. They recognized too late the internet allowed customers to read the news online, thereby eliminating the need for newspapers.
Long-runway to Growth
Growth remains the driver behind 99.9% of all great investments. If you have a company growing at the rate of the economy, no matter how great, it won’t give us great returns.
For example, a more mature, slowing business with a moat around its products will hang on for a while but succumb to father time at some point.
We aim to find companies with a history of growth greater than 10%, but we also want to find companies with products and services customers want now and into the future.
For example, the iPhone still has tremendous demand, and every year continues to defy experts.
But Apple doesn’t sit on its laurels; they continue to innovate. Who doesn’t love the AirPods, iTunes, and Apple Watch? These products don’t drive Apple’s growth but continue adding revenue streams, which overall helps maintain Apple’s moat.
Great management has long been one of Buffett’s main criteria. This category falls into the “soft skills” arena. We don’t have many metrics or numbers we can fall back on to determine great leaders.
We can look at the proxy for management pay and incentives, which helps. But we can also look at what management says and does via earnings calls. We can also look at how truthful and honest they remain during good and bad times.
For lack of a better identifier, we will know it when we see it. We want management who will be honest and forthright in communications, who will act for the benefit of shareholders and stakeholders, and who will always try to do the right thing for the company.
Some great examples:
- Warren Buffett & Charline Munger (gold standard)
- Jeff Bezos
- Jamie Dimon
- Mark Leonard (Constellation Software)
- Rich Templeton
We can use several metrics and numbers to help define great capital allocators. Remember that allocating capital remains job number one for the CEO.
Capital allocation is the most important job of the CEO. If they don’t use the company’s capital to drive growth, eventually, they will struggle and fail. For example, wasting money on fruitless projects will destroy value.
We want management to determine what’s best for the company, allocations-wise. For example, buying back its shares might be better than acquiring another business. Or they might serve investors better by paying a growing dividend instead of reinvesting.
Identifying great capital allocators encompasses both quantitative and “soft skills.”
Strong balance sheet
We can also look at how much cash they have compared to the debt load. Using ratios such as the current or quick ratio allows us to determine how liquid the company remains.
Companies with strong balance sheets can weather bad storms. For example, companies with strong balance sheets could withstand the downturn during the pandemic.
Bottom line: we want companies with:
- Good liquidity
- More cash than debt (ideal)
- Strong assets
- Growing retained earnings
- Lots of shareholder equity
Using the above five tools, we can identify strong companies that could provide great returns.
Example of Five Tool Companies
The easiest way to find five tool companies is to research and study some of the best ones. For our example, I would like to look at Constellation Software, the Canadian company led by Mark Leonard. We will use stratosphere.io for all financials and examine the company through our five-tool lens.
Constellation Software (CNSWF) is a serial acquirer of VMS companies. VMS means Vertical Market Software which companies from niche markets use. A great example is reservation software at the gym or school education system.
A serial acquirer sounds boring and risky, and considering most acquisitions don’t work out as planned, (between 70-90%), it might not indicate a quality company.
But Constellation provides a great exception to the rule.
Let’s unpack them through the five-tool lens.
Constellation has two primary sources of growth – organic and inorganic. Almost all of their current growth stems from acquisitions (inorganic). By buying VMS companies, Constellation has an almost limitless supply of growth.
At last estimate, Constellation estimates they have over 40,000 VMS businesses out there.
Constellation generates revenues through four sources:
- Professional fees
- License fees
- Hardware and Maintenance fees
- Recurring fees
Constellation has a moat generated from two main sources:
- Decentralized structure
- VMS acquisition reputation
Most serial acquirers have a bottleneck problem, which prevents them from acquiring past 10 to 12 companies annually. But Constellation has built a structure pushing acquisition decisions down the stack.
Moving the decisions down to the Business Unit level allows Constellation to allocate large amounts of capital to small and medium-sized acquisitions.
And because Constellation has purchased VMS companies for over two decades, they have cultivated relationships with potential targets over those decades.
Like Berkshire Hathaway, any potential acquisition knows Constellation offers a great home for financing, knowledge, and the opportunity to continue to operate their business independently.
Constellation also doesn’t sell, with only one divestiture over the years.
That is an important facet because, unlike private equity, Constellation takes these companies under their wings and helps them grow. Often, these VMS businesses are a family affair, and their legacy remains important to them.
Long runway for Growth
VMS software businesses have a long runway to continue to grow. Consider the businesses that still don’t have a software component and the eventuality they will someday.
Constellation has repeatedly stated they believe they have around 40,000 potential targets, and their current penetration of those targets is low. Consider as of 2017, Constellation has acquired over 500 companies. In 2022, the company is on pace to acquire over 100 companies.
At some point, Constellation can begin looking outside the VMS industry to find its acquisition targets. Or they could look to larger acquisitions to generate the returns they need.
The decentralized nature of the business allows them to deploy large amounts of capital to continue growing at efficient rates.
The company has seen revenue growth rates of:
- 5yr – 19.17%
- 3yr – 18.62%
Mark Leonard, Constellation’s CEO, started the company in 1996. He has built a decentralized system that allows individual business units to thrive on their own merits. It also allows the allocation of capital more efficiently.
Mark has also created a culture of advancement and belief in the company.
The company mandates that executive bonuses must reinvest the bonus into company stock, which they must hold for at least five years. In 2015, they reported over 100 millionaires as employees with the company because of this initiative.
The company doesn’t buy back stock, and they also don’t use equity for acquisitions or stock-based compensation as a means of encouraging employment. Mark doesn’t believe in diluting shareholders.
A quick story telling us how much Mark believes in preserving shareholder value – when he travels, he only flies coach, as he doesn’t believe in spending shareholder’s money for luxuries like first-class seating.
Because of Constellation’s decentralized structure, they can quickly allocate a lot of capital. Each operating group of the company caters to a specific group of vertical markets. Over the past ten years, the company has spent over $5.9 billion on acquisitions. Over the same period, they have generated revenue growth of 21.33 CAGR, all of which yields an ROIC of 25.6% in 2021 and a high of 39% in 2017.
Constellation finds VMS firms particularly intriguing since they meet unique and important software needs in vertical sectors. The software is incredibly sticky because customers require it, and it only takes up a small portion of their budget.
This indicates that VMS companies provide Constellation with reliable and consistent cash flows, which Constellation can use for more acquisitions to get the flywheel turning.
Strong Balance Sheet
We can see Constellation carries a strong balance sheet from several metrics, and the company carries almost as much cash as debt.
The almost net zero on debt versus cash alleviates any bankruptcy fears.
Using a few metrics, we can see how strong the balance sheet remains, all numbers TTM unless otherwise stated:
- Current ratio – 0.6
- Quick ratio – 0.5
- Debt to equity – 3.7
- Long-term debt to Capitalization – 0.5
- Interest coverage – 14.1
These metrics, plus the near net debt zero, indicate the company has a strong balance sheet. Constellation funds the majority of its acquisitions with cash flow. And Constellation has grown free cash flow at a 19.09 CAGR clip over the last ten years.
As a serial acquirer not relying on their balance sheet, the continued growth in free cash flow helps reduce the reliance on the balance sheet in tough times.
All of these reasons and more indicate Constellation Software is a quality business.
They screen well in our five-tool checklist and offer us an opportunity to a great business to potentially buy.
Other great companies to run through the checklist include:
- Texas Instruments
- Roper Technologies
- Berkshire Hathaway
But the best idea is to do this with any company you want to buy to see how they measure up.
Buying quality companies for a fair price is one of the best ways to grow wealth. Warren Buffett, along with his sidekick Charlie Munger, spent a lot of time teaching us the tricks of the trade. And one of their focuses remains on finding these kinds of five-tool companies.
Many of their investments meet these checklists, including Apple, American Express, Coca-cola, and Visa, to name a few.
These five tools can help you find great companies and offer a fantastic starting point for your analysis. Of course, I would be remiss if I didn’t mention the price we pay matters. We need to find a fair price for any of these investments.
With that, we will wrap up our discussion regarding five-tool companies.
Thank you for reading today’s post; I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,