Build Value the FarSight Way - Part 2
Discovering potential and Prioritising value drivers and defenders, in preparation for the FarSight Appraisal
This is Part 2 of the third chapter in the Investing Science section on my substack.
In the first, Bring back Capitalism, I put forward my thesis for why I believe that companies intent on creating long-term value for you, the shareholder, are more likely to be sustainable for society and the planet than companies focused foremost on doing good.
In chapter two, Investing Basics, I summarised the collective wisdom of the giants on the investing stage. From these brilliant minds we can all learn how to build wealth by understanding the basics of investing.
In Build Value the FarSight Way - Part 1, I introduced the basics of company valuation, boiling it down to a simple model that reflects the way many investing gurus think about valuation. In this model, the analyst looks for companies with a strong moat, high quality management, and a solid margin of safety, i.e. trading much below its intrinsic value.
I then noted that traditional analysis, being based largely on quantitative factors relatively easy to measure, has difficulty in getting to grips with intangible aspects of value, such as goodwill, and with assessing the quality and trustworthiness of leadership. This is the gap the FarSight model aims to fill.
In this section, Build Value the FarSight Way - Part 2, I take up the story of the FarSight model’s secret sauce for valuing a company - how to make sense of a company’s value creation narrative.
Note that nothing I write here should be taken as a recommendation to buy, hold, or sell any securities or financial instruments. See here my full disclaimer.
Quick summary
the FarSight model helps you decide whether a stock is overvalued or undervalued by the market. It does so by appraising the quality of leadership, specifically the leadership’s ability to make good on the company’s opportunities to create value and deal effectively with threats to value on the downside.
Here are the steps to Building Value the FarSight Way:
Understand the nature of the opportunities and risks facing the company (we call them Forces without and Forces within). The ratio needs to be in favour of the opportunities, and you certainly want to stay clear of companies facing unmanageable risk.
Distill these so-called ‘forces’ into a set of value-driving and value-defending challenges that the company needs to tackle and resolve. These challenges are arranged in a narrative that speaks to the Clarity of the company’s PURPOSE, the Stability of its FOUNDATIONS, the Strength of its RELATIONSHIPS, and the Ability and Trustworthiness of its LEADERSHIP.
These challenges (also referred to as ‘issues’) are weighted for materiality, i.e. for how important they are for driving or defending value for the company.
The secret sauce in the model lies in the final step, rating the quality of the company’s response to these issues. Companies that are dismissive, or ignorant, are scored negatively, while companies that respond sincerely and strategically are scored positively.
When we put all the scores together, we can derive the FarSight Appraisal: a confidence rating of the company’s ability to realise the value in its potential upside, and to manage its downside risk. Where a company with a high FarSight Appraisal enjoys reasonable tailwinds, you can expect its competent leadership to build good value over time; if it encounters headwinds, our FarSight analysis should give you comfort that the company has what it takes not to lose too much value.
Let’s dive in!
Part 2 Contents
Discovering potential
Prioritising value drivers and defenders
Need to catch up? Here’s the link to Part 1
Discovering potential
Before we can rate the business, we first need to discover its potential, both in terms of upside opportunity, and downside risk.
Step one is to learn about the business: Our hot-dog stand, for example, is in the retail sector, selling fast-moving consumer goods for cash. Let’s imagine it’s selling in Cape Town, South Africa, in an urban environment, and to moderately well-off customers. We can also ask about the brand profile and what it stands for, as this will also determine what kind of risks the company might face, for example if you stand for green practices, but have discarded plastic packaging lying around, that will present a risk to your reputation. We already know that if you’ve bought the expensive, but exclusive stand in the beer garden, you will have market dominance, which brings both opportunity and risk.
Step two is to understand the forces that arise from the external environment: Are these offering headwinds, or tailwinds? In our hot-dog stand example, external risks may have to do with the local municipality constructing a bypass which could drastically reduce visiting traffic to your community. An important local factory, the anchoring economic engine for the community, could go bust, or move to another region far away. We all remember the effect of the COVI-19 pandemic lockdowns on local markets. And of course, the weather could turn foul, affecting sales dramatically. These are all risks you have little control over, though of course alert, agile, strategic-thinking management is to respond to them.
When considering large, publicly traded companies on the stock exchange, these external forces include the state of the Economy, the stability of the country’s Politics and effectiveness of its leadership; the effectiveness of the country’s institutions for Justice, law and order to enable a secure operating environment, the state of the country’s Infrastructure, such as energy, roads and ports, and the nature of the Regulatory environment enabling or impeding ease of doing business. Finally, the Health and flourishing of the country’s people, as well as the Natural environment and the health of its resources all create opportunities and risks for the business.
Step three is to understand what we describe as the forces within: i.e. those forces inherent to the way the company conducts its business. For example, are your customers clear as to the product you are offering, is the price appropriate, and how satisfied are they with product quality and service? How competent is the manager you hired to run your business, are your staff threatening to strike or leave the business, and if so why? How stable and effective are your systems of production, from fuel energy to the management of cash in the till, including safeguards? Finally, how solid is your relationship with your landlord in order to retain your business to operate? (Spot the four dimensions of the value-creation narrative in this list given here.)
A deep-dive analysis of all these factors in the three steps above creates a landscape of opportunities and risks, which together describe the company’s potential to create or destroy value.
Pulling these all together is the next step in the FarSight process. The result will be a list of issues we can weight for their importance as value drivers and defenders. While there are 42 issues in the FarSight issue table (and a potentially unlimited number of sub-issues that could arise within this categorisation), rolling up to 12 Issue Pillars, we have created a simple structure of only four dimensions describing a company’s potential to drive value.
Here are the four dimension, presented in the form of a narrative: In essence, our FarSight analysis is aimed at assisting you, the investor, find companies:
With a Clear PURPOSE
Standing on Stable FOUNDATIONS
Building positive RELATIONSHIPS
And managed by Trusted and Capable LEADERSHIP
Here are the four dimensions, expanded to include the 12 Issue Pillars:
LEADERSHIP
Leadership is defined by its competence and trustworthiness:
Board quality: including balance of power, competence, and management of succession
Shareholder alignment: the extent to which leadership has an ownership mindset and makes decisions that align with the interests of minority shareholders. This includes a meaningful executive ownership stake in the business, remuneration incentives, governance to create an environment on alignment, and management of cases of disloyal behaviour
Ethics: how leadership lives a set of well-enunciated values and establishes a values-based culture, setting a positive example. Ethics also includes the management of unethical behaviour, both against shareholders, as well as through corruption of government officials.
PURPOSE
Purpose is defined by focus, commitment, and appropriate alignment of the business in serving its customers and society. This includes:
Value proposition: including its purposefulness the suitability of its products and services, competitiveness in terms of innovation, and the appropriate balance, between diversification and concentration of products.
Talent: how the company motivates its talent to drive a culture of excellence, and builds its talent pipeline.
FOUNDATIONS
Foundations refer to the financial health of the business and the integrity of its systems:
Financial health: including the company’s trading position, capital, asset efficiency, and reinvestment strategy
Systems integrity: how the business manages its natural assets (e.g. minerals, energy and water), operational fitness and security of operations, IT systems and cyber-security, the successful management of projects, and the integration of new businesses or divisions to deliver on promised synergies.
RELATIONSHIPS
Relationships define how the company makes trade-offs between its important stakeholders to build goodwill and value-creation potential over the long term.
Treatment of Customers: how the business manages potential harm to customers, treats customers in the marketplace, redresses disadvantages in promoting fair access to its products, and manages customer rights, such as autonomy (security of data), freedom of expression and association, etc.
Partners: How fairly and ethically does the business and its leadership deal with its business partner relationships, both major and minor.
Labour: How fairly the company deals with its relatively low-skilled employees, across work relationships, safety, health, human rights and skills development.
Local economy: how the company manages demands for equitable involvement of disadvantaged groups (by race, creed, gender, etc.) in the economy, at industry level, in the company's value chain, as well as within the company.
Environment: This includes climate change, local bio-impacts, product bio-impacts and responsibilities around habitat rehabilitation.
Prioritising value drivers and defenders
Before we can appraise the company’s response to its 42 issues (categorised under these 12 pillars and four dimensions), we need to weight them for how important they are as value driving, or value defending issues for the business. That way we can concentrate our appraisal on just those issues that will most move the value needle and not be too distracted by the rest. As a hotdog stand owner, for example, I should surely be concentrating more on serving my customers than worrying about the carbon footprint of the paper napkins, or that I am operating my business in a space that sells alcohol.
Concentrating on relevance to value
This is a critically important step, and it is here where we draw on our investment philosophy, discussed in the first chapter, Bring back Capitalism. In that chapter, I made the case that we are more likely to be doing good for society by first creating value through our business, for our shareholders.
Where the ESG movement went off track, in our view, is to weight the importance of issues so heavily towards centrally-mandated societal and environment goals, that businesses, driven by that ideology, have been forced to act against their own interests and the interests of their shareholders - sometimes even against the interests of their customers.
How distraction from value-drivers can do more harm than good - a case study
Woolworths - Falling from the heights of virtue
Leaving the hotdog stand for a moment, let’s look at fashion retailers, and Woolworths in particular. If you aren’t familiar with Woolworths in South Africa, its equivalent in the UK would be Marks & Spencer, and in the US, it would lie somewhere between Target and Whole Foods (Woolworths also owned David Jones in Australia between 2014 and 2023). In other words, it offers premium-quality products (clothing, home goods and food) to the affluent market.
Looking at the list of 12 value-driving issues above, which would be most important for Woolworths? Value proposition would definitely be near or at the top of the list, with Treatment of Customers, Financial Health, Systems Integrity and Talent certainly in the top half of the table.
Woolworths’ value proposition to its customers has focused strongly on its Good Business Journey. The company put together a range of aspects describing this Good Business Journey, aimed at assuring its customers of how responsibly it sources its products and ingredients (among other factors). Retail stores are draped with large billboards declaring how good the company is as a corporate citizen, with its carbon footprint worked out to about six decimal places.
Over time, as the company became more obsessed with its corporate PR, so it also began to believe it was above scrutiny for its behaviour, and a culture of ‘we know best and can do no wrong’ took hold, in particular at leadership level.
This exaggerated sense of being right on moral issues also leaked into the company’s judgement of fashion trends. Value proposition should firstly be about retailing products that most suit your customers. Yes, the provenance of the fabric is important, but being on trend with fashion is surely a higher priority value driver. This requires listening to customers and being highly attuned to market signals.
In our view, Woolworths appeased the ESG movement with how it ordered its table of issues, but not to the benefit of its customers, its business, or its shareholders. Worse still, corporate reputation can fall far when high moral values are not upheld. More than once, Woolworths has been in the news for stealing the intellectual property of small retail entrepreneurs, and much of its Good Business Journey report is a self-appraisal, with many underlying indicators appearing somewhat irrelevant to the core business.
Shoprite - Bootstrapping value for all stakeholders
We can contrast Woolworths with another retailer in South Africa, Shoprite. Shoprite focuses on fast-moving consumer goods and staples for the value end of the market, with its value proposition being low prices. The equivalent stores in the UK and the US would be Tesco and Walmart, respectively.
The company’s important value drivers can be categorised similarly to Woolworths’ but described differently. Its value proposition is ‘low prices’ compared to Woolworth’s ‘Good Business Journey’. Treatment of Customers is reliable availability of its product range at those low prices, while Woolworths’ has highly demanding customers that expect top-quality treatment. An issue that is critical to both companies is the integrity of their distribution systems.
Shoprite has delivered excellently against its value-driving issues. By concentrating on the basics of sourcing and distributing its products at the lowest possible prices, it has built a formidable business model, on whose foundations more sophisticated value-added services can be built. The company’s Checkers brand has now been developed to compete with Woolworths (and Pick n Pay, another major retailer) and it arguably outcompetes Woolworths in areas such as home delivery, returns and of course, pricing. While Shoprite does not boast about its environmental performance, it actually performs better than Woolworths in terms of energy efficiency, and definitely is fulfilling its societal mandate to provide low-cost, basic food for the poorest of Southern Africa’s citizens.
What about these two companies’ share price performance: Over the past ten years, Woolworths’ price has been volatile, but essentially remained at the same price as it was in September 2014, While Shoprite has delivered outstanding value, with its price more than doubling - an increase of 122 percent.
Weight issues by their relative importance as business value drivers
Taking a lesson from the example of Woolworths versus Shoprite, it is important for the business analyst to appraise each issue for its contribution or threat to the business. Indeed, the International Integrated Reporting Council and the US Securities and Exchange Commission (SEC) both used to define materiality as being the extent to which an issue may affect a company’s ability to create value for its shareholders in the short, medium and long term. For my take on how these institutions have wandered off track, see the article Bring Back Capitalism.
A simple approach to weighting
Weighting issues is obviously a difficult task that takes deep experience of the industry. However, a tip on offer is to start by simply ordering the issues in importance relative to one another. Then, order the same issue across businesses, and even across industries. Then you can raise and lower each issue until you are satisfied with their relative order. We have used a convenient scale from 0 - 30, with 30 being a ’soft top’, considering that major disasters can raise the gravity of an issue stratospherically. For example, if I lost my licence to operate in the beer garden, and all the other spots at the fair were also taken up, then the weighting of Systems Integrity and Partner Relationships would reach catastrophic proportions for my business.
Weighting issues as both value drivers and value defenders
There are further nuances to weighting issues which we’ll go into further detail as we explore the FarSight model more deeply in the future. One nuance is that we weight each issue twice, as a value driver and as a value defender for the business. Value drivers are issues which tilt towards opportunity, potential for growth, improved market share, or increased margin. Value defenders are those issues that tilt more towards the risks, harms and other externalities that might impact on the business’ licence to operate.
We note that in the latest Harvard Business Review, the article ‘It’s time to unbundle ESG’, by Aaron Chatterii and Michael W. Toffel, calls for a more sober and business-oriented understanding of materiality, and interestingly, they have also put forward a similar approach to deriving materiality as I have described here.
Issues looming under the radar
We also note issues that society might not yet have noticed as being important. For example, ten years ago, there was practically no pressure on the food industry to reduce the production obesogenic foods. However, FarSight did notice the looming crisis of obesity and noted this issue as something that business leaders ought to start thinking about. If you are operating a hotdogs stand, it might be wise to think ahead about your product. Hotdogs are highly processed and rolls are poor in nutrition. Instead of abandoning the product, you might consider introducing a ‘real food’ product line, such an organically produced sausage served with a fermented condiment, such sauerkraut, or gherkins. By carefully observing customer feedback, you can continue experimenting at the front edge of new trends and be able to dominate the new market niche.
Remarkably, when we were testing our model on the pharmaceutical (drug) producers back in 2016, it was noticeable that Novo-Nordisk wrote at length about how they were concerned that their main product, insulin, was probably doing more harm than good. In the next section, we will return to this example when we discuss the response side of the model.
Unreal issues also impact on business value
And finally, we note issues that have become overblown by society, as a result of mass-hysteria, over-exuberance, panic, or ideological capture. How do we know whether and to what extent these issues exist? We’ve created a simple algorithmic test for the extent to which free discussion or debate is allowed in the public sphere. If mainstream media has declared that ‘the science is settled’, or that ‘there can be no more debate’, then these are clues that such an issue might be overweighted by society. They are still gravely important for businesses operating in that industry, but market distortions will begin to emerge, resulting in dramatic shifts when the system can no longer bear such distortions. For an example playing itself out now, see my article on Germany’s Energiewende.
Deriving this table of issues, and weighting them for their importance (materiality) brings us to the end of the first side of the model. This sets us up for the second side of the model, which is to appraise the company for how sincerely and coherently it manages the issues that contribute to its value-creative narrative, namely: that it is a business with a Clear PURPOSE, standing on Stable FOUNDATIONS, Building positive RELATIONSHIPS, and managed by a Trusted and Capable LEADERSHIP.