(Semi) Weekly Accounting Breakdown: Working Capital


We’ve received a lot of positive feedback on the Cash Flow: It’s All That Matters series. So much so that we thought our readers would like a more regular installment of all things accounting.

The goal: Send weekly accounting lessons that you can read in less than five minutes.

We know learning about accounting is like watching paint dry. That’s why we’re breaking them into five minute bites.

Our first lesson: Working Capital Cycles

What Is Working Capital?

Working capital is your current assets minus current liabilities (CA – CL).

Current assets are things like:

    • Cash in the bank
    • Accounts receivables (money that needs collecting)
    • Inventory
    • Investments

Current liabilities are things like:

    • Accounts payable (bills you need to pay)
    • Short-term debt
    • Current portion of long-term debt
    • Unearned revenue outstanding (similar to A/R)

Apple’s (AAPL) latest 10-K reported $163B in current assets and $106B in current liabilities. This gives us $57B in positive working capital.

Positive & Negative Working Capital

Working capital has two forms: positive and negative

Positive: You have excess cash to pay for the daily operations of the business (salaries, creditors, suppliers, rent, etc.).

Negative: You do not have current cash to pay for daily operations but instead use suppliers and customers to fund expenses.

The Pros & Cons of Positive & Negative Working Capital

There’s benefits and downsides to both types of working capital cycles. Let’s start with positive working capital:


    • You have a good cash buffer for unexpected expenses
    • Can fund growth and future opportunities with cash


    • High working capital could be due to too much inventory or inability to reinvest in the business

Alright let’s shift to negative working capital:


    • Fund operations through suppliers and customers
    • Generate cash from customers before you have to pay your current liabilities
    • Ideal for businesses with high turnover in product/sales


    • Without growth, working capital eats away at profits
    • Lose money if customers don’t pay on time (i.e., higher A/R)
    • Doesn’t look good for bank funding/liquidity

Which Cycle Works Best?

The answer: it depends.

It depends on the industry you’re in and the growth trajectory of the internal business. Companies that enjoy negative working capital cycles include: Online retailers, grocery stores, restaurants and telecom companies (via financialexpress.com).

That wraps up this week’s accounting breakdown.

If you like this idea, let me know. If you hate it, still let me know. We’re always looking for ways to bring more value to you!

Red Violet (RDVT): Asset-Light Spin-off With Long Runway

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Business Description: RDVT’s platform (CORE™) stores 1+ trillion data records on nearly every individual in the US. Their data sources include MVA, property, criminal, court, and employee records. The proprietary, cloud-based platform funnels all the records into one, easy-to-query database. RDVT uses this technology in two products: idiCORE (risk management, debt recovery, fraud detection) and FOREWARN (individual background checks catered to realty professionals, see our homebuilding thesis here). 

Thesis: RDVT is a fast-growing, highly scalable data fusion company delivering 1+ trillion points of data to its customers at lightning speed. Their platform allows customers to assess risk and achieve a full-scale picture of any individual and business before meeting/conducting a deal. The company sports a fixed-cost model with 90% incremental gross margins. Management has a history of building similar companies, with two sales totaling $1B in the same industry. We believe the company can reach $190M in 2024 revenue with 40% EBITDA margins, giving us nearly 300% upside from current prices. 

History & Spin-off: The current RDVT team began developing the CORE platform in 2014 under the name “The Best One” (TBO). TBO received an investment from Phil Frost, changed its name to Cogint and listed it as a public company (under ticker CGNT). In 2018, the company merged with Fluent under the ticker FLNT. That same year FLNT decided to spin-out the CORE platform company (TBO/CGNT). Here’s what’s interesting: every single executive left TBO/CGNT to work at the newly spun-off company, Red Violet (RDVT). 

Fixed-Cost Model: The most attractive aspect of the RDVT thesis is their fixed-cost business model. In short, they pay a fixed, long-term contract on their data feed. It doesn’t matter if they generate $10M in revenue or $100M. Their cost remains fixed. This allows the company to reach 90% steady-state gross margins and near 100% incremental GM. As the business scales, they won’t have to spend as much on SG&A. This ramps up EBIT margins (in some estimates, reaches 40%). 

History of Value Creation: Dan Dubner and his executives were the early founders of the data fusion industry. They’ve built two companies like RDVT that sold for a combined $1B. RDVT is a spin-off of all the things that weren’t great in prior iterations of such data fusion technologies. We have a strong belief that management knows how to build, how to price and how to create value for shareholders. They own 20% of the company so incentives are aligned. 

Valuation: We’re assuming 45% annual top-line growth over the next five years — starting with $50M in 2020 revenue. At scale the company generates 90% GM and 40% EBITDA margins (based on their two previously sold companies). Given our assumptions, we end 2024 with $190M in revenues, $76M in EBITDA and $55M in FCF. Add back our $9M in net cash and we get a market cap of $578M ($50/share). If we assume a 17x exit EBITDA multiple (in line with historical sales), we get $700M in market cap ($62/share). That’s near 3x upside.

Risks: Data supplier concentration (receives 43% of its data from one provider), competing away margins, litigation risk from competitors (CEO is lawyer by trade), Data price increase leads to reduced margins.

***Disclosure: We currently have a position in RDVT at the time of this release***

Enlabs (NLAB): High Growth, Low Price

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Enlabs (NLAB.OM) offers entertainment through various products, including casino, live casino, betting, poker, and bingo under various brands. The company is also involved in delivering sports results and technical solutions in the online gaming industry. It operates in Sweden, Malta, Baltics, and internationally.

Thesis: NLAB is the Baltics market leader in the highly regulated, high barrier to entry and fast-growing online sports betting/gambling industry. The company commands 25% market share in the Baltic region and has its sights set on global expansion. NLAB’s growing earnings & revenues 30%+/annum while sporting 30% EBITDA margins. You can buy this business for 15x normalized earnings, well below industry/market averages. Management owns a decent chunk of stock and has zero debt. 

The Core Business: NLAB’s core business is Optibet, it’s online gambling/sports betting platform. It’s a capital-light, 80% gross margin business. The company invested a ton of money to create a new, proprietary platform that can seamlessly integrate into new countries and regulation standards. Think of it like plug-and-play for online sports betting. The core business should continue its 30% growth as the Baltic sports the fastest internet and highest mobile data usage per capita in Europe. 

Competitive Advantages: NLAB benefits from a first-mover advantage in many of its regions. Given the finite amount of betting licenses, the ability to move quickly within compliance is paramount. NLAB’s latest platform, along with its dominant market share in the Baltics create an easy choice for regulators when it comes time to hand out licenses. 


NLAB Risks 

Penetration Failure: NLAB fails to penetrate new markets like Sweden, Belarus and the US

No Relaxation in Legal Gambling: Countries fail to remove restrictions on legal sports betting/gambling

Cash-Burning Acquisitions: NLAB acquires companies that aren’t accretive to bottom-line, thus buring cash that could’ve been used to bolster core biz/platform



Scenario 1: NLAB continues its revenue/earnings path for the next five years. We’d get 2024 with $118M in revenues, $29M pre-tax profit and $24M in FCF: $5.58/share (196% upside)

Scenario 2: NLAB grows 2020 revenue 30% but 0% for the remaining four years. This gives us $56M in revenues, $14M pre-tax profit and $15M FCF: $3.05/share (62% upside)

Scenario 3: NLAB loses 13% per year in revenue, giving us $21M in revenues, $5.21M in pre-tax profit and $4M in FCF: $1.48/share (21% downside).

CD Projekt Red (CDR): Video Game Stock Ready To Breakout

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It’s that time again! Once a week I pull breakout alerts from our premium Breakout Alerts service. Members of the service receive 6-8 potential breakout opportunities each week.

This week we’ve got a play on the video game industry. We documented the rise of E-Sports in last month’s Consilience Report and outlined the bull case for this company.

That company is CD Projekt Red (CDR). CDR’s a polish video game producer. They’re the team that produced the mega-successful Witcher series (yes, that Witcher).

Here’s the bull thesis: CDR’s coming off a historical year for sales and profitability. The company will use this momentum to further bolster its line-up of gaming IP while investing in its most popular series’ like The Witcher (over 50M copies sold). The company’s net cash balance sheet is strong enough to withstand the boom-bust cycle of new game releases. CDR boasts extreme operating leverage, which we believe will continue over the next five years. Short-term catalyst includes release of CyberPunk 2077.

Breakout Formation: Rectangle Chart Pattern Above 50MA

Trade Parameters: 

  • 3% Entry: $429.92
  • 1.50% Entry: $423.66
  • Stop-Loss: $390.3
  • Profit Target: $481.80
  • Reward/Risk: 1.74x

Business Description

CD Projekt S.A., through its subsidiaries, engages in the development and digital distribution of video games worldwide. It operates through two segments, CD PROJEKT RED and GOG.com. 

The company’s product portfolio comprises The Witcher; The Witcher 2: Assassins of Kings; The Witcher 3: Wild Hunt, Hearts of Stone games, and Blood and Wine; Thronebreaker: The Witcher Tales; Gwent: The Witcher Card game; and Cyberpunk 2077, as well as online multiplayer games. – TIKR.com


  • Market Cap: $10.1B
  • Enterprise Value: $9.93B
  • Gross Margins: 70%
  • Operating Margins: 37.5%
  • EV/EBIT: 17.05x
  • P/FCF: 20x

What We Like:

  • Leading video game creator with crazy-sticky fanbase
  • Consistent high-quality games
  • Negative cash conversion cycle
  • No debt
  • Insiders own >20% 
  • High FCF generation

What We Don’t Like:

  • Boom/bust video game cycle

APEI: An Online Education Stock Ready To Breakout

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It’s that time again! Once a month I pull breakout alerts from our premium Breakout Alerts service. Members of the service receive 6-8 potential breakout opportunities each week.

This week we’ve got a play on the COVID back-to-school crisis. Schools have no idea what they’re doing for the upcoming year. This should bode well for online education alternatives.

Enter American Public Education (APEI).

The company provides online and campus-based postsecondary education. Revenues have slowed the last few years but we saw an uptick in the last quarter. APEI trades around 15x its free cash flow.

If online education ramps up dramatically, those cash flows will expand (and likely its multiple).

Anyways, here’s the alert. Our premium members receive 6-8 breakout alerts every week. So far we’re up 33.20% on the year from our Breakout Alerts.

Breakout Formation: Inverse Head & Shoulders w/ Double Bottom

Trade Parameters: 

  • 3% Entry: $34.74
  • 1.50% Entry: $34.24
  • Stop-Loss: $30.54
  • Profit Target: $47.00
  • Reward/Risk: 3.45x

Business Description

American Public Education, Inc., together with its subsidiaries, provides online and campus-based postsecondary education. The company operates in two segments, American Public Education and Hondros College of Nursing.

It offers 121 degree programs and 111 certificate programs in various fields of study, including business administration, health science, technology, criminal justice, education, and liberal arts, as well as national security, military studies, intelligence, and homeland security. The company also provides diploma in practical nursing, an associate degree in nursing, and an associate degree in medical laboratory technology. – TIKR.com


  • Market Cap: $480M
  • Enterprise Value: $296M
  • Gross Margins: 62%
  • Operating Margins: 8%
  • EV/EBIT: 16x
  • EV/FCF: 9x

What We Like:

  • Play on COVID online education
  • Receivables turnover (growing) QoQ & DSO shrinking
  • $184M in cash on balance sheet
  • Trading <1x EV/Revenues
  • FCF positive

What We Don’t Like:

  • Negative Revenue growth
  • <4% operating margins

Cash Flow: It’s All That Matters (Pt. 2)

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Last month I wrote about Cash Flow vs. Income Statement analysis. We learned that cash is king and it pays to analyze a company on its cash flows, not it’s income statement. But I left the last essay on somewhat of a cliff hanger.

I ended the essay with two key frameworks for thinking about the cash impact of revenue growth:

    1. Operating Cushion
    2. Core Operating Growth Profile

Those two frameworks deserve their own essay, not simply latched on like a last-minute soup garnish. Enter: Cash Flow: It’s All That Matters (Pt. 2).

We’ll dive deep into these two ideas and walk-through real-life examples. Once finished, you’ll learn how to truly analyze a company’s growth from a cash-flow perspective. You’ll have hard data telling you whether $1 of revenue growth actually improves the economics of the business.

Like I said in the last essay: it’s like the red-pill for fundamental analysis.

After doing a few real-life examples using this method, you won’t analyze a company without it.

We’re using Cash Flow Analysis: Modified UCA Cash Flow Format to breakdown operating cushion and core operating growth profile.

Operating Cushion: What It Is & Why It Matters

Operating Cushion is the percentage difference between your Gross Margin % and your SG&A %. In English, it’s the contribution of a $1 increase in revenues to operating profits. Hold working capital constant and Operating Cushion = Core Operating Growth Profile.

But we know we can’t hold working capital constant for most businesses.

Let’s break this down into two parts:

    1. Operating Cushion
    2. Cash Needs (i.e., working capital requirements)

Operating cushion orbits around two ideas:

    • The higher the operating cushion, the more cash a company will generate as it grows top-line revenue
    • The lower the operating cushion, the less cash a company will generate as it grows top-line revenue

There’s two ways we can raise our operating cushion. We can either 1) increase gross margin through raising prices or lowering COGS (cost of goods sold) or 2) reduce SG&A by reducing headcount, increasing operational efficiency and streamlining backend processes.

Why (& When) Operating Cushion Matters

Operating cushion matters because without it we wouldn’t know if company growth adds or subtracts value. In other words, operating cushion tells us if top-line growth increases cash or drains cash.

This matters when we go to value companies based on top-line revenue growth over a 3-5 year period. How much worth can we place on top-line growth if the company’s business model consumes cash as it grows? Not much!

That said, it’s important to understand where a specific company is in its growth lifecycle. Early-stage growth companies will devour cash as they take market share and expand manufacturing, capacity and employees. Those companies will show severely negative operating cushions.

On the other end, we expect declining/mature companies to reduce operating cushion as their competitive advantage fads. Replaced by disruptors and innovators.

What matters is the trend and if the trend is following a logical path. High-growth companies should (over time) increase operating cushion from negative to positive. If not, they’ll fail and go bankrupt (unless you’re TSLA).

At the end of the day, we want to invest in companies that generate cash as they grow and avoid companies that consume cash as they grow.

Now onto some examples of operating cushion in action.

Operating Cushion Example #1: Apple, Inc. (AAPL)

Let’s use Apple, Inc. (AAPL) as our first example of operating cushion analysis. We’re using TIKR.com for our financial data. We’ll also break each example into steps so you can follow at home.

Step 1: Find Gross Margin % and SG&A %

TIKR simplifies this process and displays GM% and SG&A % right next to each other:


Step 2: Subtract GM % from SG&A %

Next we subtract GM % from SG&A % to arrive at Operating Cushion (easier if you do this in Excel):


Step 3: Analyze Operating Cushion Data

AAPL’s generating less operating profits from a $1 increase in revenues today than they were five years ago. This makes sense as the company grows and reaches a more mature lifecycle stage.

But AAPL’s declining operating cushion is due to both rising SG&A and lower gross margin. The double whammy.

Let’s see what another, better operating cushion profile looks like.

Operating Cushion Example #2: Interactive Brokers (IBKR)

IBKR is fresh on my mind as we initiated a position in the company early last week. Collective members were alerted to our entry on 07/07. The stock’s run up nicely since then.

Let’s go through our three steps again.

Step 1: Find Gross Margin % and SG&A %


IBKR’s high margins are consistent over the last five years. SG&A remains stagnant around 23%.

Step 2: Subtract GM % from SG&A %


Step 3: Analyze Operating Cushion Data

Unlike AAPL, IBKR’s grown operating cushion over the last five years. A dollar in incremental revenue growth translates to $0.63 in operating profit in 2019. Compare that to $0.58 in 2015.

How was the company able to accomplish its growth? Rising gross margins. Notice IBKR’s SG&A % barely fluctuated over the last five years (decreasing 60bps). Meanwhile, the company’s gross margin grew 500bps!

Operating cushion informs us about the cash-generating ability of a business before any working capital requirements. If we don’t analyze working capital requirements, we’ll overstate the amount of true cash flow a business can generate.

Let’s dive in.

Working Capital: How Much Cash Do We Need To Grow?

We can’t forget about working capital requirements. Remember, it takes cash to grow top-line revenues. Some businesses require more cash than others.

Working capital requirements affect cash in two ways:

    1. The higher the working capital requirements, the less cash a company will generate as it grows
    2. The lower the working capital requirements, the more cash a company will generate as it grows

If you don’t take anything else from this essay, take this: we want to invest in companies that don’t need a lot of working capital requirements to grow. Write it down. Stick it in your office. Never forget.

What Goes Into Working Capital?

Working capital is made up of a few components:

    • Accounts Receivables
    • Accounts Payables
    • Inventory

Each of the above components represent either a decrease or an increase to a company’s cash flows.

For instance, failure to collect cash from its sales (increasing receivables)  would represent a negative effect on cash flow. Why? Because we’re receiving less actual cash from the sales we booked on the income statement.

Accounts payable works in the opposite direction. A higher accounts payable balance means we pay less cash for bills, etc. This means we get to keep our cash today in exchange for paying more in the future.

Finally there’s inventory. Rising inventory levels means a company spent more cash in the current year to make finished products/goods that weren’t sold to customers. Conversely, falling inventory levels means a company’s selling through their finished goods/products faster than they can make them.

That said, not all rising inventory levels are a bad thing. For example, a young company on the verge of signing multiple contracts with big clients may produce a significant amount of product upfront in order to fulfill a larger order.

Also, traditional manufacturing and machine-heavy companies tend to carry more inventory than knowledge-based businesses. It shouldn’t surprise you to see little (if any) inventory in some of the most popular tech-based knowledge companies.

Other (Minor) Working Capital Requirements

There are a couple minor working capital components that you might run into like:

    • Prepaid expenses
    • Deferred revenue

Prepaid expenses are items like insurance. You have the option to pay your car insurance in one lump-sum payment. This would be a prepaid expense. Increases in prepaid expenses consume cash. Decreases in prepaid expenses conserve cash.

Deferred revenue is a fancy way of saying accounts receivables. You find deferred revenues in most SaaS companies. Deferred revenue occurs anytime a company books a sale for a service or product but hasn’t delivered that service or product.

Let’s use software as an example. You book a client for a five-year subscription contract for $1,000/year. As soon as you sign that contract you have $5,000 in deferred revenue on the books. At the end of year one, you recognize $1,000 of that $5,000 in deferred revenue as actual revenue. In turn, your deferred revenue drops from $5K to $4K.

We add deferred revenues to working capital to reflect the inherent gain we’ll receive in cash once we collect payment.

Combining Working Capital & Operating Cushion

Now that we know what goes into working capital, we need to translate it into cash inflows and outflows. We need to see which part of working capital consumes cash or collects cash. We need to understand the drivers of working capital requirements in a business.

Say hello to the Core Operating Growth Profile. This tool allows you to see exactly what’s driving cash consumption and growth.

Again, once you use it, you’ll never do another valuation without it.

Core Operating Growth Profile: A 360° View of A Company’s Cash Flow

We know how to find an operating cushion. We know the components of working capital and their effects on cash inflows and outflows. Now it’s time to combine both segments to create our Core Operating Growth Profile.

Here’s the basic equation (ignore the figures in the picture):

The short-hand version of Core Operating Growth Profile is simply:

Operating Cushion % – Working Capital %

Let’s learn how to get Working Capital %.

Turning Working Capital Into % of Revenues

Before inputting our figures, we need to turn accounts receivables, inventory and accounts payable into percentages of revenues. Turning our working capital requirements into percentages of revenue allows us to do a few things:

    • Accounts receivable % represents the % of every revenue dollar left uncollected from revenue
    • Accounts payable % represents the % of every revenue dollar financed by vendors (i.e., paying on credit)
    • Inventory % represents the % of every revenue dollar that must be reserved for inventory

Percentages offer a clearer picture on how much we extract (or consume) in working capital from each dollar of revenue gained.

We subtract AR % and Inventory % because those are (normally) cash extractors. We add AP % because we’re deferring payment to our vendors, thereby keeping cash.

Okay. Now we know how to calculate Working Capital %. Let’s put these two equations together and find our Core Operating Growth Profile.

We’ll use AAPL and FB for step-by-step instructions.

Core Operating Growth Profile Example #1: Apple, Inc. (AAPL)

I know. We already know how to do the first step. But repetition is key if we want to master this habit. We’re trying to teach our brain a new way of analyzing a company.

Step 1: Calculate Operating Cushion (2019)

Gross Profit Margin % 37.80%
SG&A Margin % 7.00%
Operating Cushion 30.80%

Step 2: Convert Working Capital To % of Revenue (2019)

AAPL had $22.9B in AR and $22.8B in “Other Receivables” on the balance sheet. They generated $260B in revenues during the year. That gives us an AR % of -17.6% (note: negative due to cash drain).

The company had $4.16B in inventory on the balance sheet. That gives us -1.60% in Inventory %.

Finally, AP came in at $46.23B in 2019. Divide by our revenue (keep positive!) and we get +17.78%.

Step 3: Add Working Capital Requirements To Get Working Capital %

Here’s what the result looks like:

Operating Cushion % 30.80%
Less: A/R% -17.62%
Less: Inventory% -1.60%
Plus: A/P% 17.78%
Less: Prepaids% 0.00%
Plus: Deferred Revenue% 0
Working Capital % -1.43%

This means AAPL spends $0.0143 in working capital for every $1 increase in revenue. That’s not bad!

Step 4: Add Working Capital % To Operating Cushion

Gross Profit Margin % 37.80%
SG&A Margin % 7.00%
Operating Cushion % 30.80%
Less: A/R% -17.62%
Less: Inventory% -1.60%
Plus: A/P% 17.78%
Less: Prepaids% 0.00%
Plus: Deferred Revenue% 0
Working Capital % -1.43%
Core Op. Growth Profile % 29.37%

The final result: 29.37%. This means AAPL generates $0.29 in core operating cash flow (free cash flow) for every $1 increase in revenue. That’s fantastic. If AAPL can maintain that Core Operating Growth Profile, the company should do everything it can to increase revenues. Each dollar translates into nearly $0.30 in free cash flow.

Let’s see what the Core Operating Growth Profile looks like for IBKR.

Core Operating Growth Profile Example #2: Facebook, Inc. (FB)

FB’s known as a cash-generating machine. But what does that look like under the hood? Where are the real drivers of core operating cash flow?

Let’s find out.

Step 1: Calculate Operating Cushion (2019)

Step 2: Convert Working Capital To % of Revenue (2019)

FB had $9.52B in Accounts Receivables against $70.7B in revenue. That gets us -13.47%. The company doesn’t carry inventory on their balance sheet, so we keep that at 0%. Next is accounts payable. FB had $1.36B in AP against $70.7B in revenue, giving us 1.92%.

Finally we calculate Prepaid Expenses. FB spent $1.84B in prepaid expenses against $70.7B in revenues. That gives us 2.60%.

Step 3: Add Working Capital Requirements To Get Working Capital %

This means FB has roughly 14% of its revenue tied up in working capital requirements. That’s not bad.

Step 4: Add Working Capital % To Operating Cushion

Now we can see the true cash-generating power of FB’s business model. They generate $0.39 for every $1 of incremental revenue growth. That’s fantastic.

Closing Thoughts

Operating Cushion and Core Operating Growth Profile are two of the most powerful tools in your investment toolkit.

Analyzing businesses through these two frameworks allows you to answer each of these questions:

    1. How easily does a company generate operating cash flow? (Operating Cushion)
    2. Does the company need to spend a lot of cash to grow revenues? (Working Capital %)
    3. How much free cash flow does a company generate for each additional dollar of revenue growth? (Core Operating Growth Profile)

Get back to the basics of fundamental investment analysis: Follow the cash.


Two Free Breakout Alerts: Yunnan Baiyao (Ticker: 000538) & Dali Foods (3799.HK)

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It’s that time again! Once a month I pull two breakout alerts from our premium Breakout Alerts service. Members of the service receive 6-8 potential breakout opportunities each week.

So far we’ve had a decent 2020. But we’re not resting on our laurels.

This week we’ve got one long idea and one short idea.

Our two breakouts are Avantor, Inc. (AVTR) and Dali Foods (3799.HK).

Yunnan Baiyao (000538): Ascending Right Triangle

Business Description: Yunnan Baiyao Group Co.,Ltd engages in the pharmaceutical business in China and internationally. The company operates through four segments: Pharmaceuticals, Health Products, Chinese Medicine Resources, and Pharmaceutical Logistics. It provides health products, drugs, medical instruments, Chinese medicine resources, and tea. 

The company offers its products under the white medicine health, Leopard seven, Qiancaotang, Qiancaomeizi, and Tianzihong brand names. Yunnan Baiyao Group Co., Ltd. was founded in 1902 and is based in Kunming, China. – TIKR.com

Trade Parameters:
  • 3% Entry: $97.73
  • 1.50% Entry: $96.30
  • Stop-Loss: $84.47
  • Profit Target: $132.13
  • Reward/Risk: 3.03x

Dali Foods (3799.HK): Head & Shoulders Top

Business Description: Dali Foods Group Company Limited, an investment holding company, manufactures and sells food and beverages in Mainland China. It offers bread, cakes, and pastries; chips, fries, and others; biscuits and cookies; herbal tea; plant-based and milk beverages; energy drinks; and other beverage products. 

The company offers its products primarily under the Daliyuan, Haochidian, Copico, Doubendou, Hi-Tiger, and Heqizheng brand names. It markets its products through distributors, as well as retail, e-commerce, specialty, and catering channels. – TIKR.com

Trade Parameters:
  • 3% Entry: $4.40
  • 1.50% Entry: $4.47
  • Stop-Loss: $5.11
  • Profit Target: $2.76
  • Reward/Risk: 2.69x

Kura Sushi (KRUS): Restaurant IPO w/ Playbook for Success

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Business Description: Kura Sushi USA, Inc (KRUS). operates revolving sushi bar restaurants in the United States. The company’s restaurants offer Japanese cuisine and a revolving sushi service model. It operates 24 restaurants in five states. – TIKR.com

The Thesis: KRUS is a patent protected, technology-first sushi restaurant. The company offers high quality sushi at low prices thanks to robotic rice makers, automated dishwashers and a conveyor-belt delivery system. Such technology enables KRUS to offer lower prices while maintaining strong operating margins. KRUS flies under-the-radar of most investors IPOing around $150M. Its parent company has over 30 years of success in Japan. We think KRUS can grow into a 300-store empire generating $50M in annual FCF.

Unique Dining Experience: KRUS is unlike any other sushi restaurant in the US. The food comes to your booth via a conveyor belt. There’s no waiters/waitresses to take your order. Everything’s done at your booth via monitors. Diners also receive in-restaurant rewards like prizes for ordering 15 plates of sushi. There’s also a mobile app to track your Kura rewards ($5 coupon when you spend $50, etc.). When you’re done eating, simply deposit each plate into the installed plate disposal mechanism at your table. Each plate travels into an automated dishwashing system, removing the need for bus-boys and additional staff.

Technology-First Restaurant: We know about the conveyor belt, rice makers and automated dishwashing systems. But there’s two other facets to KRUS technology that give it an edge. First, each plate of sushi has its own unique barcode. The dishwashing system scans the plate and records which type of sushi you ate. This data allows chefs/rice markers to optimize how much of each type of sushi to produce.

Second, KRUS has patented technology on Mr. Fresh, their conveyor belt sushi delivery system. Mr. Fresh is a dome that covers each plate of rotating sushi (the sushi you don’t specifically order). Each dome has an embedded chip that alerts the kitchen when a customer takes the sushi. It also monitors how much time that plate has spent on the belt (keeping items fresh).

What’s It Worth: There’s a few main drivers to increase per-share value: annual store growth, gross margin expansion and cap-ex % reduction. Using its parent company as a proxy, steady-state KRUS would generate 40% gross margins, 5% operating margins and ~6% FCF margins. Assuming 20% annual store growth, we end 2024 with $160M in revenue, $64M in gross profit, $8M in operating income and $9M in FCF. Let’s review what shareholder value would look like under three scenarios (bold = higher than current market cap):

Cash Flow: It’s All That Matters

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Warning, this piece gets into the weeds of financial accounting statements. We dive deep into the cash flow statement, why it matters, and equip you with the knowledge to dissect statements on your own.

Before diving into the meat, one should understand why the cash flow statement is so important. There’s a few reasons:

    • You can’t easily fraud cash
    • Cash tells you the true earnings power of the business
    • You can’t pay debtors and creditors with EBITDA — you pay them with cash
    • Cash flow statements show you where a company generates cash and how it spends it over the course of a year or quarter

We’re using Cash Flow Analysis: Modified UCA Cash Flow Format to analyze the cash flow statement. I encourage you to download the PDF and follow along as you read this essay.

It’s What You Do With Cash That Matters

We study the cash flow statement because there are only a few ways companies can spend cash.

They can either buyback stock, issue dividends, acquire a business, reinvest in their own business or pay down debt. That’s about it.

Knowing how each of these decisions impacts a company’s cash balance is a crucial step in becoming a better investment analyst.

Let’s dive into the set-up for our cash flow analysis.

The Set-Up

The paper gives five case studies for analyzing cash flow statements. What’s interesting is that cases 1-4 report identical net income. How they get there is anything but identical.

We finish with a fifth example showing a net income loss. Through this fifth example we’ll see the power of focusing on the cash flow statement. It’s at this moment we see the detriment of obsessing over the P&L statement.

The First Four Cases

Our first four cases (or companies) generated $8M in revenue and $770K in net income. Those are the constants.

Let’s take a look at the first three cases’ income statement data:

C1-3 generated $1.12M in operating income and $1.02M in pre-tax income. Subtract out tax and we get our $770K net income figure.

Here’s where things get interesting. Though C4’s revenues are equal to C1-3 ($8M), C4’s operating income is almost $1M lower. How is this possible?

Take a look at C4’s income statement data:

There’s one line item that accounts for the discrepancy. C1-3 generated $140K from “Other Income” while C4 generated $1.1M. In fact, C4’s “Other Income” is enough to bring it in line with C1-3’s pre-tax income of $1.02M. That’s quite the difference.

The Power of Working Up The Income Statement

This is where we see our first large dichotomy on the income statement: Interest Expense & Other Income

Case 4 shows $770K in net income largely due to the $1.1M in “Other Income”. This is important. If you don’t actively analyze the income statement, you’d easily miss this.

If we “normalize” the “Other Income” for both companies, Case 4 would report substantially lower net income. In fact, if we normalize C4’s “Other Income” with C1-3, they’d report negative net income.

Now why does this matter? It matters because not all income is created equal. C1-3 are much stronger businesses because they generate the majority of their pre-tax income through their operations. You can’t say the same for C4.

In other words, you can’t rely on $1.1M in “Other Income” each year to make your bottom line. That figure could flip negative in an instant. Operating income on the other hand is much harder to sway. At least in that short of time frame.

That’s the 30,000ft view. Let’s dive into each specific case and look at their cash flow statements. What are they telling us that we can’t find on the income statement?

Company 1: Cash Flow vs. Income Statement Analysis

The first thing to focus on when moving from income statement to cash flow is accounts receivables. Specifically, you want to measure the change in those receivables.

In C1, we see -$500K in change in receivables. This means C1 sold more products on credit than they collected from customers that owed them money. In short, they received less cash in the bank from the product/service sold.

We adjust the change in receivables and recognize $7.5M in revenue. This is slightly lower than what’s reported on the income statement.

We see further differences in cost of goods sold (COGS). On the cash flow statement we see total COGS of $4.26M. This is lower than the income statement’s $4.96M.

The difference lies in an exclusion of an $800K deposit, as well as $300K increase in inventory reduced against $200K in paid accounts payable. This gives us $3.24M in gross profit (or 40.5% gross margins).

Operating expenses stay the same between the two statements at $1.92M.

Here’s the final core operating cash flow picture:

    • Income Statement: $1.12M
    • Cash Flow Statement: $1.32M

We’re going to use that $1.32M number on the cash flow statement to get true free cash flow.

After arriving at our core operating cash flow, we need to find how much cash to outlay for taxes. The cash flow statement shows $18K in recurring cash payments, plus $250K tax provisions.

We add $40K for deferred tax liability and -$42K for income taxes payable. This nets out to $252K needed for taxes. Those two figures ($18K and $252K) reduce our cash available (I.e., free cash flow) by $270K. This leaves us with $1.05M to service debt.

C1’s interest expense is $240K, which doesn’t deviate from income statement or cash flow statement. Now we’re left with $810K.

But we’re not done. We still need to account for capital expenditures. These can be for growth, maintenance, or a combination of the two. Regardless, we must pay them with cash.

Important Note: You won’t find capital expenditures in the income statement. You will only find that on the cash flow statement or balance sheet (potentially).

We see C1 spent $1M on CapEx in the current year. This brings our true FCF to -$190K.

The ending difference between what the income statement shows in net income vs. what the cash flow statement revealed as FCF:

    • Income Statement Net Income: $770K
    • Cash Flow Statement Free Cash Flow: -$190K
    • Total Difference: $960K

Onto Company 2!

Company 2: Same Income Statement, Different Cash Flow Statement

Remember, with C1-3 we have Identical Income statements. It’s the cash flows that differ.

C2 recognized $8M in revenue, but received $1.8M less in cash from that revenue. In other words, they sold $1.8M more product on credit than they collected from their customers. This could signal further problems with the business.

Questions to consider when faced with rising accounts receivables:

    • Why aren’t their customers paying?
    • Why are they selling more on credit?
    • Will they get those receivables back?

This gives us $6.2M in cash from revenues. Already off to a sketchy start.

It gets worse for C2. The company spent $4.76M in cost of revenue. C2 spent $1.2M on increasing inventory and saved $600K in accounts payable (I.e., not paying accounts payable for the period). They’ll eventually have to pay that $600K. So although it’s a positive adjustment to the current cash flow figure, we’ll need to reduce it by $600K at some point in time.

Adjusting for cost in revenues and changes in inventory/accounts payable gets us $1.44M in gross profit (18% margins).

You can see the effects these negative changes have on gross margins. Remember, Cases 1 & 2 have identical income statements, but C2 has 22% lower real gross margins.

From our gross margin we subtract operating expenses of $1.92M. This gives us core operating cash flow of -$480K. This is a much different picture than the income statement’s $1.02M pre-tax operating income.

Moving down the cash flow statement we see C2 with identical tax and liability payments ($252K). This brings cash available for debt service to -$750K. Bondholders won’t be happy about that.

Subtract another $240K in interest payments, another $1M in Capex and we get true free cash flow of -$1.99M. Ouch!

The ending difference between what the income statement shows in net income vs. what the cash flow statement revealed as FCF:

    • Income Statement: $770K in net income
    • Cash Flow Statement: -$1.99M in free cash flow
    • Total Difference: $2.76M

Not all hope is lost. Our third company proves a bit more promising for our bondholing friends.

Company 3: A Less Worse Picture of FCF

C3 looks better than both C1 and C2. The company generated $8M in revenue with a -$500K adjustment in receivables. This means C3 collected $7.5M in cash from those revenues.

C3 spent $4.26M to generate that revenue. $300K was spent on increased inventory, and $200K was saved by not paying accounts payable.

This gives us $3.24M in cash gross profit (40.5% margin).

Reducing our gross profit by $1.92M in operating expenses gets us $1.32M in core operating cash flow. This is $200K more than what’s stated on the income statement.

So far so good, right? Let’s move to the tax provisions and tax liabilities section.

C3 allotted identical amounts for tax provision, $250K. But this is where things get tricky.

C3 marked a $950K decrease In deferred tax liability. Confused as to what that means, check out the definition of deferred tax liability (according to Investopedia):

Deferred tax liability is a tax that is assessed or is due for the current period but has not yet been paid. The deferral comes from the difference in timing between when the tax is accrued and when the tax is paid.

The decrease means Company 3 paid more in taxes this year to make up for past taxes they didn’t pay. This is why you see C3’s total “Income Taxes Paid” at $1.242M.

After that massive tax bill, the company has a mere $60K to pay its debtors. Shave off another $240K in interest payments and we’re left with -$180K in operating cash flow.

Finally, the company didn’t spend any money on Capex in the current year. Maybe they didn’t spend anything for growth or maintenance. Regardless, C3 reported -$180K in true free cash flow.

The ending difference between what the income statement shows in net income vs. what the cash flow statement revealed as FCF:

    • Income Statement: $770K Net Income
    • Cash Flow Statement: -$180K Free Cash Flow
    • Total Difference: -$950K

Alright, at this point you’re probably wondering if we ever get to a company that shows positive free cash flow. Yes. Company 4 is our cash-flow knight in shining armour.

Company 4: What Positive Free Cash Flow Looks Like

We finally see positive free cash flow from C4’s cash flow statement. You know what we have to do. Break it down.

C4 generated $8M in revenues and $7.5M after adjusting changes in receivables.

C4’s cash cost of revenue came in at $4.9M. This breaks down to $4.8M from cost of revenues, minus $100 net change in inventory and accounts payable.

This gives us $2.6M in gross profit (32.5% gross margins).

From here we deduct our cash operating expense of $2.24M to get $360K in core operating cash flow.

As you might’ve noticed — this is substantially lower than C1 and C3. You’re wondering, “but Brandon, how in the heck can C4 get to positive free cash flow with all those interest and tax payments further down the statement? The answer: Other.

Company 4 received $942K in Other Recurring Cash Receipts. On top of that, they paid $252K in income taxes.

This means they have $1.05M in cash available for debt service.

Notice how large a benefit the recurring cash receipts were to the company’s free cash flow.

Are those receipts truly recurring? If not, we should assume this is a one-time benefit and forecast accordingly.

Now all that’s left is to subtract interest and capex to get our free cash flow.

Company 4 paid $240K in interest and spent $0 on Capital Expenditures. This gave them $810K in true free cash flow.

The ending difference between what the income statement shows in net income vs. what the cash flow statement revealed as FCF:

    • Income Statement: $770K Net Income
    • Cash Flow Statement: $810K Free Cash Flow
    • Total Difference: +$40K

Company 5: One Last Example w/ Different Income Statement

Company 5 has a different income statement than C1-4. Let’s flesh it out before going to the cash flow statement.

C5 generated $8M in sales. COGS totaled $5.6M and SG&A totaled $2.24M. This gave C5 $160K in operating income.

After subtracting $240K in interest expense, C5’s left with -$80K in pre-tax income. Add back $20K in tax benefits and you get -$60K in net loss.

Okay, now on to the cash flow statement.

C5 generated $8M in top-line revenue, but also recorded a $500K increase in cash received from receivables. This means the company reduced its accounts receivables (on the balance sheet) — collecting more cash from its customers than the previous period.

This gives us $8.5M in total cash received from revenues.

From that, we subtract $4.7M in cash cost of revenues. This includes $4.8M in COGS, a $300K positive adjustment for reduction of inventory and a $200K charge for accounts payable.

We’re then left with $3.8M in gross profit (47.5% gross margin).

Then we subtract our cash operating expenses ($2.24M) to get $1.56M in core operating cash flow.

So far, C5 has generated more core operating cash flow than C1-4. Let’s move down the statement for taxes and capex.

C5 paid $0 in income tax. How is this possible? The company had $20K in tax provisions offset by a $20K decrease in income taxes payable.

This left them with $1.56M in cash available for debtors.

After subtracting $240K in interest we’re left with $1.32M in operating cash flow.

C5 also elected not to spend any cash on capital expenditures, leaving all $1.32M for true free cash flow.

Operating Cushions, Working Capital and Core Growth Profile

As investors, we should focus more on the cash flow statement and less on the income statement. By going through each case study, we saw the differences a cash flow approach can make on analyzing a business’ true cash-generating capabilities. Each company generated the same amount of net income, but the amount of cash generated varied widely — and we could only pick that up by looking at the cash flow statement.

Our goal is to find companies that can grow the amount of cash they generate over time, and then to buy that company at a discount to those estimated cash flows.

But how can we estimate if a growing business is actually good for a company’s cash flows? After all, growth isn’t created equal. Growth can reduce cash flow in some companies, while juicing it in others.

That’s where Operating Cushion comes in. Simply put, Operating Cushion is the % difference between your gross margin % and your SG&A %. In English, it’s the contribution of a $1 increase in revenues to operating profits.

Using the paper’s hypothetical company, we see a gross margin of 39.56% and SG&A of 30%. This gives us 9.56% in operating cushion.

So, a $1 increase in this company’s revenues generates $0.096 in operating income.

The higher the better.

The paper takes it one step further, calculating a company’s Core Operating Growth Profile.

This is simply your Operating Cushion plus Working Capital %.

Here’s how we get Working Capital %:

    • Subtract A/R to revenue %
    • Subtract Inventory to revenue %
    • Add A/P to revenue %

In the example from the paper, this gets us -36.48% in working capital and -26.92% in Core Operating Growth Profile.

So, for every $1 increase in revenue, the company will burn $0.26 in operating cash flow.

You can see how powerful Operating Cushion and Core Operating Growth Profile is to an investor’s toolkit.

Closing Thoughts

The cash flow statement is the most important financial statement in a company’s books. It shows us how much cash a business generates, where management spends the cash, and how much they actually receive on their revenues.

It shows us a company’s cash-generating power, not its financial engineering pedigree.

By focusing on the cash flow statement, we’re also able to determine if growth is value creative or destructive.

If this white-paper has taught me anything, it’s that cash flow is king. Focusing on cash flow (not the income statement) will make you a better investor.

Creative Thinking: An Investor’s Last Remaining Edge

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Walt Disney epitomizes the ultimate Dreamer and Creator. From cartoons to movies to theme parks and more… His list of achievements is longer than Elon’s baby names.

How can one man develop the capacity to turn his dreams into the reality that billions enjoy today?

Superior models for operating mixed with a near-infinite supply of drive.

The creator of Mickey Mouse used a specific method of thinking to unleash his creative genius. Disney himself didn’t formally articulate this model of thinking. Robert Dilts, an NLP expert, put Disney’s ideas down on paper in 1994.

Here’s the best part. We can apply Disney’s strategy to our investment process.

Why Should Investors Think Creatively?

Before we dive into the method, we should ask ourselves, “why should we use creative thinking in our investment process?” After all, investing is pure math, right? Discount some cash flows, find an appropriate rate of return. Don’t pay too much for a good business … You get the point.

Did Ben Graham rely on creative thinking to profit from the markets? Nope. He used math. Did Walter Schloss dream about varying scenarios and future outcomes? Not quite. He bought a basket of undervalued stocks and held them for a year.

That was before computers commandeered the math.

Ben Graham and Walter Schloss lived in an age where information edges percolated every corner of the market. Find a 10-Q before someone else? You had an informational edge. Now, computers synthesize billions of data points in nanoseconds. Unless you invest in the darkest, most illiquid corners of the market, the days of informational edges are all but gone.

That’s why we need creative thinking.

As investors, our job isn’t to analyze the past. It’s to think about the future. To dream up scenarios nobody else is thinking about. To probabilistically weigh those potential outcomes to reality as we see it now.

That’s our job.

There’s no value in analyzing what’s in the past. All the value comes from what the future will look like in three, five, or ten years.

Take Chris Mayer’s 100 Baggers book as an example. You needed to have a dream of what the company would be in its early stages to hold on for dear life. An early investor in Monster ($MNST) wasn’t concerned with past operating losses. They were focused on the future of the market, the competitive advantages, and a world where Monster energy drinks sat in every grocery store.

But don’t just take my word for it. Take legendary trader Bruce Kovner’s words:

“First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen.”

We need to think creatively to generate outsized returns. Let’s learn how.

The Disney Method of Creative Thinking

The Disney Method of Creative Thinking is an active process. As investors (many of us one-man teams), we should use this method aloud. Actually speak your thoughts into existence.

The Disney Method has three “rooms” of thought:

    • The Dreamer
    • The Realist
    • The Critic

Step one, separate each room in your home or office. If you don’t have the option to create three different rooms, use your mind. Sherlock Holmes’ mind palace is a good place to start.

Disney’s process relies on flow from one room to the next. The process always follows a set path: Dreamer –> Realist –> Critic.

Now that you’ve got your three rooms, it’s time to start thinking.

The Dreamer

The dreamer is responsible for thinking outside the box. Your wildest dreams not bound by reality, logic, or common sense. You have to use your imagination. I know, it doesn’t feel normal to use your imagination when investing. But try it.

Don’t be afraid to write/say extravagant ideas or future scenarios. That’s what you’re supposed to do in the dream room.

Remember, we’re framing this through the mind of an investor.

Here’s some questions to jog your dreamer process:

    • If Company XYZ expands their product/grows margins/takes over an industry, what would that look like?
    • What will be the main driver of this company’s growth ten years from now?
    • What would sales and earnings look like if Company XYZ was able to achieve a dominant market share?
    • If my dream about the company were to come true, how much of a discount is the current market price?

The important part is that none of the above questions/answers have to make sense. They don’t have to be logical or completely reasonable. You don’t know if it’s possible — and that’s the point.

Check out the Dreamer visualization on the right from VisualParadigm.

When you dedicate a space for dreaming, you create a Rolodex of ideas, thoughts, and scenarios that either stick or don’t. In investing, dreams are often neutered by the scalpel of reality. Don’t let that happen.

One final note about the Dreamer stage — you must dream big. You can’t dream of a company with 20% EBIT margins growing to 22%. That’s not dreaming.

Really dream. Take a money-losing company and dream of a world where they gush cash and return capital to shareholders. That’s dreaming.

The Realist

Did you have fun dreaming of wild and crazy scenarios and futures? Good. It’s time to come back to reality. The next room of thought is the Realist. The goal of the Realist room is to think hard about the dreamer’s ideas. The realist asks questions like:

    • What needs to happen in order for that dream to work?
    • What are the chances that this alternate future comes true?
    • What steps can we take right now to help our dream become reality?

It’s important to note that the Realist is under the assumption that the above dreams will work In the future. In turn, their job is to discern how to actually get it done.

As minority investors, it’s hard for us to take action on a company’s future. But we can still use the Realist room as a way to channel-check our expectations of the company against the company’s plans.

For example, if we dream that a company’s revenues can grow 40% for the next five years, how will that happen?

We can assume our company penetrates new markets, makes strategic acquisitions or raises profit margins through operational leverage.

The realist takes the dreams and formulates ways to make them a reality. Sounds simple in theory.

Another key factor in the Realist process is identifying markers of achievement towards the dream becoming reality. If your dream is a company growing from $10M in sales to $100M in sales, a key marker would be top-line revenue growth. Or your dream is a net cash company with positive earnings. Your markers would be debt/equity, operating margins, etc.

Think of this step as Disney pitching his storyboard. A storyboard is the guts of a film. It’s the raw, unedited format used to build cinematic masterpieces. Every great film started as a storyboard.

Our job as investors is to create a storyboard for each company. These storyboards are investment write-ups.

Write-ups paint a picture of a dream — a variant perception of the future — with steps on how to get there. Like a storyboard reveals character and plot development, investment write-ups highlight business improvement and value creation.

The image on the left sets the stage for our Realist room.

Remember, the job of the Realist is to determine how to turn those dreams into reality.

Putting down our Realist hat, we move to the last room in our process: The Critic.

The Critic

Our Critic room has one job: punch holes and find where we’re wrong. This is the space to red-team your idea. In our Critic room, we ask questions like:

    • Does this plan make sense?
    • What barriers are we overlooking?
    • What competition is out there that could stop our plan?
    • Is the dream worth the work to get there?
    • What are we missing?
    • What are the weaknesses?
    • Where are our blindspots?

The critic focuses on the why:

    • Why won’t this work?
    • Why won’t we grow?
    • Why will it take longer than we thought?
    • Why are we wrong?

This is a critical step for investors. We’re putting our hard-earned capital at risk with each investment. We must know how/why/where we could be wrong in our Realist process. Ruthless criticism might hurt the ego, but it could save thousands of dollars in potential losses.

Talk to any successful investor and they’ll say the same thing: “I want to know how much I could lose if I’m wrong.”

My favorite quote from Joel Greenblatt echoes this sentiment (emphasis mine): “I want my biggest position to be in a stock that I think I have the least likely chance of losing money.”

Focus on the downside and let the optionality of your upside dream take care of itself.

Bringing It Together: An Investor’s Approach

I know, there’s a lot to take in. Let’s boil it down to the three main concepts:

    • The Dreamer: Focus on creating wildly different futures for a company that isn’t reflected in the current stock price and past financial data.
    • The Realist: Create a storyboard (write-up) that outlines how the company will turn your dream into a reality. Be specific, but don’t paralyze yourself with minutia.
    • The Critic: Understand and determine where you could be wrong in your plan for the company’s dream. Don’t be afraid to scrap an idea if the Critic strikes a damning blow to your alternate reality.

I wrote this essay for me. It was a reminder to myself that value isn’t created in screening for low price/earnings stocks. Computers can do that in nanoseconds. I wrote it to remind myself that true value creation comes from thinking non-linearly about dynamic businesses.

Non-linear thought in a linear, computerized world is our last remaining edge.

Computers know if a company is currently unprofitable. What they don’t know is if that same company is on the cusp of profitability. Computers can’t quantify a company culture or the skill of a CEO. Computers react. We dream.

Don’t be afraid to dream. Don’t be afraid to get creative in how you see a company growing over the next five or ten years. Disney’s creative thinking process allows you to think big while remaining anchored to reality. Invite your imagination into your investment process. You never know what you might find.