4 Tips To 99x Your Destination Analysis To Profit From Great Businesses

Successful investing requires a focus on a company's long-term destination, rather than just its current financials.

Picture created with AI by Dreamlike.art. BTW he’s drinking tea, not gross coffee!

This is the function of destination analysis. It helps keep our focus on the future. We want to find and own businesses that have the right attributes to reach that destination.

Most investors focus on current financials and short-term macro events. Then they try to generate money by holding a stock for a quarter or two. This short-term approach might work a small percentage of the time. But as the data clearly shows, stocks are highly volatile with shorter holding periods

If you can’t stomach the 1-year volatility to the downside, chances are you’ll:

• Exit your investments at a loss by selling went the price goes down

• Miss out on years of upside by selling early because your stock doubled

Full credit for the idea of Destination Analysis goes to Nick Sleep and Cais Zakaria of Nomad Investment Fund fame. I’ve just taken the idea and attempted to disseminate into it its working parts. Then I’ve tried systematizing it into my own useable frameworks so I can use it as part of my analytical process!

Let’s have a look at my favourite method for bypassing short-sightedness and exiting with fat profits!

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Focus on the Company's Long-Term Destination

This is hard for most investors to execute, but it’s possible.

If you are sick of holding stocks for 3-6 months and losing money on most of them, you’ll want to focus on taking advantage of businesses with great destinations.

To analyze whether a business has a bright destination you’ll want to focus on:

• Understanding the business

• Examining the company's DNA

• Asking better questions about its future prospects

In order for destination analysis to work, we need to have a high degree of certainty about where the business will be in 5-10 years’ time. When you have intimate knowledge of the above three points, you’ll be well-armed to answer these questions. Additionally, you’ll have more clarity on what the future holds for the business.

Let’s break down each point a little more.

Understanding the business means you understand:

• What the business is required to spend money on to maintain and grow

• What the risks are to prevent the business from operating and growing

• The business’s competitive position in the industry

• The business’s competitive advantages

• How the business makes money

• Industry KPIs

• Debt situation

• Management

• Incentives

After understanding this point, you should have the second and third points mostly answered.

You’ll know the business’s DNA by understanding its competitive advantages. You’ll be able to easily identify what key products and services have gotten the business where they are today. And you’ll understand if the business’s DNA has resulted in the business getting better and better, or if it’s been a drag.

When looking to ask better questions about future prospects, I think Mohnish Pabrai has done a great job coming up with a few:

• Is the business a cinch, or almost a cinch?

• Can executives put their feet up on their desk and let business come to them, rather than chasing it?

You can come up with your own questions that you think will help you determine if the destination is achievable.

What Toilet Paper Teaches Us About Anchoring

Back up the date to April 2020.

You went to the grocery store to buy your food and household items. When you came to the toilet paper section you’d be looking at empty shelves. This is anchoring bias in action.

People heard that toilet paper was hard to come by. They anchored themselves to this fact and would then stock up on it to make sure they wouldn’t run out. This created a self-fulfilling prophecy because toilet paper did run out because people were stocking up on it, not because of supply chain problems.

When it comes to owning stocks, investors do the same thing.

They’ll buy Carvana CVNA 0.00 at $300 and hold onto it for dear life. They've anchored the price they paid to the value they got. Unfortunately, they were wrong. The value of CVNA 0.00 is nowhere near $300, so they'll be waiting a very long time for the business to get back there (if it ever does).

Now, let’s tie this into destination analysis.

We have to understand that when we buy something, its value can change based on new information. We want to avoid anchoring ourselves to our prior evaluations, beliefs, and narratives. When information changes, we must also change our destination.

The fact is Nick Sleep, Mohnish Pabrai, Warren Buffett, Li Lu, and Guy Speier are all wrong about some of the businesses they own.

What keeps these great investors outperforming is the ability to change their minds on something when the data no longer supports their initial thesis. You must have humility here. If your ego is too big to let go of an idea you now know to be wrong, you will get crushed by both the market and your ego.

The truth hurts (and is expensive!).

Farmer Jack, Tomatoes and The Pitfalls Over-diversification

Diversification has been touted as an important part of safe investing, but it doesn’t apply to everyone.

Put yourself in the tractor seat of Farmer Jack. He owns a farm where he tends many types of fruits and vegetables:

• Strawberries

• Cucumbers

• Tomatoes

• Pumpkins

• Potatoes

• Carrots

When he learned farming from his father, he was taught that selling a variety of produce was the key to being a good farmer. His father who he admired greatly was never wrong!

Farmer Jack does an admirable job selling a diverse range of products for a time. Then he starts looking at how much of a profit he was making from selling Tomatoes vs selling Potatoes. Both are selling well, but he makes 3x the profits selling tomatoes compared to potatoes.

He starts looking at how tomatoes compare to his other fruits and vegetables and notices a similar trend.

A sense of uneasiness begins settling in the pit of his stomach.

He’s seeing that many of his other produce items are keeping his farm from producing better profits. If he’d done the opposite of what he was taught and just stuck with selling tomatoes he’d have a profitable farm rather than one which requires regular trips to the bank to stay in business.

This is a lesson on how over-diversification can be a massive drag on success.

There are 3 areas of over-diversification you need to understand if you want to take advantage of destination analysis:

1. Avoiding complacency

2. Understanding the pitfalls of over-diversification

3. Be mindful of the opportunity cost of subpar outcomes

When you are over-diversified it’s easy for complacency to set in.

When it comes to your stocks, you might notice you no longer read or listen to quarterly earnings reports and Q&As. When this happens, it becomes harder and harder to understand all the small details happening in the business that could guide future decision-making. This is one of the reasons why over-diversified investors have so much turnover in their portfolios.

When you have a faint idea of what specific holdings are doing you end up relying on emotion and price fluctuations to guide decision-making.

You want to avoid this at all costs. If you want to be diversified, cap your holdings at a realistic number you can follow thoroughly. Once you get to 100 different stocks, it’s not possible to understand what is happening with each one. The number of stocks you can follow depends on how much time you want to spend.

The less time you want to spend = the smaller amount of stocks you can realistically follow.

The other problem with over-diversification is in relation to opportunity cost.

“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money." - Charlie Munger

As Munger discusses in the short quote above, if you have six wonderful businesses, you do not require further diversification to be successful. You can argue that further diversification will reduce your upside. The reason is simple: when you allocate money to your 7th best idea you are foregoing the opportunity to invest money into your top 6 ideas.

If you understand the 6 businesses incredibly well, you’re better off investing more into one of those ideas rather than your 7th best one.

Focus on the Destination, Not Short-term Performance

From my observations, many investors claim to be long-term investors, but their actions paint a different picture.

For instance, I’ve interacted with investors who consider themselves long-term investors. Yet, when I observe what they do, it's like they're playing a game of musical chairs with their stocks… Constantly jumping in and out of positions at the sound of every price fluctuation, hoping they won't be the ones left standing when the music stops!

They’ll try to time the market to find great entry and exit prices. They’ll focus on short-term macro events to help them make decisions.

These are all speculative attributes.

Traders do the exact same thing.

Nick Sleep covers two simple concepts that help him focus on the destination and avoid the mistakes most investors make from focusing on the short term. His two concepts are:

1. Avoiding getting too caught up in adjectives used to describe good and bad years

2. Focusing on the bigger picture

The adjectives he discusses are the ones you read about regularly in the news.

You’ll see the news consistently trying to make sense of the market when it’s a complex system. They’ll use the adjectives above to attempt to show you why the market went up or down on every single trading day of the year. But they have zero ideas that are helpful.

Sleep’s point is that you shouldn’t be getting caught up in the daily pollution the news sends your way.

You can consume the news if you must, but you don’t need to base decision-making on it. What you should be doing is finding out what can happen to your business to make it better or make it worse. 99% of the news out there is completely irrelevant to the outcomes of the stocks you own.

Part of your destination analysis should help you determine what needs to happen for your destination to occur. Another part of your destination analysis should inform you of how your destination could never be reached.

I call these my two playbooks.

Each playbook holds the detailed events that need to happen or could happen that would prove my destination to be valid or false. This is what you want to pay attention to when consuming news. The rest is noise and purely for entertainment value.

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When you use destination analysis as a key tool in your investment analysis, it:

• Reduces myopic thinking

• Aims your focus on the fundamentals, not share price changes

• Allows you to consume the news while reducing errors in decision making

• Gets you focused on businesses with the best possible destinations, while ignoring the rest

• Helps you change your investing thesis based on facts, not sentiment or emotions

Do you use destination analysis in a formal or informal way when you are looking at a stock? I’d love to know in the comments section!

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Resources

• If you like fancy graphs that easily calculate CAGRs; allow for multiple metrics on one graph; have a massive database of worldwide stocks to choose from; and have incredible custom KPIs then you have to check out Stratosphere.io. If you’re interested in getting these excellent KPIs then you’ll need the premium version. If you want access to that and want a 25% discount, use my discount code “TheThinkingInvestor” to help both of us!

• 5 Minutes To No: My free ultimate guide on how to maximize your time spent on only the highest quality businesses while leaving low returning stocks in the rearview mirror. Click here to get the ebook.

• Evaluation De-Mystified Course: A free 7-day course teaching you 5 evaluation methods you can use instantly to level up your ability to value a stock. Click here to get started on the course!