Three Simplified Principles of Investment - Cryptocurrency Exchange Platform

Warren Buffett and Todd Coombs often exchange ideas in Buffett’s living room on Saturday afternoons.

Once, they posed a question:

As a valuation method: when you look at a company,

how confident are you in predicting its situation five years from now?

Buying an entire company requires examining various factors to different degrees,

such as:

capital requirements,

management style and efficiency.

These cannot be evaluated solely through financial models or formulas.

Coombs remembers that,

Charlie Munger’s first question to him was: five years from now,

how many companies in the S&P 500 will have improved?

Coombs believed it should be less than 5%,

but Munger said less than 2%.

But this is exactly the kind of question Munger,

Buffett, and Coombs ponder,

and it provides the context for this article: making investment judgments,

while being acutely aware of the world’s complexity.

He repeatedly emphasizes a core criterion: learn to simplify,

but simplification must be based on understanding the essence.

This article reads more like a long-term thinker’s personal memo,

containing his firsthand experience with IPOs like Mastercard,

dissecting companies’ moats,

and his renewed understanding of management teams,

capital expenditures, and pricing power after becoming CEO.

The Ability to Simplify Complexities

At the beginning of the article, Todd Coombs mentions a familiar yet often underestimated fact:

investing in stocks seems simple,

but doing it well is extremely difficult.

Many principles,

such as buying at reasonable prices,

identifying management,

avoiding speculation,

staying patient,

ensuring financial statement accuracy,

markets as voting machines rather than weighing machines,

and balancing quality and quantity of businesses,

are widely discussed,

but in practice, they are often easier to say than to do.

He believes that,

the biggest difference between excellent analysts and ordinary ones is: whether they can penetrate complexity,

and grasp the core.

This ability to simplify,

is not superficial compression,

but involves deep understanding,

layer-by-layer peeling,

to extract the most influential variable.

He illustrates this with his early analysis of Mastercard:

In 2002,

Todd Coombs attended a payment industry conference as a new analyst,

noticing that Mastercard was not yet listed,

and although it was not on Wall Street’s radar,

he tracked it for four years,

until its IPO in 2006.

At that time, the market was generally concerned about its pricing power and bank consolidation pressures,

but Coombs saw from industry structure that,

banks and Mastercard were actually “interests aligned,”

and after the company moved away from mutual cooperation,

its incentive mechanisms became clearer,

growth paths more transparent… some key qualitative factors cannot be ignored.

Because the process of simplifying complexities is itself quite intricate,

Coombs divides his analysis into three elements: discovering quality companies,

finding outstanding management teams,

and determining a “reasonable” price.

It’s worth noting that,

these three are not additive,

but multiplicative.

If any one is zero,

the entire investment decision loses meaning.

Principle of Simplification One: Discovering Quality Companies

In investing,

Todd Coombs is often asked: what kind of company qualifies as a good company?

In Coombs’ view,

the key lies in whether it has a competitive advantage.

Buffett famously used the “moat” metaphor,

the wider the moat, the better.

Besides this moat,

he further summarized a series of structural features that quality companies should possess: low capital intensity,

pricing dominance,

stable recurring revenue,

long-lasting market position, and long-term growth potential.

These standards seem routine on the surface,

but Coombs’ analysis emphasizes penetration,

that is, verifying these traits from the underlying financial and operational logic.

“Imagine a dollar of income flowing into a company,

through the cash flow statement,

then passing through the balance sheet,

ultimately reflected in the income statement.

” This is his explanation of the “correct research sequence.”

In his view,

starting from the income statement is misleading,

because it’s just a snapshot of the current period,

and easily manipulated.

In contrast,

the balance sheet and cash flow statement better reveal the company’s true operation.

I strongly agree with this point.

Especially in today’s information-dense,

narrative-saturated era,

many companies excel at storytelling,

but no matter how well told,

if cash flows are not real,

or asset structures are unstable,

it’s all just a constructed illusion.

Coombs mentions,

he tends to extend the time horizon,

reviewing ten years of data,

comparing retained earnings,

debt,

capital intensity, and income growth,

and using DuPont analysis to decompose ROE,

to understand the real profit drivers.

For example,

some companies appear to earn a lot on the surface,

but their debt levels have surged—

which might mean they are not growing through internal accumulation,

but relying on leverage to sustain growth narratives.

He also emphasizes,

pay attention to a company’s financing structure.

If a company relies on short-term floating-rate loans,

its profits may only be based on temporary interest rate spreads,

and once the environment changes,

problems will surface quickly.

On the accounting front,

Coombs lists a series of common “gray areas”: expense recognition vs capitalization,

immediate revenue recognition on asset sales,

acquisition accounting methods… these operations are not illegal,

but can cause significant profit swings.

He says,

profits are actually the result of many management assumptions and choices.

This reminds us,

not to be deceived by surface numbers,

but to learn to identify whether these profits hide excessive optimism or overextension.

Coombs also discusses a more specific angle: single-store economics.

He believes,

if you can estimate the construction cost,

maturity cycle, and return rate of a single store,

it often explains the company’s profitability better than consolidated financials.

He cites Costco as an example: the single-store model often reveals the business’s essence more clearly.

By analyzing publicly available data, you can roughly estimate the investment needed to open a new store,

the breakeven period,

and thus calculate ROI.

Of course,

such models can be distorted.

On one hand,

management often only includes variable costs,

ignoring maintenance capital expenditures,

which can overstate returns; on the other hand,

accounting treatments often don’t reflect the full cycle from investment to mature operation.

Similar situations occur in telecom,

“razor-razor blade” businesses, and some retail and software companies.

For example, American Tower’s profitability per tower is breakeven with two tenants,

but adding a third tenant immediately boosts unit returns,

and overall ROI increases accordingly.

Walmart’s early history is also a classic case.

Before going public, the company nearly had no book profits in the first ten years,

but analyzing its single-store economics reveals that,

at the store level, the economics are very solid.

All these reflect Coombs’ core investment principle: deeply study the business,

think like an owner,

rather than rely on management presentations or analyst recommendations.

Only by reaching this level,

can investors connect all financial, operational, and strategic details,

and truly understand how a company operates.

Principle of Simplification Two: Finding Outstanding Management Teams

If a competitive advantage is the criterion for “whether a company can grow,”

then Coombs proposes a more pragmatic question:

who is running the company,

and is that person still trustworthy?

He quotes Graham and Dodd’s words as a reminder: if a company’s management is dishonest,

the best approach is to completely avoid that stock.

Because management decisions not only impact financial results,

but also subtly influence organizational culture and long-term direction.

In identifying excellent management,

Coombs does not follow the common path of “listening to executives’ speeches” or “reading media reports.”

He says,

he always approaches from three angles: examining incentive mechanisms,

observing how they allocate their time,

and conducting in-depth market research for cross-verification.

In his view,

a good manager,

may not shine in current performance;

a seemingly outstanding team,

may just be riding on past achievements from three or five years ago.

Because in real operations,

many key decisions’ impacts only manifest after years.

Coombs reminds us,

a smooth environment can mask judgment,

and sustained good conditions can hide the quality of capital allocation.

For example,

outsourcing can indeed improve profit margins over many years,

but if it destroys core capabilities,

or weakens control,

its side effects can suddenly explode.

“Capital allocation” is also a litmus test for management’s ability.

Even with a stable business,

an experienced CEO,

if resources are misallocated at critical moments,

such as repurchasing shares at high valuations,

pursuing value-destroying mergers,

or failing to adjust resource deployment in response to external changes,

can cause long-term damage.

In Coombs’ view,

the most direct way to understand management’s motives,

is to look at how they are incentivized.

He usually starts from the company’s articles of incorporation,

analyzes annual compensation changes,

especially whether incentives are based on long-term performance,

or overly reliant on short-term stock prices.

He pays close attention to questions like: are management’s rewards based on real capital returns? Are options tied to actual performance,

rather than market fluctuations? Do CEOs frequently sell their holdings? Are there asymmetric risk incentives?

These details reveal management’s true considerations.

It’s worth noting,

Coombs warns us not to focus solely on total compensation,

but to observe the behaviors behind it.

Sometimes,

a high salary scheme may seem unreasonable,

but in fact, it recognizes long-term achievement; while some “reasonable” plans,

may actually encourage management to chase short-term stock performance.

From an investment perspective,

such incentive mechanisms determine how management responds to pressure,

whether they operate conservatively,

or chase valuations; whether they build steadily,

or take quick profits.

Another dimension Coombs values highly,

is how CEOs allocate their own time.

He admits,

he has never seen a manager who, within a year,

can travel frequently,

promote the company,

and still maintain deep understanding of the business.

He poses a resonant question: “Imagine,

if this were your family business,

wouldn’t you expect your CEO to be fully committed to operations? I prefer CEOs who focus on substantive work,

rather than just superficial appearances.”

He also mentions a “lateral verification” method.

Coombs actively communicates with people who have worked with the CEO,

to understand management style and the real impact on employees.

He seeks to deeply understand these managers’ personalities,

to gain a more comprehensive background.

For example,

a manager who emphasizes efficiency and high productivity,

may boost profits at certain stages,

but if that suppresses internal feedback and communication,

the company could become fragile in times of change.

“Maintaining honesty in knowledge within the management team is equally crucial,”

he writes.

Principle of Simplification Three: Determining a “Reasonable” Price

Compared to judging whether a company is excellent,

setting a “reasonable” price is often more challenging.

Todd Coombs does not provide valuation formulas,

nor list common multiples,

but emphasizes one point: pricing must be based on understanding the company’s essence.

He quotes Philip A. Fisher: “Determining whether a stock is cheap or expensive,

does not depend on its current price relative to historical prices,

but on whether the company’s fundamentals are above or below current market expectations.”

In other words,

we need to understand the quality of the business,

not just the price movement.

Coombs observes that,

many investors form opinions based on a “hearsay” approach: listening to friends,

attending conference calls,

reading analyst reports,

scrolling through research notes… after hearing so much,

they may develop a seemingly complete judgment,

but that’s often an illusion created by information transfer.

His own research approach is entirely different: starting from 10-Ks,

10-Qs,

annual reports,

company letters,

SEC filings, even reviewing ten years of industry magazines and news releases,

building a bottom-up framework based on corporate disclosures and factual materials.

Once this framework is established,

he then reviews conference call transcripts and channel research results,

constantly verifying and approaching the truth like a journalist.

This approach is especially effective against “cognitive pollution.”

Particularly in today’s highly dense information environment,

without your own fundamental judgment,

every piece of news can become a source of volatility.

When analyzing price reasonableness,

another core question is: does this company’s moat really run deep? Can it be sustained?

Coombs reminds us,

not to assume that a company with high returns over many years necessarily has a durable moat.

History shows many such companies,

once glorious,

ultimately faded due to technological change or increased competition.

Therefore,

he advocates Fisher’s “chat research” method,

not only analyzing financial data and historical performance,

but also engaging with customers,

suppliers,

employees—these “channels”—to assess the company’s current competitive position.

For example,

does the company truly have pricing power,

and is it fully leveraging it? Are there gaps in the system,

or unnoticed growth opportunities?

He emphasizes,

moats are not static,

but feature diversification: brand,

low cost,

convenience,

network effects… these are elements that form a genuine, multi-faceted moat.

Coombs lists a series of practical questions to help investors answer a core question after research: do you really understand this company?

Does it have a sustainable,

even scalable moat?

What are its most vulnerable points in the next five years? What are the path dependencies?

Does the company have pricing power? How will it exercise it?

In the face of the next recession,

is it fragile,

or “antifragile”?

What conditions are needed to replicate this company?

In five years,

will this company be in a better position,

with a broader moat?

He writes,

“If you can confidently answer these questions,

you will have a clear understanding of what truly matters,

and be able to accurately assess its intrinsic value.”

This is the starting point for making wise decisions.

I particularly like the concept of “antifragile.”

Coombs borrows Nassim Taleb’s phrase,

to describe companies that not only withstand adversity,

but absorb external shocks,

and grow stronger.

For example, attracting top clients and employees during economic downturns,

expanding market share when competitors falter… such companies’ moats not only do not shrink,

but actually “widen and deepen.”

Coombs also reminds us,

the purpose of research is never to “gamble,”

but to remain calm and rational during market fluctuations,

not to act impulsively.

If you spend enough time understanding the business,

tracking channels,

dissecting moats,

your confidence in facing stock price swings will be significantly enhanced.

As for the “reasonable price,”

Coombs believes it must be based on intrinsic value.

A company’s value,

in essence, is the present value of its future cash flows.

This seemingly simple model,

hides several key variables: discount rate,

growth quality,

and the capital needed to sustain that growth.

He provides a particularly clear valuation example (assuming a constant discount rate of 10):

• If a company’s annual growth rate is 15%,

and it requires no additional capital expenditure,

its valuation can reach 26 times its current earnings;

• If all profits are reinvested to sustain growth,

the valuation drops to 16 times;

• If the growth rate is 5%,

the valuations in both cases are 14 and 7 times respectively;

• Over a 30-year compounded horizon,

15% growth can generate an 87-fold increase in value,

while 5% growth yields only 4.5 times.

This model illustrates the importance of seeking companies with low capital needs and long-term growth potential.

Those that keep growing but burn cash and have low returns on capital are traps that look attractive but are deceptive.

He reminds us,

even a great company, if paid too high a price,

its future returns can be significantly diminished.

Valuation is not an inconsequential “epilogue,”

but a crucial step in investing.

Additionally,

he emphasizes two often-overlooked dimensions:

First, focus on “shareholder returns”—free cash flow after maintaining capital expenditures,

not just EBITDA;

Second, examine the company’s capital structure.

Higher debt levels mean greater volatility in equity value.

Because debt must be repaid,

shareholder returns are conditional.

Finally,

revisiting Coombs’ words in the article:

“Less is more.

In investing,

complexity does not yield extra returns.”

It feels a bit like Charlie Munger’s “soul,”

haha,

because Munger often says,

“We are always keen to keep things simple.”

By the way,

Todd Coombs initially connected with Munger,

after many deep conversations,

he was recommended to Buffett.

Remember,

behind all simplicity, there is no reduction,

only a deep understanding of the essence.