I’m a big fan of checklisting. It helps you make sure you’ve covered your bases before you make a big decision. Plus, when you make a mistake you can always add it to your checklist to avoid making similar mistakes in future. I use lists of questions before I make investments, but before I jump into the specifics of the lists, I should first touch on what kinds of investments I try to make.
In my approach to portfolio management I have three categories of holdings: “hold-forevers”, “turn-arounds” and index funds. Those are in order of preference and pretty self-explanatory.
A hold-forever is a strong business with significant economic moats that is temporarily underpriced, usually due to scandal that doesn’t end up having material impact on the business over the long run. These are long-term compounders and they are ideal because you don’t have to worry about when to sell them. They are also much more tax efficient than an approach where you have to buy and sell often.
By contrast a turn-around is a company that isn’t necessarily very strong, but is nonetheless underpriced. Here you want to identify a catalyst that will cause the market to come to its senses, after which you get out. These are less preferable than hold-forevers, because once you’ve gotten that return you have to keep looking for other ideas. Plus you have to pay tax (potentially short-term capital gains) every time you get out.
Since good ideas are relatively rare, the next best thing is to use index funds. I use index funds as a placeholder until I find an individual stock idea. I don’t try to time the market, because I don’t think anyone can do so reliably. Instead I try to prepare for eventual changing conditions without guessing when they will happen. I do this by having some capital in “safe” assets. This is especially important because if I only had stocks and stock index funds in the portfolio then, when the whole market goes down, I’d have to sell my stock index funds at a low price in order to finance the purchase of all the new bargains. It’s better to have some dry-powder for the market downturns, so I keep either bonds (in the form of bond index funds) or cash in reserve. The choice between cash and bonds is based on how high bond yields are (at current rates, I’d rather have cash). The amount of bonds/cash to hold depends on how overvalued the market is.
In assessing hold-forevers and turn-arounds there are some core questions that have to be answered before I enter the position. I think too many people only answer a portion of the core questions before entering positions and this can lead to big mistakes. Over the next sections I’ll list what I consider the core questions to be for each category of investment and then include some auxiliary questions to always consider, even though they are not as essential as the core questions. To clarify my thinking I also give example answers. For the hold-forever category I will give answers from my investment in Apple (in May 2016) and for the turn-around category I will give my answers for my investment in AutoZone (from July to December 2017).
Here the major categories are: a) intangible assets (i.e. strong brand, diversified portfolio of patents, exclusive access to a resource, etc), b) high switching-costs or a sticky product, c) network effects, or d) permanent cost or scale advantages (see Pat Dorsey’s book on Moats for more information on how to analyze moats). Strong brands are not always durable, so be careful with that (e.g. Crocs). Think about why the moats wouldn’t be disrupted in future.
AAPL example: Apple has a very strong brand (people don’t shop around when they have an iPhone), some patents that help them have very good build quality in their hardware, very high switching costs (Apple products only work with other Apple products), network effects (the App Store and Google Play Store are the only viable players in the mobile app space), etc.2. Do you have data to support the notion that the company has a competitive advantage?
Companies with a competitive advantage earn a higher return on capital (relative to cost of capital) compared to other businesses. Theoretically, in highly competitive industries you should see returns on capital converge to the cost of capital. It’s economic moats that keep returns on capital high. So, you want to look for high margins, with a gross margin that is very steady (pricing power), the ROE/ROA/ROIC should be both high and higher than its competitors, and low capital intensity helps. Note that the SQL Screener now has a MoatRank field that can help you identify companies that appear to have moats.
AAPL example: http://www.vuru.co/analysis/AAPL/economicMoat3. Is there data to suggest that the company is cheap?
Here you are looking for a price ratio (price-to-earnings or enterprise value-to-EBIT, for example) that is low relative to the prospects for the business. I try to look at the growth implied by the ratio. If historical growth has been higher than the implied growth, that’s a good sign. It’s even better if implied growth is negative, because you usually can be confident that a good business will at least grow a little bit. Another approach is to do a discounted cash flow model, but this can be a bit speculative because you have to guess future growth rates.
AAPL example: When I bought it, the PE ratio was less than 10, which implied negative growth. This was obviously crazy cheap.4. Why is the company cheap? What is the market’s thinking?
This could be any reason, but you should be able to identify it. If you just pick a stock based on it looking statistically cheap you open yourself up to making a mistake. Always remember that a stock can have a low price (relative to earnings or book value) for a good reason. Maybe the company is really going to shit.
AAPL example: Revenues declined for the first time (this was the event that was the death knell for Motorola), China’s demand was not as high as expected, and a big player, Carl Icahn, dumped all his shares.5. Why is the market wrong about the price?
It’s important to have a good counter argument here. The less speculative the better. It usually is anchored on the moats that the business has.
AAPL example: With Apple’s myriad of moats I found it very hard to believe that it wouldn’t have positive growth in the future.6. What is a bad development that would cause you to sell?
A price drop is not the right answer here. If you buy a hold-forever compounder at a good price, you have to be able to ride through rough times in the market, while anchoring yourself to the key reasons the company has an advantage. The only reason to sell the stock is if you have a very strong reason to believe that the moat has been disrupted, usually by a new technology (e.g. the Internet disrupted many traditional businesses).
AAPL example: I would have to see a dramatic disruption to the mobile phone and computing industry to get out of Apple.7. What is a good development that would cause you to sell?
The only answer for a hold-forever is sell it when you plan to or need to use the money. Hopefully that is a long way away, like 10 years or more. The beauty of a hold-forever is that you commit capital once and then you have no work to do or taxes to pay for years and years. It is much less time consuming than constantly trading in and out of stocks, but the one catch is that true opportunities are hard to come by.
For turn-arounds you don’t need a super strong company. It just needs to be underpriced. This means that the PE (or other price ratio) should be lower than usual and potentially lower than its competitors (depending on the reason for cheapness). Alternatively, you can look for whether the company has tangible assets that you could essentially purchase for less than their value in liquidation or use a DCF to reason about the price. Either way, you need quantitative evidence that it is cheap. It’s also good to look for a recent price drop which you could use to determine what event triggered the cheapness.
AZO Example: The PE ratio was less than 12, when the company usually traded between 15 and 19. Meanwhile, margins had not budged, while revenue had been lower than usual.2. Why is the company cheap? What is the market’s thinking?
It’s important to fully understand why the company is cheap. It’s not good enough to just see that it’s statistically cheap.
AZO Example: The market had sold off due to the declining revenues, however management thought it had more to do with weather than anything. The market was also very fearful of Amazon getting into the car parts industry.3. Why is the market wrong about the price?
Here you have to come up with a flaw in the market’s logic. Look for behavioral biases (excess fear) and selling for non-fundamental reasons (like reacting to someone else announcing that they sold). The less speculative, the better.
AZO Example: I believed the manager’s assessment of the declining revenues and felt that people would be more inclined to shop at a store for a car part, because of the added benefit of getting advice and help with installing the part.4. What is a catalyst that would cause the market to realize it is wrong?
Cheap stocks can stay cheap for a long time and the longer you wait for the market to come to its senses, the lower your annualized return will be when it finally happens. For this reason it’s best to only get into turn-arounds where you see a clear catalyst (or event) that will cause the market to realize its mistake. More often than not, it’s just an earnings report.
AZO Example: I believed that future earnings reports would show the market that the revenue decline was temporary.5. What is a bad development that would cause you to sell?
Again, I don’t think price should be the basis of selling. The market can go all over the place based on speculation alone. You should anchor to fundamental facts. You want to sell if something proves your thesis wrong or if the catalyst you expected did not occur.
AZO Example: If the earnings reports after I bought showed a continued decline in revenues, with no good explanation from management, I would have sold.6. What is a good development that would cause you to sell?
Unlike hold-forevers, we want to get out once we witness the turnaround and get the outsized return. So, here you want to either get out once the catalyst has occurred or once a price ratio has returned to normal (indicating that people are no longer fearful).
AZO Example: I waited until the PE ratio returned to the lower bound of the “normal range” (15).
Do I fully understand the business (i.e. is in within my circle of competence)?
If the business is too complicated or requires too much domain expertise, then you have a lot of unknowns that might affect your judgement. You don't have to make a bet on everything that looks like an opportunity. Make sure you know your risks.
Have I read the latest 10-K filing? Have I read both bullish and bearish analyst writeups about the company?
This is a no-brainer. You want to have more than one perspective on the stock, including the managment's perspective (which is likely to be biased but useful).
How predictable are the returns for this business (e.g. how exposed is the company to changes in commodity prices which are hard to forecast)?
The more predictable the cashflows are the more accurate your valuation will be. It's as simple as that. Avoid businesses that can easily be disrupted.
Does the company have capable management? Does management allocate capital appropriately? Is management rationally compensated? Is management self-serving?
Buffett famously wrote: "With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." This is why it's best to focus on business with great economics (i.e. strong moats). However, he also wrote extensively about how much he wants to have a management that it both brilliant and trustworthy, because having great management in a strong business is even better. It pays to look into signs that management are competent and aligned with shareholder interests.
Does the company have a good culture? Is it a desirable place to work?
A company's culture and employees can add up to an intangible value that only produces positive surprises. Having this factor can add to the prospects for a hold-forever investment.
How leveraged is the company? What is the debt-to-equity ratio and what is the interest coverage ratio?
High returns on equity can sometimes be the result of dangerously high leverage (borrowing money to magnify returns), but leverage cuts both ways. When bad times hit a highly leveraged business, they hurt a lot more. It's better to avoid taking that risk and sticking to businesses that are modestly leveraged.
Does the business have a runway for growth or is the market saturated?
This is an important point to consider when evaluating your assumptions for a business. If a market is saturated you can't project high growth rates, even if they did occur in the past.
Are the revenues overstated / understated due to boom or bust conditions?
Make sure you're not anchoring to results in abnormal conditions. Look at a long enough history that you can tell what part of the business cycle the company is experiencing and adjust your expectations accordingly.
Who are the customers of the business? What fraction of revenue comes from the few largest customers?
When a great business is at the mercy of a single customer, there's a risk that the company's earnings could be badly hurt by that customer changing its mind. It's best to stick to businesses that have a diversified set of customers.
What percentage of the company do insiders own? Is there any insider buying?
Watching the behavior of insiders can be a tipoff. Insider selling can occur for a variety of reasons (raising funds to buy a house, for example), but insider buying only really occurs when insiders believe the business is undervalued. Keep an eye on this.
Ultimately, the purpose of this exercise is to help you avoid taking risks irrationally, to try to understand what your edge is, and to keep you disciplined when the market behaves badly. The key takeaway is not only to ask "does it look cheap?", but also "why is it cheap and what variant perception do I have here?" Are you actually observing overly fearful, herd-like behavior and acting rationally? Or are you just being a speculator playing devil's advocate?
Have I missed any important questions? Let me know by emailing me at email@example.com and maybe I'll add great ideas to an "updates" section.