Wednesday, January 16, 2008

Check list for new investment

The purpose of this checklist is to evaluate different aspects of an investment in a methodical fashion. Each investment is different and it is unlikely any single investment will meet all the criteria listed in the checklist. However, it does help an investor to methodically think through different aspects of an investment. This is well suited for long term buy and hold investor.

Think like a business man:

Identifying good businesses is the most important decision for a long term buy and hold investor. A good business can make money inspite of mistakes by management and investor. Here are few items to think about related to business.

1. Is the business a commodity type business or a franchise or something in between? Either business can make money but understanding the difference is critical.

2. What are the competitive advantages for the business and are they sustainable over extended periods of time (say over next 5 years)? Warren Buffet has laid out a question that will help us answer this question. If you ask yourself, what will prevent a well financed competitor from taking business away, usually answer should start to come out.

3. Will the product or service sold by the company still be in demand after 5 or 10 years? The obsolence risk is key as it can mean the investment could be wiped out. This is not limited to technology companies. Think impact of Amazon on barnes and Noble.

4. Who are company's primary competitor's and what are their strengths? Is a competitor getting stronger? What are the chances of competitor breaking the competitive advantage of the company in question? Think what HP did to Dell. I will admit this is easy in hindsight but is worth thinking about.

Growth drivers

Stong moat based business is essential but that does not guarantee share holder returns every year going forward. Buy and hold investors need earnings to increase year after year to benefit from an investment. So having ample growth opportunities for the business is critical. Plus it prevents management from allocating capital to value destroying projects. Here are some growth drivers to think about...

1. International opportunities: Need I say more here...

2. Favorable demographics for the product...

3. Market is fragmented and possibility of market share increase from small players by either acquisition or competition.

4. Pricing power: This is easy way to increase earnings if the product has strong franchise characterstics. Think See's candy...Not much growth but big rise in profits...

5. Depressed market demand for the product due to current economic conditions that is likely to change in the near future. This needs to be differentiated from secular demand reduction.

6. Cost reductions is also a driver but must be combined with one of the above factors to be meaningful.

I particularly welcome thoughts about other growth drivers....

Lets check the numbers!

While evaluating numbers, it is critical that one thinks about business attributes that drive the numbers. ROA greater than 10% must immediately ask what causes the businesss to earn such superior returns. Also, it is important to remember, that numbers represent past performance and an investor must evaluate whether business fundamentals are intact to create similar numbers in future.

1. ROE > 15% and ROA > 10% [for non financial companies] over past 5 years provide a quick look at how well the business is doing and also how well the management is allocating new capital. Is ROA and ROE decreasing from past? If so, is it due to management's poor capital allocation or business fundamental changes? It is important to distinguish between cyclical factors (economic slowdown) vs secular changes. It is an interesting excercise to screen for these two factors and you will not find many businesses that meet this threshold over past 5 years.

2. Getting a decent ROIC( return on invested capital) provides a good proxy for determining whether the company adds value or destroys. If possible, identify return on incremental capital. ROincrementalC will decide future earnings growth. This number is difficult to figure out but changes in ROIC is a good proxy for ROIncC.

3. Long term debt: Looks for companies with no or mimimal debt. Usually companies in good business can grow without too much outside debt. So better to avoid companies with too much debt. As a thumb rue, say debt of more than 3 times yearly earnings is an orange flag and more than 5 times earnings is a red flag. Exceptions exist but for part time investors, it is not worth getting into gray area.

4. For non retail consumer companies, look at operating margin. This provides an indication towards the strength of the franchise. If a company can sell it's product at a premium, it also implies, that company has some strong competitive advantages and possibly pricing power. In contrast, retail companies have thin margins and make money by high turnover.

5. Increasing revenue and earnings over past 10 years. This will not occur every year but the trend showing upwards indicate increased demand for company products and services and general growth culture.

6. Prefer small cap companies. This is not hard and fast rule.


The idea here is to identify managements that think like owners. That is easier said than done. But some pointers are listed below...

1. Management experience: Peter Lynch said buy a business even an idiot can run because eventually one will. This speaks to buying simple and strong businesses. While management can make enormous difference in the outcome for a shareholder, one area needs particular emphasis. A commodity type business needs very able management and may not survive missteps. So do not buy commodity type business without a feel for the management ability.

2. Insider ownership: If it is so good an opportunity as the annual report suggests, why will the insiders not want a piece of it. It is even better if their stake is obtained by purchases in the market as opposed to options.

3. Share holder communication: Management should at least take time once a year to clearly explain the business prospects to shareholders. If you do not follow how the company makes money after reading the annual report, make no mistake. It is not your fault. Annual report is a report and not a marketting document.

4. Capital allocation: Capital allocation is the most important job of top management. It can take few years some times to see the results. Use both numerical (decline in ROE or ROA could be a sign) and business analysis (too many mergers or acquisitions without past success) to make a judgement.

5. Does management graph ROIC (Return on invested capital), ROE and/or ROA in addition to eps growth? I find that if annual report has a graph for ROIC for past 5 years or so, it is usually a good sign that management is not just focussed on growth but on profitable growth.

6. Kudos from other good value managers. It is worthwhile looking at all past news stories and articles to both understand business aspects as well as about management. If a fund manager talks highly of a manager, usually keep your ears tuned. If Warren Buffet appreciates a CEO (like he did about Ken Chanault, Jeff Emelt, Fastenal and COSTCO CEO's), you get an endorsement that is worth keeping in mind.

For small investor, assessing management's quality is not easy but not impossible.

7. Management talks about spinoff rather than merger: Managements usually like to build empire rather than dismantle it. But if management voluntarily talks of spin off, it is a good sign to look at.

8. Management compensation: Rather than size of it, look for alignment of incentives. Compensation must look at ROIC as well as eps growth.

A high ROIC but no eps growth means that management is not adding much value and is just operating the business to milk cash. This may be ok for saturated businesses and not for a business with good growth prospects.

A diminishing ROIC with eps growth means that incremental growth is not profitable. So some combination of these two must decide compensation incentives.

Also, equity capital is not free but is usually treated as such. Even a bank acount will earn more interest if additional capital is added. An ideal compensation does not treat share holder capital as free money. I find very few examples but here is one from Thor industries proxy. Thor industries compensates it's subsidiary as follows. It is no surprise that CEO owns 30% of the company stock.

" The management of each operating subsidiary is provided with incentive based cash compensation through the Company’s Management Incentive Plan (“MIP”), which provides for an annual bonus pool equal to a percentage of their operating subsidiary’s pre-tax profits in excess of a threshold established by the Company’s Chief Executive Officer. Pre-tax profits of an operating subsidiary are determined by reference to the income statement of the operating subsidiary after deducting an interest factor based on the amount of capital, if any, utilized by the operating subsidiary during the fiscal year. We believe that we have been successful in attracting, motivating and retaining management of our operating subsidiaries in large part due to our policy of providing cash compensation based upon the profitability of our operating subsidiaries."

While this does not take ROIC into account, it does take into account that equity capital used in the year to generate growth.

How much to pay:

More on this to follow....

Keep your comments coming....

Thursday, January 10, 2008

Creating value by growth.

For buy and hold investor in public companies, it is important to make sure company has additional avenues for growth in it's line of business. It is often easy to overlook this important aspect while reviewing Warren Buffett's investment criteria. Lets first take a minute to review Warren Buffet's investment criteria.

To put it simply, buy businesses with sustainable competitive advantage(s), run by honest and competant managers and selling at a fair price. Warren adds that to evaluate these qualities, the company needs to be within one's circle of competance.

I would add that in addition to these qualities, it is also important for buy and hold investor in public companies to also look for potential growth opportunities that the company has in it's line of business.

It is instructive to look at a question that was asked in May 2008 Berkshire share holder meeting. The question was whether Warren would prefer a company like See's candy (with moat and high profit margins) but not many opportunities for growth or a candy company with 14% profit margin but lots of growth. Warren replied that he does not mind either. He has no preference between the two. This implies that growth is not necessarily that important in an investment. This is true but Berkshire business model is different from other companies and it is worth looking at that closer.

If a company like See's candy generates lots of cash without growth opportunity, the best course of action is to distribute that cash to shareholders. In the case of Berkshire, Warren would deploy the profits from See's candy in other businesses that have opportunities for growth. But most companies operate in single line of business and are forced to either distribute the capital to shareholders or to allocate capital within the current line of business. Since management is paid for growth, returning capital to share holder is not on top of their mind. So Management usually deploys the earnings in a lot of value destroying projects rather than returning the capital to share holders. Over long term this reduces return on invested capital and eventually share holder return.

To avoid this dilemma, pick a company with opportunities for further growth and management will at least have some place to meaningfully allocate capital rather than dream up meaningless projects. For buy and hold investor in a public company (unlike Berkshire), it is better to identify companies that have good growth potential in addition to competitive advantage.

A company having sustainable competitive advantage can protect it's turf but if it operates in a saturated field without opportunities for further growth, it will likely not create long term value for the stock owner. Don't mistake me here. There is a possibility of making one time excess return if the company is under valued. But after that, it does not create long term value. Based on DCF, if discount rate of 10% is assumed and if company distributes all it's earnings and does not grow it's earnings, it is valued at 10 times earnings. So if you buy at 5 times earnings, you may make a great one time return but after that it does not create excess return.

But to truly create value over long term, a company must not only have sustainable competitive advantages but also have room to grow. Or in other words, it needs to be able to use it's advantages to deploy retained earnings at a very high rate of return. Sustainable competitive advantages are very important. But for buy and hold investors in public companies, future opportunities to grow using those advantages are equally important. Thus one must also evaluate how much growth opportunities exist for the company's products before investing. Otherwise the company's moat may not result in long term share holder value.

I recently read Jack Welch's book 'Straight from Gut' (Ex-chairman of GE). One of the mantra's of Jack was to only own businesses in GE that were number one or two. The reasons are obvious. If they are No.1 or No.2, those businesses obviously have some inherent competitive advantage. But there was an unintended consequence. That is, the business leaders started to define categories so narrowly that their products were No1. or No.2. Essentially this narrow definition limited future growth because of fewer opportunities to further expand. Or in other words, it is not only important to have competitive advantage but also to have opportunities to use those advantages to expand further. That creates true long term value.

One of the reasons for Warren buying Coke in late 80's apart from it's low valuation was because of it's huge international opportunities. To be sure, this is not a new concept and has been documented in Phil Fischer's book 'Common stocks and uncommon profits'. But when reviewing Warren's criteria, this aspect could be easily missed by part time investors like me.

In the next article, we will try to dwelve deeper into what growth drivers one could look at. If I get an opportunity to ask Warren, I would ask a list of growth drivers that he usually looks for. Until then, lets come up with a few that can help us. See you next time with a list of growth drivers.