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....

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