Value investors talk a lot about checklists. I assume this is due to the book “The Checklist Manifesto” and Mohnish Pabrai’s talks on the subject. It might also be due to Charlie Munger using the term. I’m not sure I want to call these seven areas I look at a checklist. It’s too broad to be called a checklist. A checklist should really be a list of quick actions you can take. These are more like aspects of a stock to analyze. However, many investors probably skip some of these aspects. The order in which I present them may also be informative.
First, the list:
5. Capital Allocation
Then some caveats:
This is not a pure value approach. Many of the stocks I buy are value stocks. But that can be seen pretty quickly. As I like to say, I own some “conspicuously cheap” stocks. But you don’t need a long list to see they are cheap. Ben Graham and Walter Schloss-type stocks are instantly identifiable.
So this analytical checklist of sorts is meant for a more qualitative approach. I tend to analyze in words. I make very few predictions. Basically, my analysis is a combination of:
· Direct Comparison (Ranking of alternatives)
So, when I say I look at an area – I mean I try to sketch out how to frame my thinking about that aspect of the stock in logical terms. I use stats – especially 10 to 15 years or so of historical data for the company. And I make a lot of comparisons – especially to stocks I already know well.
This last part sets my approach off from what lots of other folks do. I tend to rely on direct comparison – actually forcing myself to rank one stock against another on each point. So, instead of just saying for “value” that a stock’s P/B is x, its P/E is y, etc. I write down an actual question. I think about a stock I know and believe to be cheap. For example, I now own George Risk (RSKIA) and Ark Restaurants (ARKR). So, I’m always going to compare the EV/EBITDA of a new stock I’m looking at directly to those stocks.
Explaining how I analyze stocks on that micro a level is too detailed for this article. And it’s personal. It’s how I do it. I feel most comfortable being explicit about:
I feel least comfortable being explicit about future predictions. In fact, you’ll find very few predictions with actual numbers attached in any of my analysis. I do, however, use what I’d refer to more as thought experiments. Basically, I take a possible complaint – like this stock is “dead money” – and work out the basic math to see just what it would take to make that objection valid and persuasive. This is very different from predicting. For example, I might say a company will simply pile up cash for 15 years and then the market will suddenly decide it should trade at a normal EV/EBITDA, or the board will pay all the cash out in a special dividend, or it will be acquired, or…
This is obviously not a prediction. It’s just sketching out a logical limit to an argument. For example, it’s unreasonable to make a dead money argument that relies on the stock price and capital allocation policies of the board being unfavorable for 15 years. I’ve never seen that occur in real life. In fact, my experience has been that prices and policies adjust a lot faster than that – often without explanation.
So, before taking a look at the seven areas I focus on – keep that in mind. I don’t predict. I describe. And then I try to sketch out the logical ways to frame the investment. That’s almost always how I operate.
You can look at these seven areas in one of two ways. One, you can consider them dangers. You can treat them as possible failure points that disqualify a stock. Two – and this is more how I think of them – you can think of them as potential defenses against loss. You can think of each area as a possible strongpoint you can fall back on to protect your principal. If a company is high enough quality, if you buy it cheap enough, etc. you can afford to miscalculate a bit in your analysis of some of the other areas and still not lose money.
This is how I think. But again, this is a personal list created through a personal process.
Finally, remember it always changes. I used to include other areas and I eliminated them. I used to explicitly focus on management and organization – two separate questions – and now I don’t. This is more of a research issue than anything. I found that while I could gather plenty of info on those aspects of a company – they didn’t lead to decisive conclusions. So, they had to be treated under different areas.
Likewise, I used to think in terms of “product economics” and “return on capital” and “competitive position”. I found these were good ways of listing stats, etc. but bad ways of coming to conclusions. Now, my “qualitative” concerns are divided into more conclusion friendly categories:
3. Quality (including product economics, organization, and management)
In fact, just one of my seven areas to look at encapsulates almost everything Phil Fisher writes about. That tells you I’m not as thorough as Phil Fisher. This also helps you understand that a list of 7 areas of interest could easily be expanded into probably 100 questions. For example, Phil Fisher lists 15 points that almost all have to do with quality. I mention just one word: quality.
Let’s take a look at the full list again:
5. Capital Allocation
Remember, I am a concentrated investor. I like to own no more than 5 stocks at once. I usually expect to own a stock for a minimum of 3 years. This has a huge influence on the 7 areas I look at. If I was a wider diversifier and focused more on the next 1-3 years, I would rank value at the top.
Let’s take it section by section. Just knowing 7 words doesn’t tell you much about my actual approach. Describing what I think each word means will tell you more.
This is very personal. I tend not to understand commodity companies and financial companies. Some commodities – and some financials – are harder for me to understand. Soft commodities are the most difficult for me to understand. And banks are the most difficult financial stocks for me to understand. I can understand certain insurers.
Likewise, at the right prices, I feel I could understand oil companies, copper miners, etc. Lately, I haven’t seen prices at which I could understand them because the prices for those commodities have been unusually high relative to the real prices of those commodities over the last century or so.
Does that mean they are overpriced? No. It might just mean there will be inflation in the future. Or that demand for certain commodities will be sustained. I worry about societal waves. Generally, that means I’d have trouble buying things tied to China, global trade, healthcare, and higher education. All of those things have grown a lot faster in the timeframe I’d look back (10-20 years) than I can be sure they will grow going forward.
I don’t understand technology real well where there are viable alternative approaches possible – though perhaps not yet commercialized or even imagined. In general, I’m more comfortable with the least physical – most pure data like – technology.
There are exceptions to every rule. For an example of a commodity company I’d feel totally comfortable understanding see U.S. Lime & Minerals (USLM). For banks, see those with low cost deposits, other obvious advantages. For example, Bank of Hawaii (BOH).
This kills a ton of value ideas for me. When I read value blogs, the biggest objection I tend to have within a couple seconds is durability. Now, durability is very speculative.
What do I think is durable?
Sports, entertainment, media, food, data, pets, etc.
Examples: International Speedway (ISCA), DreamWorks Animation (DWA), John Wiley (JW.A), Village Supermarket (VLGEA), Dun & Bradstreet (DNB), VCA Antech (WOOF), etc.
Here I am talking about demand for the product – not the exact way it is delivered, etc.
Let’s look at some examples of companies that do something that might – even if they are successful relative to competitors – not prove to be in demand forever.
Examples: Dell (DELL), Lexmark (LXK), Q-Logic (QLGC), Barnes & Noble (BKS), Haynes Publishing, etc.
Notice how subjective this is. I have a bookseller – Barnes & Noble – listed as a durability risk. Meanwhile, I have John Wiley listed as an example of a durable company – and it’s a publisher.
John Wiley earns very little from books. It sells some books. But the shareholder value clearly comes from academic journal publishing. A lot of people – in academia, technology, etc. – think that may not be a durable business, or at least the for-profit model for publishers may not be. I disagree. And I expect the biggest publishers of academic journals will make a lot of money – and nearly infinite returns on capital – for a long time to come. Pretty much forever, in fact.
You may disagree. And you may be right. It’s a speculative and subjective issue. I will – however – add one more “s” word to the list. Scuttlebutt. Durability can sometimes be helped by learning more about the customers. That’s the kind of thing I did with John Wiley. I came away thinking it was a durable, essential product. In other cases – like Haynes Publishing – I came away with the opposite conclusion.
It’s also important to make a distinction here between corporate durability, demand durability, competitive durability, and profit durability.
Plenty of companies survive their products being obsoleted. This is normal. It’s part of the Phil Fisher approach. In analyzing tech companies, you often assume the products will be made obsolete and new products will be developed.
Demand durability means people want the product. Music has durable demand. I still hear tons of music. People still crave tons of music. The business – of music publishing – makes money for a couple companies who dominate it. But, the profits in that business turned out to be less durable – they’ve declined even while the need they fill hasn’t changed one bit. People are pretty much as addicted to music as ever. The dealers just make less money selling it.
Competitive durability is something I consider mostly in “moat”. Profit durability is why I have a hard time understanding some commodity companies, financial companies, and almost everything that makes money off the federal government (defense contractors are a rare exception). I know their product will be needed. I’m less sure of the spread at which they’ll be able to sell it. Often, it is unclear if competition and regulation could whittle down margins, returns on capital, etc. The product is durable – the profit may not be. It can have really good climates and really bad climates that last a decade or more at a time. Analysts can usually read the industry tea leaves better than I can.
This is one of the most overused terms in value investing. Also, it’s one of the most important.
I think I see moats differently than a lot of folks. The biggest moats are around specific locations, customers, standards, and habits.
I think advertising agencies have moats – with existing clients. I think some stores, mines, transit systems have moats – in specific locations.
I see many more moats than the average investor. However, I see very few expandable moats. This is partly due to my microcap focus. I look at things like “Hidden Champions”.
Plenty of companies can earn good returns on capital. They just can’t earn good returns on $1 billion of capital.
You pretty much have to be lucky to achieve that. You can’t just win. You have to win in an area that can support a goliath. Microsoft has a moat around a huge business. There are other companies similar to Microsoft. They are usually very small. It’s weird to have almost the whole world – of businesses, consumers, etc. – running one system. But there are plenty of little industries where people use one system.
I’ve already mentioned several companies – see my examples list – that have huge market share in a specific industry or product (Dun & Bradstreet, Q-Logic, etc.) and in a specific location.
In addition to thinking about moats, I think about unique strategic assets. Is this company something competitors, new entrants, etc. would rather buy than build. Do suppliers, customers, etc. fear the company, try to create alliances against the company, want to prop up a competitor, make a strategic investment, etc?.
If you look at the examples I gave – you’ll find a few examples where those clues were present. You have a strong market position if customers and suppliers are obsessed with talking about you instead of their own businesses.
One difference between how I see moats and how many investors see them is that I take a much more favorable view of distribution based moats. In fact, I tend to think that standardization and distribution are two of the biggest sources of moats.
Finally, I separate moats from product economics. Some products have better economics than others. I try to focus on products where price consciousness is low, quality concerns are high, etc.
Example: I tend to think that computer animated movies are simply better products than live action movies. They have better economics. Maybe Pixar, DreamWorks, Blue Sky, Illumination, etc,. can have wide moats or not. But a wide moat in live action is probably worth less than a wide moat in computer animation.
An animated product simply has more potential to be unique.
But competition can ruin good product economics. The reverse is rarely true. If product economics are extraordinarily poor – think steel – it’s hard to have such a strong competitive position that you can overcome this. Location is an exception.
Like I’ve said before, I’d rather own the #2 razor blade company than the #1 steel company. It’s important not to confuse slight advantages relative to competitors with a moat. The idea of a moat is wider than just a peer comparison.
That’s only half the list. I’ll tackle the other four areas I look at:
5. Capital Allocation
In my next article.