A fellow GuruFocus reader recently sent me an email with the following question: “Which books would you recommend if I want to start investing in individual companies?”
I think there are two answers. You can find numerous articles and blogs discussing the “must-read” investment books as well as the books recommended by some of the great investors over the years (for example, see here, here and here). That’s clearly an important step in the process and a great way to build a foundation (in my opinion, you can’t do any better than Warren Buffett (Trades, Portfolio)’s shareholder letters). However, I find that most investment books are lacking in one critical area: outlining a usable process for analyzing a company. In my experience, there are few books that share a detailed framework of value investing in practice. Personally, when I first started, I stumbled along for a few years before I found a repeatable process that worked for me.
With that in mind, I thought it might be helpful to walk through my approach to analyzing an individual security (for the sake of brevity, this will be somewhat broad; as always, comment or send me a message if you would like to go into more detail). For this example, I’ll look at Costco (COST). Hopefully this step-by-step outline can help new investors hit the ground running.
The first step in my investment process is a broad overview of the financials. I’ll open a new Excel document and manually input financial data for the past 10 years (at a minimum).
The numbers I add at this point are the basics: revenues, cost of goods sold (COGS), gross profit, operating expenses, operating income (EBIT), net interest expense, taxes, net income, shares outstanding, diluted EPS, total assets, total shareholder’s equity, total debt, cash flow from operations, capital expenditures (CapEx), cash outflows for mergers and acquisitions (M&A), other returns to shareholders (dividends and share repurchases) and so on. My Excel sheet has been tweaked over time to take this data and calculate high-level financial metrics (margins, return on assets (ROA) and return on equity (ROE), revenue growth, etc.).
From here, I can answer several basic questions: What has happened with revenues over time? Has a lower tax rate juiced earnings growth? What has been the driver of EPS growth? How do cash flows compare to net income? How has the company spent its excess cash historically? The list goes on and on. At this point, I have a general idea of the financial picture. From this alone, you can get a broad view of how the company has evolved and performed over the past decade.
My next step is to read the most recent 10-K. To access this document, go to SEC.gov and search for the company’s ticker symbol on the right-hand side of the page; from there, scroll through the documents and open the most recent 10-K. Depending on the company/industry, this document can be anywhere from a few dozen to a few hundred pages. In the 10-K, you’ll find important pieces of information including an overview of the business and industry, the business model, the business risks, an in-depth discussion of the financial results in recent years and other items worth knowing about (segment results, funding status of the pension, etc.).
Bringing it back to Costco, you learn several important items in the early pages of the 10-K: the business model is based on high inventory turns on a limited number of SKUs. There’s a clear emphasis on moving products from manufacturers to store shelves as quickly – and with as few hands touching the product – as possible. If this strategy is effective, the company can pay its suppliers early (capitalizing on payment discounts) while simultaneously limiting the amount of inventory that needs to be financed out of the company’s working capital. In addition, the company strictly controls the entry (requires a membership card) and exit (receipt checked by an employee) of its warehouses, limiting shrinkage. Savings are largely passed through to customers as lower prices. Importantly, most of these ideas can be quantified and confirmed by analyzing the financials (for example, Costco’s inventory turns are much higher than its peers).
As I’m working my way through the 10-K, I’ll add additional company- and industry-specific items to my Excel document. For Costco, this includes the number of warehouses (now we can calculate sales and profits per unit), the number of members, comparable store sales, etc. When you work through this exercise for the company’s primary competitors – in this case, Walmart’s (WMT) Sam’s Club business – you’ll notice important competitive trends. For example, you would see that the average Costco sells ~85% more per unit in a year than the average Sam’s. In addition, the gap has held over time (an impressive feat). Costco is clearly doing something right.
When I’m finished reading the 10-K, I’ll think about what I’ve learned and ask some more questions. For example, how has Costco used its excess cash? We can see in the cash flow statement that Costco reinvests a large percentage of cash flow from operations back into capital expenditures (well ahead of depreciation expense) to build new warehouses. Is that an intelligent use of capital? Well, considering the attractive unit economics as well as continued comp store sales growth (both of which have been added to your Excel document by this point), it’s safe to say new units are an attractive use of excess cash.
After the 10-K, I’ll pull the shareholder letters for at least the past five years. These letters can usually be found on the company’s Investor Relations (IR) page. They will either be individually listed or in the introduction to the “annual report to shareholders” (the glossy book with pictures of smiling employees and immaculate facilities). Companies like Wells Fargo (WFC) and Walmart have decades of annual reports on their IR pages. In my experience, reading as many shareholder letters as possible is worth your time.
I’m looking for a few things in the letter: One, is there substance or pure fluff? I want a CEO that frankly discusses what has happened over the past year and what the company will do to increase per share intrinsic value over time. The beauty of years of shareholder letters is the benefit of hindsight: What was the CEO focused on five to 10 years ago? When investments or acquisitions didn’t work, did the CEO frankly discuss the mistake or sweep it under the rug? This is an opportunity for management to be forthright with investors; if they pass up the chance to do so, it's a big red flag. (I’ve previously discussed the example of a CEO that spent more time discussing a $900,000 donation than he did on a $1.6 billion loss in the business; see here).
After I finish the shareholder letters, I’ll pull up old investor presentations, CEO interviews, quarterly conference calls, analyst reports – pretty much anything I can find that relates to the company or the industry. These additional sources give you a chance to assess the management team and the strength/predictability of the underlying business. What problems have plagued the company in the past, and how serious were they? I’m constantly searching for additional information.
With 10-plus years of data, we can step back and think about what truly matters: How has the business model evolved over time? In the case of Costco, it has been astoundingly consistent. Do people enjoy dealing with the company? With Costco, consumers are clearly happy (look at the comps and unit sales relative to competitors). The work I’ve done suggests most employees are proud to be associated with Costco as well. As you work through this process, the important questions have a way of coming to the surface.
At this point, if I haven’t already, I like to work through a similar exercise for the company’s primary competitor(s). I mentioned Walmart previously. If you do the work, you’ll notice a stark difference between Costco and Sam’s Club. Simply put, Costco has consistently proven that it has the upper hand on its primary competitor (this is an example where on-the-ground research and speaking with customers is invaluable).
Finally, I’ll pull up the proxy statement (on SEC.gov, document DEF 14A). This is where you can find important information about executive compensation and equity ownership. How many shares do the named executive officers (NEOs) own? I'll look online at recent insider activity as well. If the CEO and chief financial officer have no interest in owning the stock, why should you? At the end of the day, actions speak louder than words.
It’s only at this stage that I’ll start thinking about valuation. I will build a simplistic model for the next few years that is based on historic results and management’s guidance. Costco has said it will build 31 (net) new units in fiscal 2017; how much will it spend on CapEx? Assuming anything is left over, what are they likely to do with the excess cash? How long will it take for new units to reach the productivity (average sales) of legacy units? Is there any reason to expect a change in margins over time? The answers to these questions are the basis for our valuation.
Considering the length of this article, it’s probably a good idea to stop. Hopefully I haven’t missed too many important points. For new investors that do a deep dive on Costco or Walmart, feel free to comment or send me a message if you would like to discuss any of this in more detail. Obviously this isn’t the only way to complete the task at hand; it’s simply what works for me. For the new value investor, hopefully this exercise will help you find what works for you.
Disclosure: Long WMT
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About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.