How do we find rare high-quality businesses out of the more than 100,000 public companies around the globe?
We at Urbem employ a checklist-based approach to conduct both quantitative screening and qualitative research. In the end, we build, monitor and update our investable universe composed of no more than 100 names of our highest conviction.
This work, as you may have imagined, consumes the majority of our time, primarily through reading regulatory filings and industry reports, checking with suppliers, channels and customers, talking to competitors, management and employees, etc.. In this article, we share the key components of our checklist.
Most investment risks come from not knowing enough about what you own. If we cannot fully understand a business, we simply disregard it, no matter how strong the fundamentals appear. This way, it is likely that some moneymaking opportunities are missed, but we are aware that "missing out" is simply part of the investing life and are absolutely fine with it.
2. Economic moat
We think that the best offense in the stock market is a good defense. The fundamental law of capitalism encourages peers or new entrants to compete for market shares in the face of superior returns. Equity interests can be quickly eroded unless a reliable defensive mechanism, which Buffett calls "moat," is in place to fend off those competitions. An economic moat can be a highly recognized brand owning significant mind share among consumers (e.g., Hermes (XPAR:RMS)), a scale advantage (e.g., Amazon (AMZN, Financial)), a high switching cost of an install base (e.g., Automatic Data Processing (ADP)), a network effect (e.g., Facebook (FB)), or a good reputation earned through decades in a mission-critical space (e.g., Intuitive Surgical (ISRG)). A business may equip itself with multiple layers of moats, which is a case that we would greatly appreciate.
3. Growth prospects
Even in cases that a company cannot grow, we may still be okay with investing in it as long as the business is well-moated to protect current profits and the shares are quite undervalued. Otherwise, we would generally hope the company could grow in an organic and sustainable way. Quality growth is better than no growth, which is, in turn, better than "poor" growth (e.g., expensive acquisition, huge CapEx requirement). Usually, we expect secular growth to come from sources like regional expansion, line extension, industry tailwinds (e.g., passive investing), or global megatrend (e.g., aging population, premiumization). Cyclical growth does not intrigue us on account of being unsustainable. Neither does inorganic growth, not unless a prudent, disciplined acquisition strategy, along with a proven track record, can convince us.
As with the moat, a business may possess a multi-cylinder growth engine. Take Mastercard (MA, Financial) as an example. The leading payment technology provider is expanding its footprint globally (especially in the emerging markets) and developing new products (e.g., the commercial payment space) while benefiting from the "War on Cash," the increasingly digital purchasing experience and even inflation (due to its revenue model driven by processed dollar volume).
You cannot make a good deal with a bad person, as Buffett once put it. This is why we require an able and honest management team to run the businesses that we co-own. Please note that this does not necessarily mean that the company has to have genius or charismatic founder-leaders like Steve Jobs or Jeff Bezos. As a matter of fact, we think of a business that needs such a figure to make it work as being risky. What we care about the most include the management's capital allocation skill and integrity, which can be demonstrated by their past records and communications. Additionally, we look for sound corporate governance and a compensation scheme that is aligned with the interests of minority shareholders.
5. Track record
Analyzing past financial performance is an efficient way to filter out the low-quality. We look for consistently super-normal returns on capital and tangible assets, industry-beating profitability, strong cash generation, low CapEx requirement and healthy growth for at least a full economic cycle in the past. We are also interested in learning about the company's business economics during the previous recessions. Our aim is to co-own businesses that have already won and that we think will keep winning thanks to their defensive moats. It is to our belief that such a strategy, although looking less exciting, is way more doable and rewarding from a risk-adjusted perspective than trying to predict the winner in the future.
6. Compounding capability
We hope that our co-owned businesses can compound shareholder value by reinvestment the retained earnings at a high rate of return. We gauge such a capability mainly by checking recent incremental returns on equity capital, returns on retained earnings, and free cash returns on incremental investments. We also compare the company's previous projects, initiatives and strategies with what the management claims to do for the near future. As with the growth prospect above, it is sensible that some businesses cannot find any attractive opportunity internally to reinvest their cash. In this scenario, we would require the company to, instead of spending on low-return projects or expensive acquisitions, return any residual capital through dividends or opportunistic share repurchase for us to re-allocate somewhere else.
We understand that it would be impossible to precisely predict future cash flow for a business in the long term. Nevertheless, some companies are more forecastable than others and therefore should be the focus among equity investors, in our view. For instance, some business models, such as SaaS, produce recurring sales. A stable installed base with high customer retention also sheds light on future revenues.
Lastly, we prefer slowly-evolving, "boring" industries (e.g., luxury goods, pest control, elevators) over rapidly-moving, "exciting" ones (e.g., artificial intelligence, biotech, 5G), as well as everyday-use, non-durable products that generate small-ticket, repeatable transactions (e.g., toothpaste, baking soda, pesto sauce) instead of large-ticket, durable, one-time-purchase items (e.g., auto, computer).
8. Cash flow
Corporate earnings can be meaningless to owners without being converted to cash. We look for companies with a high cash conversion rate and a short cash conversion cycle. For instance, accounting and financial software provider Intuit (INTU, Financial) leveraged its prepayment revenue model to generate more free cash flow than net profit over the last ten years. Moreover, e-commerce giant Amazon took advantage of its scale-driven bargaining power to achieve a negative cash conversion cycle every year for the past decade.
9. Moat trend
As with fueling long-term growth, we hope for the management to invest consistently to widen the moat of the business. Depending on the business nature, investments can occur in various areas, including R&D, branding and distribution network. Take Nike (NKE, Financial) for an example. The sporting goods supplier never seems satisfied about its market-leading status. The company maintains its efforts to increase its mind share among consumers to widen the gap against its peers. The brand now enjoys exclusive uniform partnerships with three major sports leagues in the States (i.e., NBA, MBL and NFL), leading to an unfair competitive advantage for many years to come. We feel that there is a good reason for Nike's superior return on capital to stay.
10. Social impact
In our opinion, a business can sustain its value most profoundly through a positive social impact from its products and services. We hope for our co-owned companies to deliver shareholder value alongside social value and hereby tend to get cautious about some industries, such as gambling and tobacco (though both areas are filled with high-return businesses).
11. Insiders and gurus
Significant insider ownership can align the interests of management and shareholders. We also pay attention to the recent buy/sell transactions by insiders and index-beating stock-picking gurus (e.g., Fundsmith, Sequoia Fund and Polen Capital).
12. Financial leverage
It is almost impossible for a company to go under without any debt. Ideally, we look for a business that can deliver a superior and hopefully improving return on equity capital without leveraging up, as well as a cash-rich balance sheet that can come to the rescue in case something goes entirely wrong. There can be some exceptions to some businesses in this regard. For example, restaurant chains like Domino's Pizza (DPZ, Financial) employ a franchise model to take advantage of the franchisees' capital to operate and grow their own businesses and harvest steady cash inflows. We think that negative equity may be justifiable here.
Finally, we hope that our interested targets are not put in the spotlight by media or Wall Street. Gaining too much attention may lead to intense competitions and high valuations. As a result, our preference often goes to under-appreciated hidden gems in the small- and micro-cap space. We tend to avoid sectors filled with hot buzzwords (e.g., machine learning).
We hope that this overview of our checklist can be a useful reference for you to make better long-term stock investments. Should you want to discuss any of the factors or the investment strategy in general, we would welcome your questions and comments.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Domino's Pizza, Nike, and Mastercard.
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