I recently listened to an interesting podcast interview with Bryan Lawrence, founder of Oakcliff Capital, who laid out his investment framework in detail. He really impressed me with his clarity of mind and ability to go straight to the core of each investment topic, not to mention Oakcliff's great returns.
Lawrence, who is also a friend of Guy Spier, very rarely give interviews or speeches, so I took the chance to synthesize his investment principles in order to integrate them in my process.
The five-question filter
Lawrence's investment framework is based on a five-question filter. Let's analyze them one by one.
The first question is: Do we understand this business?
It is no coincidence that this question comes first. Let's think about it; does it really make sense to continue with a company analysis if we do not fully grasp their business model? The answer to a question like how a company makes money is paramount and if the business is too difficult to understand or it is too far from the border of our circle of competence, we can simply do what Buffett does in this case. That is, we put it in the “too hard” pile.
Understanding a company means much more than reading the business section of its last annual report. Investors should try as much as possible to get first-hand information on it, like talking with its customers, suppliers and managers. Analyzing its competitors is also crucial in order to understand if the company has competitive advantages and how resistant to their external attacks it is.
The second question is: Is it a great business?
Everyone wants to own a great business, but what does that really mean? For Lawrence, the definition of a great business is one that has durable cash flows, which is equivalent to saying one that has strong competitive advantages.
A simple test he always performs is that of asking if the company's customers get (or at least perceive) more value than they are paying for. There is no company in the world who can keep its dominance if its customers feel they could potentially get a better deal elsewhere.
One example from his portfolio he provides is Guidewire Software Inc. (GWRE, Financial). The company, which provides software for the insurance sector, is usually not on the top of other big investors' watchlists, but what makes it so interesting to him is the fact that most of the big U.S. insurers, like Allstate Corp. (ALL, Financial), cannot function without their products.
Its customers are probably not going to switch to a competitor anytime soon, as this would mean big switching costs and re-training their employees on a new software product, potentially experiencing frequent interruptions, etc.
Other sources of durability are, for example, being the low-cost provider in a specific area (better, of course, if low costs come from structural reasons) and being part of a duopoly or monopoly.
The third question is: Does it have management aligned with us (the shareholders)?
Even if a company satisfies the first two filters, investors still need to understand if management is shareholder-friendly. Do they have a stake in the company? Is our interest aligned with theirs?
There are, unfortunately, many examples of good companies led by competent management where the minority shareholders do not get the chance to be rewarded for their investment and patience. Complicated share structures, obscure corporate operations and lack of profit distribution plans are the signs you will probably not participate in the company's success.
The fourth question is: Is it cheap?
For Lawrence, it is all about cash flows. The real question is, are the cumulative projected cash flows the company is going to earn in the future bigger than the current capitalization?
This point probably does not require an explanation, but there is clearly always a price at which even a great company with a robust competitive advantage becomes a bad investment.
The fifth and final question is: Is there a temporary misconception about making it cheap?
This is not something every investor normally worries about, but I found this smart. If we know that the company is selling at a cheap price, can we also say why? This means being able to fully understand the market dominant view and asking yourself, “Am I wrong or are they?”
Another important aspect of this question is timing. If we know why there is such a big price discrepancy between the current price and the intrinsic value, we can probably also figure out when the misconception, and consequently the price gap, will be eliminated (either one way or the other).
This is the same as asking if there is a catalyst, and, even more important, how much time we need to wait to realize our returns. Indeed, what really counts is not the absolute return, but the internal rate of return of the investment, which indicates how profitable it is going to be.
“Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag," Buffett said.
All great investors have something in common. In this case, there is a big overlap.
Lawrence's investment filter is a powerful tool that can be used to screen the market to find the right investments. His quite concentrated portfolio (composed of only 10 stocks) speaks to the strictness of its “enter” rules and shows how difficult it really is to find truly outstanding investments.
Above all, his questions can help us to force ourselves to look at what really counts when researching a company and ignore information that has too short of a shelf life.