One of my favorite books is "Seeking Wisdom: From Darwin to Munger" by Peter Bevelin. Since it covers the multidisciplinary approach that Charlie Munger has followed during his lifetime, it also touches upon how to evaluate a business. The approach is very simple and straightforward, and yet, there are many points that we overlook on a daily basis as investors.
On this ocassion, I will touch upon the critical questions that we can ask ourselves to better understand a business and its competitive advantages. To me, it is remarkable how simple, yet deep these questions go, which helps the foundations of our investment thesis to become stronger.
Filter 1 - Can I understand the business?
Reasons for demand: How certain am I that people are likely to continue buy this type of product or service in the future? What has happened in the past and what is likely to happen in the future? Cyclically in demand? Capacity versus demand?
Return characteristics: Industry and company return characteristics and change over the last 10 years?
Industry structure: Number of competitors and size? Who dictates the terms in this industry? What is needed to make money in this industry? Position within the industry? Do I know who is going to make money in this market and why?
Real customer: Who decides what to buy, and what are his decision criteria?
Filter 2 - Does it look like the business has some kind of sustainable competitive advantage?
Competitive advantage: How certain am I that they are likely to buy the product or service from the company rather than from someone else? Are the reasons virtually unchanged from what they were 10 years ago? Are these motivations likely to be unchanged over the next 10 years?
Value: How strong and sustainable is this advantage? Have the advantages become stronger and more durable over the years? What can destroy or reduce them? Barriers to entry? Brand loyalty? Vulnerable to change in demand or prices? Easy to copy? Short product life cycle? Customer cost and incentive to switch supplier? Annual cost differential against competition? Capital investments needed? Bargaining power? Obsolescence risk? New customer alternatives? Change in buying habits or power? Competitor potential to undercut prices assuming same cost structure? What is needed to make sure the advantages are sustainable? Growth opportunities left? Is the demand for the product likely to grow? Untapped unit volume demand? Pricing power?
Filter 3 - Able and honest management?
Is the management composed of competent and honest people who understand and focus on the creation of value?
Filter 4 - Is the price right?
Can I buy at a price that provides a good return with a huge margin of safety measure against other available alternatives and with evidence from facts and figures?
Filter 5 - Disprove
How can the business get killed? If the company would kill one if its competitors, which would it be and why? How resistant is the business to adversity? Assume the company paid out all its equity capital, would it still have any value? Could someone with the access to billions of dollars and talent successfully compete with the company? How much damage could a competitor do if he doesn't care about returns? Recession sensitivity? Execution risk? Will new technology help or hurt?
Filter 6 - What are the consequences if I'm wrong?
I believe that these are all components of a good answer to the question "Why am I deciding to invest in this business?" As Munger puts it, it is very helpful to think not only on the logical aspects of what makes a company work, but also on the subconcious effects that are affecting both the business and the stock price. With this kind of two-track analysis, we are more likely to achieve positive results when we are investing.
I believe the questions in these filters seem rather obvious, but require a great deal of insight and details that can only be obtained through careful examination of the company's industry, prospects and reports.
Do you find these filters helpful?
