Checklist for Evaluating Generals

“We’re generally overconfident in our opinions and our impressions and judgments.”

—Daniel Kahneman

Different Weather Requires Different Clothing…

In his Partnership Letters Warren Buffett discusses four different investment methods used by him in order to best act in accordance with his investment principles. The methods are: (1) Generals-Private Owner, (2) Generals-Relatively Undervalued, (3) Workouts, and (4) Controls.

In Buffett’s Ground Rules, written by Jeremy Miller, the author provides the following checklist as a tool for evaluating a potential investment in a General, i.e., both Generals-Private Owner and Generals-Relatively Undervalued.

Here is a checklist for evaluating a potential investment in a General: (1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me? 

I enjoy reading Buffett’s Ground Rules, and one third into it I can highly recommend it. In this book the author provides a compilation of the old Buffett Partnership letters, and discusses different investment principles, methods, and digs into some of the investments made by Buffett during the 1956-1969 era.

The author then goes on to provide some insight about what to do when you’re not able to clear each paragraph in the checklist.

If you find yourself unable to make it all the way through the checklist, then write down in a single paragraph the metrics of the investment. If you get caught up along the way, either do more work or simply forget the idea as “too hard” and move on to something else.

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New Mauboussin Paper: Total Addressable Market (incl. Checklist)

Title: Total Addressable Market – Methods to Estimate a Company’s Potential Sales
Authors: Michael J. Mauboussin & Dan Callahan, CFA
Date: September 1, 2015

“TAM is an area where overconfidence and optimism are rife. We have provided some analytical approaches to check these biases and to come up with a reasonable assessment of whether the market’s expectations are reasonable.” —Mauboussin & Callahan, Total Addressable Market – Methods to Estimate a Company’s Potential Sales

The concept of total addressable market (TTM) is the subject of Mauboussin and Callahan’s most recent paper.

“The ability to calibrate the total addressable market (TAM) is a major part of anticipating value creation. Since 1960, about one-third of the value of the S&P 500 Index has been attributable to the anticipated payoff from future investment. Assessing value creation requires understanding how much a company can invest and the returns those investments will earn.

We define TAM as the revenue a company would realize if it had 100 percent share of a market it could serve while creating shareholder value. TAM is a concept that executives and investors use frequently, but that few define properly or thoughtfully. You should recognize up front that TAM is not about how large a firm can grow to be but rather how much it can expand while adding value”

Click on the image below to read the paper.

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Included in this paper is an checklist addressing certain important questions to consider when performing an analysis of TAM.

Checklist for Estimating a Total Addressable Market

Categorizing New Products

  • Is the product technology new or current?
  • Are the customers new or current?

Market Size

  • Are the users and payers of the good or service the same?
  • How much money do the buyers have?
  • Are the resources of buyers growing or shrinking?
  • Are there physical limitations, such as how much one can eat or use a product, that can curb demand?
  • What is the elasticity of demand?
  • How cyclical is demand?
  • How do consumers allocate their time and money now and how might that change?
  • Are the suppliers and sellers of the good or service the same?
  • What is the business’s production capacity?
  • Is there a reliable infrastructure to get the goods or services to market?
  • How broad is the geographical footprint?
  • Where is the industry in its life cycle?
  • What does that imply about the growth rate and pricing flexibility?
  • Does manufacturing capacity match the rate of growth in demand?
  • Is the company using pricing as a lever to drive scale or to increase profitability?
  • Are there existing or potential economic or social regulations that could limit TAM?
  • What are management’s incentives and are they aligned with shareholders?
  • Are there economies of scale? Local? National? International?
  • Are there two or more competitors, which could push each company into a separate niche?

TAM and the Bass Model

  • Which stage of the life cycle is the company’s industry in?
  • What analogous products can inform your estimates for the Bass Model parameters?
  • Limitations of the Bass Model When a consumer buys something once, how frequently does he or she replace it (repurchase rate)?
  • Has the company’s good or service overshot the market?
  • Might that happen soon?
  • Does the company have a competitive advantage that will allow for value creation over time?
  • Do network effects exist?
  • Consider Base Rates What happened to other companies when they were in a situation similar to the one you are examining?
  • Are your TAM estimates plausible when considering these base rates?

TAM and Ecosystems

  • Does the company operate primarily a physical, service, or knowledge business?
  • What is the company’s source of advantage?
  • What are the investment triggers?
  • Does the company sell rival or nonrival goods?
  • Are there opportunities to extend into new business categories?

Want More?

See here for a collection of links to other Mauboussin papers.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

5GQ: Michael Shearn – The Investment Checklist [TRANSCRIPT]

“…the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company.” —Michael Shearn

In this post you find the most recent interview from 5GQ with Michael Shearn, the author of The Investment Checklist: The Art of In-Depth Research.

I have transcribed the first two questions, question number one beeing about what part in a 10k to look at and the second question about how many checklist items there are in Michael’s own investment checklist.

For questions number three to five I have transcribed only the question, so you can see what they’re about and go to the video interview to hear Michael’s answers to these questions.

 

  • 5GQ1Q1: What part of the 10k do you spend the most time with? There’s so much information in there, what section do you think that investors maybe aren’t paying enough attention to you?
  • A1: When I look at a 10-K, my goal is I wanna understand what the business does. I also want to know how how does it make money. So one of the first thing we look at is, we go to the income tax footnote, and what we wanna see is: Do they make money? Because under the income tax footnote, that’s usually about note 12 or around there, they have a line item called “Current taxes” and that’s the money that they send to the IRS. So if a company is not making money, they’re not gonna be, on a cash basis, they’re not gonna be sending any money to the IRS. So that’s kind of the first stop in the 10-K, to see if there even making money.Just to give you a historical example I remember looking at Enron, and looking at that footnote and it was negative. They were not making any money.

    But after that you know the other section, this is something I’ve learned recently, is the risk section, because it’s really, if you think about pharmaceutical drugs, there’s funny commercials where they’re always talking about all the risks, the things that can happen to you. They are pretty much disclosing a full amount of things that can happen. The same thing happens in the 10k under the risk section, and what happens is that it’s very easy to gloss over those risks because they are written in very plain language, and so it’s very important that kind of spend a lot of time there because every company that has failed or had a problem, the problem has been in the risk section, it’s always in there. But what happen is that the language is written in such a way where it’s not alarming and it’s kind of innocuous language. So what we do is that we look at the risks and we read it and we try to understand; Has this company encountered any of these risks before, is there an historical example that we can look to, to see kind of how that risk affects the company or is this something we don’t know how it’s gonna affect the company?

    So we where recently looking at a company called FXCM, it kind of hit our screen so to speak and as we were reading articles about what was going on at the company the stock dropped quite a bit. They talked about exactly an article reference one of the risks that they had to make up their clients equity accounts if they ever got negative. But when we went to go read the footnote it was very innocuous, it kind of was written in such a way that it was very difficult to catch. So I think, you know for me, how it works, I really pay attention to the risk section because it really gives you a good insight into what could go wrong and you can do your worst case scenarios and things like that. … The lawyers make sure you cover all of them. … So you kind of really have to weigh those things and what’s real real big risks and what’s not. But I take the first part not the second part about stock fluctuations or clustering and things like that. It’s more the business risk section.”

  • Q2: How many checklist items do you have for your personal investment checklist?
  • A2: I look at a checklist more as a research process. What it allows us to do is a series of questions that allows us to examine the business from a lot of different perspectives. So we’re not looking at in, you know, in the past I spent a lot of time just focusing on whether the company had a competitive advantage and I’d ignore things like the customer side or the management side. And just kind of on that one thing. So the questions really help you get a holistic view of a business. But really the goal of it and the goal of the questions is, you kind of want to understand the distribution of the cash flows for a business. Are they narrow? Or are they wide? So there’s questions in there like fixed cost base that would tell you that they had a wide range, so you would know the earnings would fluctuate quite a bit. So it’s kind of a far as a number of questions and it really becomes kind of a judgement call. So for certain companies for example, let’s think of FactSet, a service that I subscribe to. I’m not gonna be really asking a lot of questions about their suppliers. But if I was looking at a metals recycler, well suppliers are very important ’cause they’re recycling metals, so the supply of the metal is very important or where they can get aluminum and to turn into steel so the questions kind of way depending on the company. But I will say there’s two questions I think must be answered for every company, and I think they carry a lot of the weigh. And the first question is: How dependent are the customers on the product or the service? That let you know, let’s say a restaurant, we’re not all dependent up on it. But it allows you to understand the degree to which those cash flows are gonna vary. Because if the customers are stuck to your product the more narrow distribution cash flow and the less surprises. But if your customers are not as dependent, they could use other areas, and you know there’s gonna be a lot more variation so you can prepare in advance for that. Second question, we always like to know who we’re partners with. Is management that we’ve evolved in our investment strategy we have learned to us it’s really the most important component so we spend a lot of time answering that question as well. But, you know, the number of questions is not so much the important, but it’s just that the quality of the questions and then come to having that analytical judgement on which questions are important for a particular company. So if you’re worried about the CEO and that they’re very aggressive in their accounting, well you will spend a lot of time on the accounting side. We just generally pass on those kind of companies. But say you’re a value investor and look at all different kinds of companies, you would have to spend a lot of time on adjusting the financial statements to make sure, to see what they’re really earning, because you know they’ve been aggressive in their accounting. So it’s really, it kind of depends on the company.

The remaining questions (not transcribed in this post) are:

  • A3: The subtitle of your book is the art of in-dept research and it really struck me while I was reading your book that the real art involved is a lot of these little adjustments that you can make to the numbers that you’re looking at when you’re performing you’re analysis to normalize things to get some kind of an idea of like how to approach what is happening in the real world, like economically versus the accounting. Other than just the obvious, you know, be conservative or find a margin of safety. Do you have any tips for us on have to make analytical adjustments?
  • A4: I think this is one of the greatest problems to solve as an investor, in a person doing research. There’s forty thousand stocks roughly in the world. You don’t have the time to be an expert on every single one of them. How do you go about narrowing down your universe to screening for the ones we think they’re gonna give you the best bang for your research buck so to speak? 
  • A5: If you think about investing like a horse race, where it’s a para-mutual betting basically, so you don’t always have to know who’s the fastest horse necessarily, but it’s the odds of winning versus the payout. I feel like your book gave an amazing insight into picking the fastest horse, a great checklist of all the different things that make up for a great business to buy, but I’d like to hear a little about how the price factors in in that context of horse-betting where it’s not all about the fastest horse. 

From having looked at the first two questions, let’s turn to the last one outside of the five ordinarily questions.

  • Q6: What book would you like to recommend? 

theInvChecklist

Checklist for Assessing Capital Allocation Skills

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance

Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance is another great paper written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse. See here for yesterday’s post.

CA1Capital Allocation: The Problem

Let’s us start with an excerpt from the paper and a quote from Warren Buffett about the problem of capital allocation, i.e., that the heads of many companies are not skilled in capital allocation.

“…our focus here is on how companies spend money.

The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to allocate the capital of the companies it controls. Buffett is worth quoting at length:

‘This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)'”

Checklist for Assessing Capital Allocation Skills

In the end of the paper the authors share a Checklist for Assessing Capital Allocation Skills. This checklist is reproduced below.

Past Spending Patterns

  • Have you analyzed how companies have spent money in the past, separating operating uses from return of capital to claimholders?
  • How has the company funded its investments?
  • Identify the prime use of capital. Do you know if management thinks about that use of capital properly?
  • Have there been shifts in the pattern of spending?
  • If there is new management, has spending changed?
  • Who makes which capital allocation decision?
  • How does the company conduct its budgeting process?

Calculate ROIC and ROIIC

  • Have you calculated ROIC over time and observed a trend?
  • Examine composition of ROIC through a DuPont analysis—does this suggest a consumer or production advantage?
  • Have you compared the company’s results to those of its peers?
  • Have you calculated ROIIC for one year and rolling three- and five-year periods?

Incentives and Governance

  • How is the company’s incentive compensation structured?
  • How much stock does senior management own?
  • Is total shareholder return calculated on a relative basis?
  • Have you examined the company’s incentive score?
  • Are the measures in place to encourage management to think for the long term?

Five Principles of Capital Allocation

  • Does the company use zero-based capital allocation or is it dominated by spending inertia?
  • Is the company focused on funding strategies or projects?
  • Does the company have a “scarce but free” attitude about capital, or “abundant but costly?”
  • Does the company prune businesses with poor prospects for creating value?
  • Does the company know how to calculate the value of its assets and does it act accordingly?

Checklist: Singleton’s Aquisition Standards

Henry Singleton’s Standards for Acquisitions

HS1In the earlier post The Great Man Behind Teledyne: Henry Singleton and the recording The Manual of Ideas on Business Leader Henry Singleton, Founder of Teledyne, there is a part starting at 1:12:31 that describes the standards that Singleton had for deciding whether or not a company was a good acquisition candidate for his Teledyne.

The questions that Teledyne asked when analyzing and considering potential acquisitions were:

  • Is the company profitable?
  • Do they have a good balance sheet?
  • Is their profit and loss statement accurate?
  • Do they have a clean inventory?
  • Is their backlog realistic and well documented?
  • Is their management on top of their operations?
  • Would management be willing to stay if acquired?
  • Have they made long ranged plans to maximize their profit in a sell out?
  • Does the business have growth potential?
  • Is there opportunity for growth in profit?
  • Can cash be taken from the company for use elsewhere?
  • How is depreciation counted and is it a significant percentage of profits?
  • What is the condition of their physical plant?
  • Would this company be a good fit within Teledyne organization and its goal?

See here for a review of the book Distant Force A Memoir of the Teledyne Corporation and the Man Who Created It.

This book is also mentioned in the article What Would Value Investing 101 Look Like? written by Geoff Gannon at GuruFocus.com.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. This article is informational and is in my own personal opinion.

Seth Klarman Defines What Constitutes a Good Business

What constitutes a good business?

Let’s turn to Seth Klarman for some advice.

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In other words, a good business is one that enjoys the following characteristics:

  • Strong barriers to entry
  • Limited capital requirements
  • Reliable customers
  • Low risk of technological obsolescence
  • Abundant growth possibilities
  • Significant and growing free cash flow

Keep these six characteristics in mind as a mini-checklist when thinking about and analyzing a certain business, trying to decide if the business in question meets these requirements for what constitutes a good business.