Surgeons, pilots and many critical professionals have saved lives using checklists. In last 12 years, our investment checklist has evolved after being battle tested with real life wins and losses. Here’s that checklist summarised into five key hurdles/ questions that every company we own or wish to own has to pass:
First and the biggest hurdle is that we must be able to independently understand the business. This involves understanding how the business makes money and why do consumers demand its product/ services. Due to complexity of the business or our own ignorance, many businesses are not able to pass through this screen. No understanding, no conviction, no investment case. Time, reading and thinking help us improve understanding of new or existing businesses.
The second key question that we ask is how large is the opportunity size. A company that is serving an essential product/ service with no threat of substitution and has low penetration can be said to have a long runway (for example demat accounts, air conditioners, health insurance etc). A definite disruption threat is a key risk to avoid.
Long runway, however, in itself is not enough. The business should have some inherent competitive advantage that allows it to tap the runway profitably. Competitive advantage allows the company to protect profits from competition or regulations. Low cost, network effects, patent/ license/ copyright, switching costs, consumer habits, culture etc. can be some of the sources of competitive advantage. Without competitive advantage, growth does not create shareholder value. This is an area where we spend a lot of time. High returns on capital hints presence of an advantage in the past. We probe the causes and durability of such high returns. It is important not to mistake cyclical tailwind/ headwind as competitive advantage/ disadvantage.
The fourth and the most difficult filter is management quality. We look at the past actions of management around three areas. First is execution track record i.e. ability to create distribution, human resource, and supply chain capabilities that allows it to maintain or grow its market share. Second is capital allocation i.e. investing incremental earnings on return accretive projects or in absence, returning them back to shareholders in best possible way. Last is treatment of minority shareholders as evident from accounting quality, embezzlement, remuneration and skin in the game.
The last but important hurdle is valuation. For core equity positions, valuation alone is useless unless the company passes all the four hurdles above. Our preferred method to value is to see what growth and margin assumptions are built into current price versus (a) past and (b) our conservative imagination of its future. Often a company that passes the above four tests does not come cheap. While quality demands paying up, paying any price can be a mistake. We need to wait for temporary hardships or size discount (smaller companies can remain mispriced due to lack of attention from larger investors) that can create mispricings.
Despite failing to pass one or more of the above five hurdles, a company’s stock may do temporarily well. An 80 P/E stock may go to 100P/E; stock of a company in a new long runway sector but no entry barrier may rise in initial euphoria; temporary tailwinds may be mistaken for enduring advantage etc. But if the truth around the five steps hold, weak thesis gets its due punishment. Conversely, a company passing through all the five hurdles sooner or later gets it due reward. Keeping the investing bar high and executing all five of them with discipline and margin of safety is the key to minimise investment mistakes and improve long term returns. Funnily, the five hurdle process eventually works because it does not always work