In a prior post, I recommended Michael Shearn’s Investment Checklist: The Art of In-depth Research. A good checklist is short but not too short. If the list is too long, it won’t be used. Warren Buffett and Charlie Munger keep it very simple. The 4 criteria they use to evaluate new business ideas is outlined in Peter Bevelin’s Seeking Wisdom:
(1) Can I understand it? If it passes this filter,
(2) Does it look like it has some kind of sustainable competitive advantage? If it passes this filter,
(3) Is the management composed of able and honest people? If it passes this filter,
(4) Is the price right? If it passes this filter, then we write a check!
While this may work well for Buffett and Munger, I think we need something slightly more inclusive. There are a variety of checklists that can be found online. I modeled mine based on insights from Shearn’s book. I also adopted Monish Pabrai’s suggestion of looking at past mistakes to determine what was missed (so you don’t make the same mistake again). My current list includes 18 questions. There isn’t any magic to this list, but I find it useful to review before making a pitch or taking a position in the stock. The questions are:
(1) Is this idea within my circle of competence?
(2) What are the 1-3 main things that will drive the business, and what data can I used to track them over time?
(3) What is the secular growth potential for company? Consider the size and growth of its end markets.
(4) What defines the quality of the business (strong brand awareness, customer loyalty, pricing control, cost advantages)?
(5) Is there some element of defensiveness in the business model (e.g., brand strength, intellectual property, regulatory environment, scale, switching costs, network effect)?
(6) How capable is management? Do they have a commitment to enhancing shareholder value? Personally, I look for owner-operators. See Management Interview Prep.
(7) What is management doing to position the company for the future?
(8) Does the company earn high returns on capital (ROIC)?
(9) What is the company doing to operate more efficiently and effectively? Remember, growth can both create and destroy value.
(10) Does it have a long runway of reinvestment prospects? Does it have a moat that protect returns on this projects from competition?
(11) Is it a capital intensive business?
(12) Is the balance sheet structured to allow the company to take advantage of unforeseen opportunities?
(13) Are there any off-balance sheet liabilities that need to be accounted for?
(14) Are there any potentially disruptive technologies?
(15) Is it trading at a good price? What is the downside to your worst case scenario? Is there a case for making a 26% IRR (i.e., double in 3 years)? Obviously, with these questions I’m looking for asymmetric payoffs.
(16) What are the catalysts for value creation?
(17) How long do you anticipate holding the stock? Remember, if you aren’t willing to own a stock for 10 years, you shouldn’t even think about owning it for 10 minutes.
(18) If you ultimately have to get out of the stock, what’s the likely reason you were wrong?
As they say, if I can get 80% of the way there by answering the big questions like these, I probably don’t need to waste time on the remaining 20% because the marginal utility just isn’t there.