Introduction

Describe how the business operates, in your own words. Do we want to spend a lot of time learning about this business? Explain what the business does to a fifth grader. How does the business make money?

What are the three or four most important factors for the business and for our investment thesis?

Invert, always invert. How do you kill this company?

Its three years from now and were selling our position at a loss. Write a brief story describing why/how the investment lost money. What errors might we have made from a behavioral perspective? What might we have misinterpreted from the business perspective? Did we misjudge the potential for structural change within the industry? What about competition? New entrants? Was this a melting ice cube? Did we misjudge the speed of change? Why?

The story can also include cognitive errors made in selling the position too early or too late, or failing to re-evaluate it because it was going up. What was the opportunity cost?

Risks & Opportunities

What are the key risks the business faces?

In bad times, cyclical companies with heavy debt loads may face insurmountable problems. A company should own twice as much as it owes. Avoid overly leveraged companies.

Analysts are overly focused on short-term earnings gains than future long-term success. Missing earnings is not fatal, and tends to create opportunity for the value buyer; if the trend continues, however, the shares will likely continue to fall.

If a company has excessive pension liabilities or there exists a contentious labor environment, it may be best to put these companies on the no-thank-you list. If a company is facing strong competition from a more efficient competitor with lower costs, it is best to move on to the next candidate.

Steer clear of financial reports that seem overly complicated. Approach your list of investment candidates with a healthy dose of skepticism.

Stamping Out Irrationality

How have we done recently? Are we suffering from an inability towards inaction? Or are we pressing to find the next winner to make up for past mistakes?

How did we source this idea? Has the source impacted our confidence in the thesis? Would we buy this company if this was not owned by anyone we admired? Why havent we previously invested in this company? Are we anchored to a specific price?

Do we have a variant view? Can we articulate the short thesis? What is the risk-reward and the probability of each? How does our assessment differ from consensus opinion? Do we understand why the stock is undervalued? Is there a catalyst for this to change?

Can we hold this investment forever? What is our expected holding period for this stock? Does changing the holding period affect our comfort in establishing a position? How? If the stock market stopped quoting prices for 10 years, would we still want to hold the position?

Under what circumstances would we sell this position before the projected holding period is over? Under what circumstances would we hold this position longer than the projected holding period? Name some scenarios in which we would increase our position? Decrease the position?

How is this position going to lose money? What is the likelihood of permanent capital loss? Under what conditions would a permanent loss of capital occur? Have we seriously considered the scenarios in which this company could die?

Do we have the risk appetite to see this stock cut in half? Do our clients? Are we willing to put a significant amount of capital in this business? If no, why?

Are demographics a headwind or a tailwind? What factors will drive the success of this investment? How do they impact the upside and downside potential in the stock? Does the overall portfolio need more exposure to this part of the economy?

Does the business fall within our circle of competence? What framework have we used to categorize the opportunity?

Be careful to estimate upside and downside potential on historical data as a starting point, but on the downside be especially conservative in expecting outcomes that are worse than have previously been recorded.

Assessing Advantages

To keep the analysis manageable, move one step at a time. Begin with one force potential entrants and barriers to entry not five. If there are barriers, then it is difficult for new firms to enter the market or for existing companies to expand. No other feature has as much influence on a companys success as where it stands in regard to these barriers. Start simply and add complexity later. Whenever things become confusing, step back and simplify again. Clarity is essential for strategic analysis.

It is essential to determine whether a company benefits from a competitive advantage and to identify the sources of that advantage. There are three basic steps to doing such an assessment:

Identify the competitive landscape in which the firm operates. What markets is it really in? Who are the competitors in each one?

Test for the existence of competitive advantages in each market. Do incumbent firms maintain stable market shares? Are they exceptionally profitable over a substantial period?

Identify the nature of any competitive advantage that may exist. Do the incumbents have proprietary technologies or captive customers? Are there economies of scale from which they benefit?

The first and most important step is to develop an industry map that shows the structure of competition in the relevant markets. There are two telltale signs of the existence of competitive advantages:

Stability of market share among firms. The key indicator of this is the history of the dominant firm in the segment. If the leading firm has maintained its position over a period of many years, that fact strongly suggests the existence of competitive advantage. The history of entry and exit in a market segment provides another clue.

Profitability of firms within the segment. After-tax returns on invested capital averaging more than 15-25% (i.e. 23-38% pre-tax) over a decade or more are clear evidence of the presence of competitive advantages. Identifying historical profitability for particular markets often requires extrapolation. The best way is to look at the reported profits of pure play companies.

The third step is to identify the source of these advantages. Do the firms in this industry benefit from proprietary technologies or other cost advantages? Do they have captive customers thanks to habit formation, switching costs or search costs? Are there significant economies of scale in operations, combined with at least some degree of customer captivity? Or, do the incumbent firms profit from government intervention such as licenses, subsidies, regulations or some other dispensation?

Barriers to Entry

Strategic analysis should begin with two key questions: In the market in which the firm currently competes or plans to enter, do any competitive advantages exist? And if they do, what kind of advantages are they? The analysis is made easier because there are only three kinds of genuine competitive advantage demand, supply and economies of scale and two straightforward tests to confirm their existence market-share stability and high return on capital.

Supply Advantages: One way a market incumbent obtains a competitive advantage is by having a lower cost structure that cannot be duplicated by potential rivals. Sometimes lower costs stem from privileged access to crucial inputs. Access to low-cost inputs is only a source of competitive advantage when the market is local, either geographically or in product space. Otherwise, it is not much help as a barrier to entry. More frequently, cost advantages are due to superior, proprietary technology that is protected by patents or by experience or some combination of both. Process patents may be equally powerful. But patents expire.

Demand Advantages: For an incumbent to enjoy competitive advantages on the demand side of the market, it must have access to customers that rivals cannot match. Branding by itself is not sufficient to establish this superior access. Competitive demand advantages require that customers be captive in some degree to incumbent firms. There are only a limited number of reasons why customers become captive. Taken together, habits, switching costs and search costs create competitive advantages on the demand side that are more common and generally more robust than advantages stemming from the supply side or cost side.

Habit: Habit leads to customer captivity when frequent purchases of the same brand establish an allegiance that is as difficult to understand as it is to undermine. Habit succeeds in holding customers captive when purchases are frequent and virtually automatic. Habit is usually local in the sense that it relates to a single product, not to a companys portfolio of products.

Switching Costs: Customers are captive to their current providers when it takes substantial time, money and effort to replace one supplier with a new one. When the applications involved are critical to the companys operations few want to abandon a functioning system. These costs are reinforced by network effects. Standardized products are one antidote to high switching costs.

Search Costs: Customers are also tied to their existing suppliers when it is costly to locate an acceptable replacement. High search costs are an issue when products or services are complicated, customized and crucial. All these details foster an aversion to change. The more specialized and customized the product or service, the higher the search cost for a replacement.

Economies of Scale: The truly durable competitive advantages arise from the intersection of supply and demand advantages, from the linkages of economies of scale with customer captivity. The competitive advantages of economies of scale depend not on the absolute size of the dominant firm but on the size difference between it and its rivals, that is, on market share. If average costs per unit decline as a firm produces more, then smaller competitors will not be able to match the costs of the large firm even though they have equal access to technology and resources so long as they cannot reach the same scale of operation. The larger firm can be highly profitable at a price level that leaves its smaller competitors losing money. The cost structure that underlies these economies of scale usually combines a significant level of fixed cost and a constant level of incremental variable costs. As the scale of the enterprise grows, the fixed cost is spread over more units, the variable cost per unit stays the same and the average cost per unit declines.

Measured by potency and durability, production advantages are the weakest barrier to entry; economies of scale, when combined with some customer captivity, are the strongest. The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space.

Most companies that manage to grow and still achieve a high level of profitability do it on of three ways. They replicate their local advantage in multiple markets. They continue to focus within their product space as that space itself becomes larger. Or, they gradually expand their activities outward from the edges of their dominant market positions. By definition, in any market in which companies enjoy a competitive advantage, there will be a short list of legitimate competitors.

Five Forces

The essence of strategy formulation is coping with competition. The state of competition in an industry depends on five basic forces, which are diagrammed below. The collective strength of these forces determines the ultimate profit potential of an industry.

Good analysis looks rigorously at the structural underpinnings of profitability. Distinguish temporary or cyclical changes from structural changes. A good guideline for the appropriate time horizon is the full business cycle for the particular industry. It is average profitability over this period, not profitability in any particular year, which should be the focus of analysis.

The point of industry analysis is not to declare the industry attractive or unattractive but to understand the underpinnings of competition and the root causes of profitability. As much as possible, analysts should look at industry structure quantitatively, rather than be satisfied with lists of qualitative factors. Many elements of the five forces can be quantified: the percentage of the buyers total cost accounted for by the industrys product (to understand buyer price sensitivity); the percentage of industry sales required to fill a plant or operate a logistical network of efficient scale (to help assess barriers to entry); the buyers switching cost (determining the inducement an entrant or rival must offer customers).

The strength of the forces affects prices, costs, and the investment required to compete; thus the forces are directly tied to the income statements and balance sheets of participants. Industry structure defines the gap between revenues and costs. Intense rivalry drives down prices or elevates the costs of marketing, R&D, or customer service, reducing margins. How much? Strong supplies drive up input costs. How much? Buyer power lowers prices or elevates the costs of meeting buyers demands, such as the requirement to hold more inventory or provide financing. How much? Low barriers to entry or close substitutes limit the level of sustainable prices. How much? It is these economic relationships that sharpen the understanding of competition.

Finally, good industry analysis does not just list pluses and minuses but sees an industry in overall, systemic terms. Which forces are underpinning (or constraining) todays profitability? How might shifts in one competitive force trigger reactions in others? Answering such questions is often the source of true strategic insights.

Economic Evaluation

Is it a good business? How do they make money? What segments does it operate in? What are the fundamentals of each? What are the operating metrics of the business that we need to monitor? Have we diagramed the companys value chain and competitive landscape?

How does the company compare financially with other companies in the same business? Does it earn the same returns on capital? Does it have more or less debt than its peers? How does the marketplace value the company?

To what degree is the business cyclical, countercyclical, or recession-resistant?

How much confidence do we have in forecasting ten years of owner earnings? Income Statement Analysis

Determine where the revenues are coming from. Does the business generate revenues that are recurring or from one-off transactions? Are the revenues and cash flows sustainable or under/overstated due to boom/bust conditions? A well-performing division may be masking problems in the core business or conversely, a poorly performing division may hide overall strength.

What is the outlook for pricing? How does inflation affect the business? A company with a product that is in demand can easily raise prices to generate more profit.

What is the outlook for units? Can the company sell more? The simplest way to raise the bottom line is to sell more! What is the outlook for the gross profit margin? Can the company increase profits on existing sales?

Rising expenses as a percentage of sales may indicate that rising costs that cannot be passed on to the customer are squeezing long-term profit potential. Gross margins should be fairly stable the steadier the gross profit margin, the better. What is the outlook for SG&A? Can the company control costs? Every dollar saved flows to the bottom line and helps restore profitability.

Can the company be as profitable as it used to be, or at least as profitable as competitors? What are its competitors doing differently?

Does the company have one-time expenses that will not be paid in the future? Does the company have unprofitable operations they can shed? If these divisions can be sold/closed, earnings will rise as the losses are eliminated.

What is the return on invested capital for the business? A company with a high Return on Capital has a greater chance of financing growth with self-generated cash. Be mindful of the trends. At a minimum, look for stability.

How does working capital impact the cash flows of the business? Does the business have high or low capital-expenditure requirements? Are there temporary tail/headwinds enhancing cash flow?

Consider the net profit margin earnings divided by total revenue. If a company can grow margins over time, every dollar of goods sold has a leveraged impact. A falling margin may indicate bloated overhead and careless management, or cutthroat competition.

To what degree does operating leverage impact the earnings of the business? If the company does raise sales, how much falls to the bottom line? Often, the cost of gaining market share can actually cause margins to fall or reduce profits.

Balance Sheet Analysis

Does the balance sheet match up with the income statement over time? Are the accounting standards that management uses conservative or liberal? Does the accounting reflect reality? If there are questions, complete the Financial Shenanigans checklist.

Does the company employ leverage on the balance sheet? Is the businesss balance sheet strong or weak? Is debt proportional to operating income?

Does the company have a manageable amount of leverage? Is the debt to total capital ratio less than 0.5x? Is the interest coverage ratio more than 2x?

When is the earliest maturity for the companys debt? When is the latest? How are the maturities spread out? Are they bunched together or far apart?

Does the company depend on access to the capital markets to stay alive? If this is a financial company, then we must really trust their risk management. How long can the company withstand a closure of the capital markets? Does the company have any restrictive covenants that could put the company into bankruptcy?

Growth Potential

Has historical growth been profitable and will it continue? What are the future growth prospects for the business? What will it look like in 5 years? What will it look like in 10-20 years?

What is the management teams motivation to grow the business? Is the management team growing the business too quickly or at a steady pace? How much can the company grow over the next five years? How does management intend to achieve that growth? Growing revenues is not enough if those sales arent generating profits.

Does the business grow through mergers and acquisitions, or does it grow organically? How does management make M&A decisions? Have past acquisitions been successful?

Does the business have an easy additional vertical or horizontal market using existing assets? In what foreign markets does the business operate, and what are the risks of operating in these countries?

Evaluating Management

Does the business have trustworthy management? What is managements track record? Does management have integrity? Are they Outsiders and do they possess the following traits?

The complete lack of an ego. Highly capable and energetic individuals. A singular focus on core truths they believe in. Deeply in love with their company and shareholders.

What are the companys core principles and how are they communicated? Is the business managed in a centralized or decentralized way? Does management value its employees? Does the management team know how to hire well? Where are top executives coming from? Internal promotions or competition? If the latter, which ones? Do we have access to employees? Competitors? Who can we speak with to get a better sense for what its like to work here?

What type of manager is leading the company? Is he a lion or a hyena? How did he rise to lead the business? Has management been tested by a rough business cycle? Is the CEO self-promoting? Does the CEO love the money or the business? Does the CEO manage the business to benefit all stakeholders? How would you evaluate this business if you were to become its CEO? Can you identify a moment of integrity for the manager?

Are managers clear and consistent in their communications and actions with stakeholders? Does management communicate consistent goals over time? How do these goals compare with peers? How have they changed? Do they make sense? Does management issue guidance? If so, do they under-promise and over-deliver? Or, sadly, vice-versa? Is the company comfortable with Wall Street estimates? What does the company expect its competitors to do? Does management think independently and remain unswayed by what others in their industry are doing?

Are the CEO and CFO disciplined in capital allocation decisions? Do they buy back stock opportunistically? Are there distributions of earnings? If they retain earnings, how is their record of capital allocation? Does management plan to buy back stock and is it actually buying in shares after the announcement? What will the company do with excess cash generated by the business? Does it plan to increase dividends? Invest in new stores or factories? Acquire companies or buy back stock? The proper use of excess cash flow can add substantially to corporate earnings and increase profits years ahead. Does the management team focus on cutting unnecessary costs?

Ownership & Incentives

Have the managers been buying or selling the stock? Do they have skin in the game? Does managements share of the company represent a significant investment of net worth? How did they acquire their holdings? What is their ownership relative to their cash compensation? What are insiders doing? Look for patterns.

If management owns about 10% to 30%, thats great. If management owns greater than 30%, still good but might think company is private.

How is management compensated? How does management evaluate itself? How difficult are their performance hurdles to meet? Do they use long-term metrics? Do they use the right metrics? Look at compensation per dollar of sales, profit and employee. How do they stack up relative to peers?

What qualifies a director to serve on the board? What abilities does a director bring to the committees they serve? How were they recruited? Do they have a relationship with the company? What percentage of their income do board fees represent for each director? How does this compare to their stock ownership?

What are the effects on the business of bringing in outside management? Are there activists with significant positions? What is their agenda and is it a positive or negative for the company? Have we talked to them? What is the likelihood they are successful? What if they are not? What are the other significant active fund owners of the company, and how long have they owned the company? Have we talked to them?

Valuation

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. Reported book value, earnings and cash flow are only the best guesses of accountants who follow a set of standards and designed more to achieve conformity than to reflect economic value. Business value is imprecisely knowable and changes over time, with macroeconomic, microeconomic, and market-related factors. Any attempt to value business with precision will yield values that are precisely inaccurate. Markets exist because of differences of opinion among investors. To be a value investor, we must buy at a discount from underlying value. Analyzing each potential opportunity therefore begins with an assessment of business value. Investors should use several methods to value a single business in order to obtain a range of values.

Net present value (NPV) is the discounted value of all future cash flows that a business is expected to generate. A frequently used, but flawed, shortcut of valuing a going concern is private market value. Private market value is based on the valuation multiples that sophisticated, prudent business people have recently paid to purchase similar businesses. Investors must ignore private market values based upon inflated securities prices. Liquidation value is the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, a variant of liquidation analysis, considers each of the components of a business at its highest valuation. Stock market value is an estimate of the price at which a company or its subsidiaries considered separately, would trade in the stock market. This is only useful as a yardstick of value.

NPV would be most applicable in valuing a high-return business with stable cash flows such as a consumer products company; its liquidation value would be far too low. When future cash flows are reasonably predicted and an appropriate discount rate can be chose, NPV analysis is one of the most accurate and precise methods of valuation. There is no single discount rate for a set of cash flows and no precise way to choose one. The appropriate discount rate depends on an investors risk profile, the perceived risk of the investment under consideration and on the returns available from alternative investments.

It is essential that investors choose discount rates as conservatively as they forecast future cash flows. At times when interest rates are unusually low, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low. When interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available.

Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value. The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered. Some investors calculate net-net working capital as a shortcut - defined as net working capital minus all long term liabilities.

Earnings per share has historically been the valuation yardstick most commonly used by investors. But corporate managements are generally aware that many investors focus on reported earnings and a number of them massage reported earnings to create a consistent upward trend. Analysis of reported earnings can mislead investors as to the real profitability of the business. It is important to remember that the numbers are not an end in themselves. They are a simply a means to understanding what is really happening at the company. Book value is the historical accounting of a shareholders equity, the residual after liabilities are subtracted from assets. What something cost in the past is not necessarily a good measure of its value today. For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know have a considerable advantage over everyone else.

A good investment needs two facets to be in place. First and foremost, we require downside protection through a Margin of Safety. However, a Margin of Safety alone is not enough. Core positions should have an upside earnings engine in the form of a wide moat in addition to downside protection.

Does the price make sense? Whats our best estimate of the downside? What would the company be worth if it were sold? Is the business growing? If so, then maybe pay up to 20x reasonable cash flows. How profitable is the growth? How consistent is the growth? Whats driving the growth? If the business isnt growing, then it should be worth about 8x to 10x reasonable cash flows.

Consider where we are in the cycle. How was the backdrop different than today during fair skies or rough waters? Are there temporary headwinds/tailwinds depressing/enhancing free cash flow? Is the revenue/free cash flow sustainable or overstated/understated due to boom/bust conditions?

Does the business have a good free cash flow valuation but a low price to sales ratio? Is there an easily identifiable improvement to margins that could boost price to sales?

Are there additional assets that are missing from the free cash flow calculation? Does the company require additional capital investment merely to remain competitive? If were using EBITDA, did we make sure that the EBITDA - maintenance capex makes sense?

Does the company own any real estate that is being overlooked by investors? Is there an identifiable catalyst that will help realize a more reasonable valuation?

History Lessons

How has the business evolved over time? How has the industry evolved? Has the company kept pace with change? Discuss management changes, acquisitions, spin-offs and other relevant corporate events. Has the companys strategy shifted with time? Review previous investors experiences if relevant.

Resources & Contacts

Investment Checklist| Page 4

SEC Filings Investor presentations Annual Reports Transcripts Proxies M&A 13Fs S1s

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