1. Can I describe how the business operates in my own words?
2. How does the business make money?
3. How has the business evolved over time?
4. What are the costs that the business have to incur?
5. Is the business affected by commodity prices? If so, what commodities and what factors affect the commodity prices? Where are these commodities in their respective commodities cycle?
6. What factors contributed to historical booms and busts?
7. What is the proportion of revenue and profit from foreign operations?
8. Who is the core customers of the business and are customers purchasing decision affected by economic conditions?
9. Is the customer base concentrated or diversified?
10. Is it easy or difficult to convince customers to buy the products or services? How high is the switching cost?
11. What pain does the business alleviate for the customer?
12. How are the business's products/services differentiated from those offered by competitors?
13. Does the business have sustainable moats and what is the source?
14. Does the business have pricing power, can it pass along inflation impact to customers?
15. What type of relationship does the business have with its suppliers?
16. What risks does the business face?
17. Is the business subject to the competition of foreign cheap labor? (Dexter shoes, Berkshire textile)
Industry Analysis
1. How has the industry evolved over time?
2. How does the industry operate?
3. Who are the big players in the industry? How did they become so successful?
4. How intense is the competition within the industry?
5. Is the industry concentrated or fragmented?
6. What are some key indicators/statistics relevant to this industry?
7. Historically, how does the industry perform in different phases of the business cycle and stock market cycle? Does it perform well during bull market or bear market? Does if fall more than the market in a falling market?
8. Is there a long term trend benefiting the business?
9. Is the industry subject to rapid changes?
10. Is the industry subject to strict regulations?
Financial Analysis
1. What are the operating metrics that need to be monitored?
2. What are the best valuation metrics to use?
3. What types of assets does the business have and how easier can they be converted to cash?
4. What is the return on invested capital for this business?
5. What is the level of operating leverage?
6. Does the business generate revenues that are recurring or from one-off transactions?
7. How does working capital impact the cash flow of the business?
8. Does the business have high or low capital expenditures?
9. Is the business subject to huge pension liabilities?
10. What is their derivative exposure as a % of operating income?
11. Is ROA or ROE a better measurement for returns?
12. What is the proportion of intangible and goodwill as a percentage of total assets?
13. What is the asset/equity, debt/equity and interest coverage ratio?
14. When are the debt due?
15. What are off-balance sheet commitments and obligations?
16. Have operating cash flows moved consistently with net income?
17. During the past 3, 5 and 10 years, did the business have to spend all its earnings in capex and acquisitions?
Management Team
1. What type of manager is leading the company?
2. How did the CEO rise to lead the business?
3. Is the compensation structure aligned with the interest of shareholders?
4. What is the stock ownership percentage of the business?
5. Have the leaders been buying or selling stocks?
6. Are the CEO and CFO disciplined in making capital allocation decisions?
7. Do the CEO and CFO buy back stock opportunistically?
8. Does management buy back shares to satisfy RSU issuance? i.e Did share count shrink as the company buys back shares?
9. Is the letter to shareholders meaningful to read?
10. Are managers clear and consistent in their communications and actions with stakeholders?
11. Do the option grant and RSU grants policies encourage management to manipulate earnings so they can exercise options?
Evaluating Growth
1. Does the business grow from M&A or does it grow organically?
2. What is the management team's motivation to grow the business?
3. How much is future growth subject to the law of diminishing returns? i.e What stage in business cycle is the business in?
4. Is the management team growing the business too quickly or at a steady pace?
5. Has the growth in business attracted more competitors?
6. How does management make M&A decisions?
7. How much did management pay for past acquisitions and have they been successful in achieving synergies and expanding market?
Additional Items from Past Mistakes of Other Investors and Myself:
1. Are recent earnings peak earnings? (Berkshire bought Cort, Pabrai bought Delta Financial).
2. Are recent earnings reflective of any bubbles ( First Solar)?
3. Is overcapacity building up? Pay special attention to industry such as shipping and drilling where it can take years for overcapacity to become obvious.
4. If dramatic changes are made rapidly, did management test new strategies before full implementation? Such as Ron Johnson's change at JC Penney.
5. What psychological biases are managers subject to?
6. Does the change ignore human psychological biases? Ron Johnson's termination of promotion at JC Penney.
7. Are gross margin and net margin contracting?
8. Is the business deteriorating due to new entrants or new products from existing rivals? If so, is management too arrogant to acknowledge the need to change? Think about what iPhone did to Nokia and Blackberry and what Nokia and Blackberry's management said about iPhone. Also think about what iPad is doing to Dell and HPQ.
9. What structural factors and long term mega trends are negatively affecting the business? Think about what internet did to Radioshack and newspapers.
10. If short, is there a long term trend benefiting the business? Is it a valuation only based short?
11. Reverse engineer: How many products does the company need to sell at a normal industry margin in 5 years, 10 years to justify its current valuation.
12. Is the upside at least 2X current prices in 2-3 years, or 5x in 5 years?
Psychological Biases Checklist:
- Look for disconfirming evidence – killing your own ideas.
- Emphasize factors that don’t produce lots of easily available numbers.
- Under-weigh extra vivid experience and overweigh less vivid experience. Same with recent events, i.e. cool off.
- Remember the lesson: One idea or fact is not worth more merely because it is easily available to you.
- There’s no logical answer in some cases except to wring the money out and go elsewhere.
- Don't make any investment decision under euphoria or extreme depression.
Below is from an article from gurufocus:
http://www.gurufocus.com/news/171556/avoiding-value-traps-a-four-question-test
1) What are the odds that this company will not be around ten years from today? – As I noted in my previous article “Kill the Company,” this is the first question Buffett will always ask: Is there any chance that a significant amount of my capital could be subject to catastrophe risk? As Alice Schroeder noted, if the answer is yes, he just stops thinking; this is a good example to follow.
2) What is the company’s sustainable competitive advantage? – In my mind, this is essentially the same thing as No. 1: What does this company do that all but guarantees its existence 10, 20 and 50 years from now? For Coca-Cola (KO), it delivers a product with unmatched brand equity (partly due to significant economies of scale) via an unrivaled distribution network; in addition, it has levered this success to enter new categories (juices, teas, sports drinks, etc.) in order to all but guarantee its continued growth even if the shift away from CSDs experienced in the U.S. continues in the future.
3) Does the company have the financial strength to ride out a rough patch? This is overwhelmingly important, and has been captured as of late in two high profile examples:
The first is Diamond Foods (DMND), which has been plagued with an accounting scandal: The company was itching to grow a bit too quickly, and now holds $530 million in debt (compared to a market cap of $470 million) compared to marginal profitability. As a result, the company has had to explore strategic alternatives, and will likely need to dilute the current shares outstanding or sell the company as a whole (they are in talks with KKR according to a recent Barron’s article).
Even when adjusting the prior year’s financial statements to account for the misstated numbers, DMND starts to look attractive at the current valuation based on their growth potential and their current earnings power; the minute my eye catches that overwhelming debt load, I’m forced to walk away in fear of what might lay ahead for this company.
On the other end of the spectrum is Nokia (NOK); while the company has gotten clobbered by Apple’s (AAPL) iPhone and Google’s (GOOG) Android operating system, they are fine from a financial perspective. Even after losing more than 1 billion euros last year, the company has net cash of 5 billion euros, leaving them plenty of time to right the ship (now that we abandoned that burning oil rig, right Mr. Elop?) before the balance sheet becomes an issue.
4) Would you LOVE to see the stock fall 50%? – For me, this is the ultimate test for an investment. If you can look at a company’s competitive position within an industry and know that you would love to buy more at half of today’s price regardless of the short-term noise, that’s a good sign in my book (I've been begging for many to do some since I missed out in 2009, but so far, no gravy). If this isn’t true, there are two likely culprits: Either you question the long-term sustainability of the business, or you don’t understand enough about the company to feel comfortable with bouts of volatility. Either way, its probably a sign that you should move on to the next opportunity.
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