The Investment Checklist

by Michael Shearn

  Once a business meets your criteria, it is important to track it. You may want to create a spreadsheet where you list the businesses that meet your criteria, similar to the example in Table 1.2. It is essentially a formal watch list of businesses and can range from a few ideas to hundreds of ideas.

  Table 1.2 Inventory of Ideas

  Source: Capital IQ, December 14, 2010

  KEY: TEV = Total Enterprise Value; EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization; FCF = Free Cash Flow

  Once you add an investment to your list, you should begin learning about the business and management team, and track the valuation of the business using financial metrics such as free cash flow (FCF) yield or total enterprise value (TEV) to earnings before interest and taxes (EBIT) to alert you if a business drops in value. Because of the GAAP issues mentioned earlier, you may want to avoid using valuation metrics such as price-to-earnings ratios. Also, you don’t need to update these spreadsheets yourself; instead, there are various services you can use to update the numbers on a daily basis, such as Bloomberg or Standard & Poor’s Capital IQ.

  Valuation Is a Filter

  The one thing you can’t fix after making an investment is the price you pay, so it is critical to remain disciplined on price. Your future rate of return will be determined by the price you pay for the business. This is why you should only consider those investments that are trading at a low price. The following case study gives you an example of how investment manager Brad Leonard generated high returns for his investors by paying low prices.

  Brad Leonard founded BML Capital Management, LLC in 2004. He has compounded capital at a rate of 26.94 percent, net after fees from 2004 to 2010, compared to 3.87 percent, net for the S&P 500. He credits this record to being disciplined about paying low prices for stocks. He typically pays three times enterprise value (EV) to EBITDA for a stock, and he prefers to buy businesses that do not need a lot of capital expenditures to maintain their businesses and those that have little to no debt. In 2009, when the stock market was declining, Leonard was buying stocks at one to two times EBITDA. Leonard says, “When you are paying one or two times EV EBITDA, not much needs to go right. If the business survives, you win. As long as the business does not end, you don’t need to make a lot of great assumptions in your analysis. If instead I were paying a 5 percent earnings yield (earnings divided by market capitalization) on depressed earnings, it would not really be that cheap.”

  For example, Leonard first began buying Kirkland’s, a home décor retailer, at $1.70 per share in the fall of 2007. Shortly thereafter, the stock price declined to $0.70 per share (when the stock market declined by more than 36 percent in 2008). As Leonard was buying Kirkland’s, the fundamentals of the business continued to improve. After reporting negative comparable store sales in the fourth quarter of 2007, Kirkland’s same-store sales turned positive in the first two quarters of 2008. Cash flows, comparable store sales, and margins all continued to improve, yet the stock price continued to decline. Leonard stepped on the gas even more in his purchases. He said, “Every quarter, the results of Kirkland’s would improve, and it seemed that no one cared. At this time, I thought it was likely the company would post around $20 million in EBITDA, so in essence, I was buying the stock around 1 to 2 times EV to EBITDA.” The stock eventually recovered to around $2 per share by 2008, and by 2009, it was trading at more than $20 per share. Leonard’s disciplined buying was well rewarded.7

  Using a Spreadsheet to Track Potential and Existing Holdings

  There are many advantages to using a spreadsheet to track your potential and existing holdings. First, the discipline of placing newly developed investment ideas in a spreadsheet lets the novelty of the new idea wear off, and it helps you counter your natural desire to act on impulse and buy a stock. You will not feel as if you are about to miss the opportunity of a lifetime because you have many choices to invest in. Most of us look for stocks that are cheap and then study the business and assess management. By the time you are up to speed on the business and ready to buy, the opportunity is gone. After this happens a few times, you will begin to feel a sense of urgency whenever you spot a new investment idea. You might be tempted to short-cut your research process so that you will not miss another opportunity.

  Having such a spreadsheet, however, allows you to optimize the use of your time by allowing you to concentrate on those opportunities with the greatest upside potential and lowest downside risk. Instead of scrambling to analyze the many investment opportunities being offered to you by the stock market, you can carefully choose from the best opportunities in your spreadsheet.

  The greatest advantage to maintaining an inventory of existing and potential investments is the ability to make comparisons. If you are comparing your existing holdings with hundreds of potential investment opportunities rather than a limited set, you increase the probability of making good investments and avoiding bad ones. The more comparisons you can make in your spreadsheet, the higher the probability of uncovering an investment idea. In addition, those comparisons will increase your awareness of areas of the stock market and individual stocks that are out of favor. You can gradually build your spreadsheet over time or proactively build it—two approaches that I’ll discuss in the final sections of this chapter.

  Gradually Building a Spreadsheet of Potential Investments

  When you do not have investment opportunities that you are ready to act on, you can use your time to prepare for future opportunities. When you identify a unique business or superior management team, add the business to your inventory of ideas or watch list, regardless of its current valuation. This is the secret sauce to investing intelligently, because it allows you to act decisively when a good opportunity is in front of you, and it prevents you from acting imprudently when you first have the idea or insight. In essence, you are letting time work in your favor.

  Be Proactive

  One of the biggest advantages of investing in public markets is that you can identify every business in your investable universe. You have the ability to review more than 9,000 publicly traded businesses one by one. You can look for those businesses that meet your criteria. Exclude those businesses that you do not believe you can accurately value because this will help you get through the list at a quicker pace. This will help you narrow down the number of businesses you consider investing in from 9,000 to a more manageable several hundred.

  Once you have some ideas of the companies you’re considering investing in, there are a couple of preliminary questions you should ask yourself before getting into the nitty-gritty of researching those businesses. Turn to Chapter 2 to discover the first several questions of The Investment Checklist.

  Key Points to Keep in Mind

  You will not have many outstanding investments in your lifetime.

  Investment opportunities are created when capital is scarce. Capital becomes scarce when one or more of the following events occurs: An entire market declines

  There is forced selling from a stock being thrown out of an index or if it is spun off

  There is some type of uncertainty about a business that causes investors to sell their stock

  If you use stock screens to identify investment ideas, understand that you may miss many investment opportunities because most screens are based on GAAP accounting numbers which may under- or overstate the earnings of a business.

  Be careful when following investment managers in their investment ideas.

  Use specific criteria to filter out the investment ideas you don’t like.

  Create an inventory of ideas to track potential investments that meet your criteria on a continual basis in order to prepare for future opportunities.

  1. Sobel, Robert. The Rise and Fall of the Conglomerate Kings. New York: Stein and Day, 1984.

  2. Shepard, Stephen B. “A Talk with Scott McNealy.” BusinessWeek, April 1, 2002, pp. 66–68.

  3. Standard & Poor’s Capital IQ.

  4. Author’s inter
view with Paul Sonkin in November 2010.

  5. Author’s interview with Todd Green in March 2011.

  6. Author’s interview with Paul Sonkin in November 2010.

  7. Standard & Poor’s Capital IQ; Author’s interview with Brad Leonard in March 2011.

  CHAPTER 2

  Understanding the Business—The Basics

  Once you know you are interested in a particular business and ready to begin your research, you should take a structured approach to evaluating that business. This chapter tells you how to nail down the most basic questions you encounter when analyzing a new company: What does it really do, and how does it make money? Sometimes this is easy, but I’ve certainly been surprised at times. If you have a solid understanding of what a company does and can explain it simply, you are less likely to waste time on tangential issues as you go into more depth.

  Essentially, you want to understand the company as it is today by looking at how it evolved. I believe that history goes to the heart of why a company is successful: Was it really good? Or was it just really lucky?

  After gathering the basic information on a business, we’ll turn our attention to the special case of evaluating a company’s success in foreign markets. For most companies, globalization has created interconnected markets, which creates a new research task for you. Even if the company you’re researching is still mostly a domestic operator today, you want to evaluate the company’s profitability and commitment to foreign markets.

  Let’s start by considering whether or not you’re even interested in learning about a particular business, and then imagine yourself in the shoes of the company’s CEO. Let’s take a closer look at these questions.

  1. Do I want to spend a lot of time learning about this business?

  Before you begin to analyze a business, ask yourself if you are interested in learning more about it. If not, you probably won’t have sufficient interest to do in-depth research and as a result, you may make an uninformed investment decision. You can’t truly understand a business in a couple of weeks. It takes a long time, years in most cases, to truly understand how a business operates and to determine the competence and integrity of a management team. It is a continuous process, and if your interest begins to wane in a couple of weeks, you will not have the stamina to continue to learn about the business over the long term.

  If you are just beginning to invest, it is best for you to analyze one business over a long period of time. Too often, even professional analysts spend their time analyzing too many businesses, and they never develop the ability to fully understand the value of a business (i.e., they don’t see the whole picture).

  For example, at the beginning of my investment career, I spent six months analyzing TV ratings company Nielsen Media Research. I spent my time interviewing more than 80 percent of Nielsen Media Research’s customer base, and I developed an in-depth understanding of the business. As a result, I was in a good position to value the business.

  As you begin to read about the business, ask yourself how steep your learning curve will have to be to understand a particular business. If you find that it is extremely difficult for you to evaluate the business or that you are simply not interested, this is a sign you might want to pass on the investment. Most of us can eventually understand a complex business if we invest enough time, but our understanding may ultimately still be shallow. Instead of over-investing in a process that yields less return, try to develop a deeper understanding of businesses you genuinely care about.

  Too many investment firms assign investment ideas to their analysts without considering whether those analysts will enjoy researching the business or industry. If the analyst is not interested in learning about the business, he or she may never uncover useful insights. It is common sense that you are less likely to succeed at something you are not interested in, yet investors force themselves to study such businesses.

  For example, I remember researching a bank recommended by an investor with a long track record of successfully investing in bank stocks. As I read through the 10-K form, I quickly found that I did not enjoy learning about the bank. Although I forced myself to continue to read about the bank, I found myself looking for distractions. My lack of interest caused me to lose momentum in my analysis. I waited for inspiration to continue reading and sometimes would find it, although it was short lived. Because I was uninterested in the business, I was unable to conduct a thorough analysis.

  In contrast, retail held instant fascination for me. If there was a term I did not understand, I researched its meaning or how it was calculated. I searched for articles and books on how to identify an efficient retailer, took classes to learn more about retail operations, and started going to industry conferences. Thoroughly engaged and stimulated, I found that few things distracted me. I recall cutting phone conversations short so I could get back to learning more about retail. My passion for retail gave me the drive to constantly learn more about the industry and put me in a better position to evaluate opportunities within this sector.

  However, there’s an element of risk to this passion: Personally liking a product or service can lead you to believe that others will like it as well. For example, it’s hard to objectively weigh criticism of your favorite restaurant: Because your own experience has been different, you may even discount a negative report. My own passion for retail has caused me to lose discipline at times, as I overlooked negative attributes and instead focused on the positive ones. Whether positive or negative, be aware that your personal preferences may negatively influence your investment decisions.

  2. How would you evaluate this business if you were to become its CEO?

  The goal of any long-term investor should be to have the greatest understanding of the underlying economics of a business and know how those can change. Ideally, you should research the business as though you would be taking over the business in the next few months as chief executive officer (CEO). That is exactly what Robert Silberman, CEO of Strayer Education, did.

  I interviewed Silberman at a Strayer University campus opening in Austin, Texas. The opportunity to take over as CEO of Strayer came about when one of Silberman’s friends, Bob Grusky, called Silberman and told him that the private equity firm he was starting, New Mountain, had identified Strayer as a company they wanted to invest in. New Mountain was buying out the former Strayer CEO, who was set to retire. Grusky and his partners needed someone to come in as CEO and asked Silberman to join the company.

  Silberman’s first reaction was, “How can you own a university?” He had never heard of the business model before this phone call. At the time, Silberman was the chief operating officer (COO) of Cal Energy, which was owned by Berkshire Hathaway. Before formally accepting the position, Silberman spent the next five months completing an in-depth research study of the for-profit education industry and Strayer Education.

  From March to July 2000, Silberman researched the history of for-profit education and the education sector in the United States. In particular, he wanted to understand the role of private capital in this sector.

  Silberman told me, “One of the advantages of running an international energy company is that you are on airplanes a lot—I had all these 13-hour flights. After a few hours of sleep and taking care of my other responsibilities, I was able to really dive in on an uninterrupted basis. And the more I looked at this as a business, the more excited I got. The renewable energy business that I was in had incredible capital requirements, very low returns on capital, and all sorts of extraneous risks such as technological risks, political risk, and currency risk. The education sector in this country, at the post-secondary level, was the exact opposite. It had low capital requirements, very high demand, very limited supply, and if you really ran a great university with a good reputation, a very wide moat.”

  Silberman read broad histories of higher education in the United States and then focused on the for-profit sector. His analysis included macroeconomic factors and sector-level data. He identified a
nd studied other companies in the industry that were publicly traded, and finally, he researched Strayer.

  He studied the industry’s history in order to understand how the for-profit education industry had developed, and he analyzed the factors that had driven the accelerated growth of the industry over the last 20 to 25 years. To study the public companies, he read 10-Ks and 10-Qs, annual reports, and analyst reports from competing education companies, such as Apollo Group, DeVry, and ITT Corp. Silberman analyzed reams of statistical data about the for-profit customer. He wanted to understand who went to for-profit colleges and who did not. He looked at the outcomes for the customer by analyzing data about the earning potential for someone who had a college degree.

  Silberman learned that the earnings potential for college graduates was high and rising as the U.S. economy shifted away from its manufacturing base, where a high-school degree and limited technical training had been enough to support a middle-class lifestyle. As the United States moved toward a knowledge- and service-based economy, achieving a middle-class lifestyle with only a high-school degree was getting tougher. The gap in earnings between educated and non-educated people was growing wider and creating intense demand for higher education. Furthermore, the supply was essentially fixed.

  As part of his due diligence, Silberman visited Strayer’s campuses in Washington, D.C., and he wandered into classrooms, where he pretended to be a student. As he saw professors and working adult students interact, he sensed how intense the students’ desire was to complete their degrees. He could see that the educational experience was life-changing.