The Investment Checklist

by Michael Shearn

  Silberman explains, “Take a 35 year old, with only a high-school degree, who has been working either as a pink-collar, blue-collar, or underutilized white-collar [employee] for 15 years. Their earning power and ability to maintain a middle class lifestyle has become more difficult. When they attend college, it is an absolute game changer.”

  Silberman remembers flying in to Washington, D.C., for a Monday evening class. It was fall, and the Washington Redskins were playing that night. Having grown up in the D.C. area, he understood how important it was to watch the Redskins play. Meeting just once a week, the class usually went from 5:30 to 10 p.m. Around 9 p.m., the professor started wrapping up and told students he was giving them “a Redskins break” that night. The students nearly started a small riot in protest. Silberman thought about what a serious contrast this was with his own college experience and how thrilled he was when a professor let him out early. At Strayer, however, many of these students were paying out of their own pockets for this education. They knew they needed it, and they didn’t want to go home and watch football. They wanted to finish the class.

  Silberman’s research made him excited about the for-profit education industry as a whole, and especially excited about Strayer Education. It was a great platform—it had been around for more than 100 years, and it had achieved regional accreditation. He saw great financial characteristics, too: a motivated customer base and a big market. By the middle of summer 2000, Silberman told his Cal Energy boss that he was leaving to run Strayer.

  Fast forward to 2009: Silberman’s efforts to intimately understand Strayer Education have paid off. Since Silberman assumed stewardship of Strayer in 2001, revenue, operating income, and earnings per share have grown at compounded rates of 24 percent, 23 percent, and 22 percent, respectively, at the end of 2009. Under Silberman, Strayer Education has been a true compound machine. The stock price increased from $30 per share at the beginning of March 2001 to $215 per share by the end of 2009.1

  In essence, Silberman went through the process of answering key questions from the checklist. Silberman developed an understanding of how the for-profit education industry developed; the types of customers that typically enroll in for-profit universities and the benefits these customers receive; and he visited campuses to understand firsthand the value of the education to the student. This is the same process that an investor should use in order to analyze a business.

  3. Can you describe how the business operates, in your own words?

  To understand how a business operates, read the business description found in the 10-K. Item 1 of the 10-K provides an overview of the business and a detailed description of all of the following:

  Each of the business’s segments

  Distribution channels

  Marketing strategies

  Manufacturing activities

  Regulatory requirements

  Extensive management discussions of strategies and risks facing the business

  Industry size and trends

  Insight into the competitive environment

  After reading this section carefully, write in your own words how the business operates. How does the business manufacture products or produce its services? How does it distribute these goods and services to the customer? Try to visualize how a product or service is delivered.

  Next, visit the website of the business to better understand what the products or services look like. Your goal is to be able to explain how the business operates to a friend who has limited business knowledge. By writing it in your own words, you will gain a deeper understanding of how the business operates than you would by reading the text and taking light notes.

  For example, after reading Item 1 of the Form 10-K for company VCA Antech, which is 10 pages long, I summarized the business description as follows:

  VCA Antech operates 471 animal hospitals in 40 states that offer pet physicals, dental care, neutering, spaying, and specialty surgeries. These hospitals represent 75 percent of 2008 revenue. The industry is composed of 22,000 companion animal hospitals operating at the end of 2006.

  Each hospital employs a staff of between 10 and 30 full-time equivalent employees, which typically includes administrative and technical support personnel, three to five veterinarians, and a hospital manager.

  Customers choose an animal hospital based on convenient hours and recommendations from friends.

  In addition, it operates 44 veterinary diagnostic labs, which represented 21 percent of 2008 revenue, where 16,000 customers send blood, tissue, and urine samples for testing.

  In 1999, the company operated 194 animal hospitals and 13 labs and then mainly grew through acquisitions: 2004: 67 animal hospitals;

  2005: 46 animal hospitals;

  2007: 44 animal hospitals.

  Main industry association survey indicates that 63 percent of U.S. households own at least one pet.

  A source of growth is technology migrating from the human healthcare sector into practice of veterinary medicine so pets have more treatment options.

  99 percent of customers pay in cash at the time of visit.

  The business markets through targeted demographic mailings regarding specific pet health issues.

  The business employed 9,000 full-time-equivalent employees in 2008.2

  If you are having a difficult time understanding a business, ask what the customer’s world would look like without the product or service. For example, if you were analyzing Internet media delivery company Akamai Technologies and could not find a simple way to summarize how the business operates, ask yourself, “What does the Internet world look like without Akamai Technologies?” In a world without Akamai Technologies, it would take longer to download video to your computer. Content providers such as movie rental company Netflix would be unreliable and would have to charge more to deliver movies.

  Another method you can use to simplify a business description is to find an analogy that best explains how the business operates. For example, Akamai Technologies is similar to an air traffic control tower. Akamai Technology’s software routes data from its customer, such as online video website YouTube, to the closest server on Akamai’s network. The control tower charges a fee to the producer (YouTube), and gets the plane (the video) to its destination faster.

  4. How does the business make money?

  At first glance, this sounds like a simple question to ask, but it is critical for you to summarize how a business generates earnings. If you can’t understand how a business makes money, then you should not invest in it.

  Many investors fall into the trap of investing in businesses where they do not understand how the business generates earnings. For example, if you had asked most investors in insurance firm American International Group (AIG) how the firm generated earnings, they would have given you vague answers. Even the top managers of the business had difficulty understanding each of the different pieces of the business and how they contributed to the total earnings of the firm. As AIG moved from its core insurance business into esoteric financial instruments (such as credit default swaps), it became more opaque, offering little visibility into its future earnings. New businesses, such as International Lease Finance and the Financial Products group were not easy to understand. Most investors bought into the past reputation of AIG and its historical performance, without understanding how these new business lines contributed to the earnings and risk of the business. Later, AIG entered bankruptcy due to losses sustained by these new business lines.

  You want to summarize how a business makes money much like Robert Silberman, CEO of Strayer Education, did in his 2001 shareholder letter:

  Strayer’s revenue comes from tuition payments and fees paid by, or on behalf of, Strayer University students. That revenue comes in essentially three forms. Roughly half is paid through federally insured student loans by banks, approximately 20 percent is paid directly to Strayer by corporations or institutions on behalf of their employees who attend Strayer, and the remainder is paid by students thr
ough their own sources of credit. Strayer’s expenses include salaries paid to the faculty at the university who perform the teaching duties, salaries paid to the administrative and admissions staff who manage the campuses and recruit the students, and salaries paid to the corporate staff who manage the company’s affairs. Expenses also include lease payments for the campus buildings we lease and depreciation for the campus buildings we own, as well as advertising and marketing costs which serve to attract prospective students to Strayer. Finally, our expenses include supplies such as books, paper, pencils, desks, chairs, and computers necessary to support the educational process. Some of the furniture and electronic equipment is capitalized on our balance sheet and the expense is recorded as amortization over the period we expect the equipment to last, in accordance with generally accepted accounting principles.

  5. How has the business evolved over time?

  A historical perspective on a business provides both a deeper understanding and useful insight into its competitive advantage. You can better understand if the success of the business is due to managerial brilliance or simply being at the right place at the right time. If the business you are researching has a particularly complex story or has made many acquisitions, answering this question is especially useful.

  The first place to start is the company’s website. Most businesses will include a timeline or history of how their business evolved. Write in your own words a short summary of the history of the business.

  Another great source, typically found at a library, is the International Directory of Company Histories published by Gale, which profiles more than 8,500 companies. Each entry is usually a few pages long and includes citations of news and magazine stories for follow-up reading. It will give you the complete background and history of a company, including merger and acquisition activity over time and key dates.

  If both of these sources yield limited insight, then gathering and reading the business description using at least 10 years of 10-Ks can be useful. Print out the business descriptions and read them, starting with the first year. Summarize in your own words how the business evolved by noting acquisitions made and new product developments from year to year. You can then read articles written for the past 10 years about the business to help you fill in the gaps in your understanding of how the business evolved.

  6. In what foreign markets does the business operate, and what are the risks of operating in these countries?

  Over the last few decades, the global economy has become more interconnected. It is difficult to believe that before World War II, the U.S. economy was the largest in the world, and both China and India represented only a small percentage of the world economy. U.S. businesses now sell more of their products and services to other countries, and these sales are becoming a larger percentage of revenues for many of them. As a result, it has become increasingly important to learn more about the foreign markets in which a business derives its earnings.

  When a business first enters a foreign market, revenues may grow quickly, which signals to investors that the product or service will be successful. Most management teams will highlight this revenue growth in their annual reports or other financial filings. It is dangerous to project these high initial growth rates into the future, however, because growth in new markets will, of course, stabilize at some point.

  To determine whether a business will be successful in a foreign market, you must determine how committed a management team is to growing in a foreign market. Many management teams overestimate the potential of new foreign markets, and after they sustain losses, they reduce their commitment to these markets. As a result, the business does not replicate the success it has in domestic markets. You need to understand if the management team is prepared to commit enough resources to sustain their growth in that particular market. Just as in domestic markets, the more customers are comfortable and familiar with an existing product or service, the more difficult it is to persuade them to change brands. To build brand awareness, a business must commit to a sustained presence and invest for the long term.

  For example, Peter Brabeck, CEO of Nestlé, said that to have sustainable profits, he had to be willing to invest for the long-term even if it had a negative impact on the short-term. He noted that “the financial community” often thought in timeframes of between six months and a year, so it was tough explaining to them what it really meant to build a business in Korea, China, or Russia, where it takes five to 10 years to reach profitability. Brabeck recalled his decision to stay in Russia during the Russian crisis, saying that if he had thought only about short-term profits, Nestlé would have withdrawn “. . .like everybody else.” He said, “It very clearly had an impact on my profit margins, but in 18 months, we doubled our market share in confectionary.”3

  To understand how committed the top executives are to growing in foreign markets, you need to answer the questions discussed in the next subsections:

  How long has the business been operating in the foreign market?

  Is the business investing in research and development (R&D) to adapt its products to the specific tastes of the customers in a foreign market?

  Has the management team assigned a specific regional manager to emerging markets?

  How Long Has the Business Been Operating in the Foreign Market?

  Scan historical press releases and articles found in news archival services to learn when the business expanded into each foreign market and the reasons behind the expansion. For example, if a business states that it operates in Europe, find out which countries it operates in, and determine why the business chose those particular countries. Also, when dealing in Europe, keep in mind that it is not a cohesive market. Each European country can be considered a unique set of customers.

  Is the Business Investing in R&D to Adapt Its Products to the Specific Tastes of the Customers in a Foreign Market?

  Few products are so globally appealing that a business can market them around the world without adapting them. Exceptions are products like Microsoft’s Windows 7: Microsoft made only minor tweaks to its software before selling it to more than 100 countries. Boeing’s airplanes also travel well without design change, and nearly 80 percent of Boeing’s sales for commercial airplanes in 2010 came from international customers.4 But these are exceptions. It is difficult for most businesses to sell the same product or service it sells in one market to all markets without adapting in some way.

  Urban Outfitters, owner of Anthropologie women’s apparel stores, started its European business by first setting up a local design and merchandising unit in London so that it could tailor goods to European tastes. This increased overhead costs and delayed profitability in Europe, but it helped Urban Outfitters successfully expand throughout Europe. These European stores now account for more than 10 percent of revenue and have close to the same operating margins as those based in the U.S.5

  Similarly, to better familiarize itself with local markets, Nokia established R&D centers in China and India. As a result, Nokia built a phone that was specialized to the needs of customers in India: It had a built-in flashlight, alarm clock, and radio, all of which help customers during blackouts. Nokia also learned that its poorer customers shared phones, so it built handsets with multiple address books.6

  In contrast, when Wal-Mart expanded into Germany and Korea, it did not adapt its stores to local customs and tastes. It ended up withdrawing from these two countries in 2006 to stem its losses.7

  Has the Management Team Assigned a Specific Regional Manager to Emerging Markets?

  It is a red flag when a regional manager oversees both emerging and developed markets, such as the head of Europe overseeing Africa. The reason for this is that these are two different markets that need different strategies and oversight.

  For example, for most of its history, Nestlé SA has assigned an executive in charge of emerging markets, rather than having an executive oversee both developed and emerging markets. This has contributed to the success that Nestlé
had in emerging markets: As of 2010, 32 percent of sales came from these markets.8

  Is Revenue Growth Translating into Profit Growth?

  You need to determine whether revenue growth is translating into profit growth over the long term in a foreign market. The amount of disclosure for revenues and operating profits earned in international markets varies from company to company. Most businesses break down their revenues and assets by geographic region in the footnotes to the 10-K, but few will disclose enough information to allow you to assess whether the business is increasing its profitability in foreign markets. If the company does not provide adequate information, such as the operating profits earned from certain geographic regions, be cautious. This means that management is probably not generating excess profits in these foreign markets.

  For example, in its 2009 10-K, Western Union broke down its revenue between the United States, Mexico, and International. The International section is not further broken down into separate countries or regions, so it is difficult to understand how much operating profit Western Union generates in various geographic regions.

  In contrast, Coca-Cola breaks out its revenues and operating income by continent: Eurasia & Africa, Europe, Latin America, North America, and the Pacific. It also separates capital expenditures and identifiable assets for each of these regions, which allows you to calculate financial metrics, such as return on invested capital.

  If a business does not break out its operating income by region, you can sometimes determine whether international expansion has been profitable by comparing historical financial statements of the business before it expanded into foreign markets to recent financial statements. Review the financial margins before the expansion and then after the expansion. Has the operating margin over this period increased or decreased? You will need to assume that the core domestic business has not deteriorated or improved during this time or if it has changed, you will need to make the proper adjustments. Keep in mind that when a business enters a new market, it typically has a higher cost structure, earning less in new geographic regions than in more mature markets. You can also read press releases and articles and speak with the investor relations department of a business to help you obtain more insights.