Successful investing comes from finding great businesses and buying them below intrinsic values. So, the key investment tools are focused on How to find such companies and How to evaluate their intrinsic value. In simple terms a successful business is the one that earns a high return on capital which is sustainable in the future and has many options for reinvesting capital (growing the business). Ability to maintain high returns is often linked to having unique competitive advantage ('moat' as Buffett refers to it) in an industry with relatively low competition and high barriers to entry (scale advantage, brand, unique R&D process, patents, regulation). Such businesses are normally run by exceptional management teams with strong alignment of interests (who have direct interest in the business).
A summary of investment tools and questions:
1. Economics of a business. What is company's product, what determines its price and costs. Is the product more of a commodity (easily substituted by other suppliers) or well differentiated product with a strong brand? What is the profit margin of this business? How much capital it requires to maintain the current operations and to grow? What are returns on capital?
2. Future economics of a business. How can it change relative to the current state? How unique is the product, how strong are competitors. What is the size of the market that the company operates in? Is the market growing and why? Will customers need this product in 10-20 years?
3. Leverage. Does the company use a lot of financial leverage relative to its assets, profits, cashflows? How significant is operating leverage (share of fixed costs relative to variable costs and relative to gross margin).
4. Management. How competent is the management team, what is their track record? What are their key KPIs, incentive structure? Have they purchased company's stock
5. Capital allocation. How does the company allocate its cashflows – what share goes on maintenance capital, growth investments, M&A, dividends, buyback? What big investment projects has the company undertaken historically, what results they have achieved (incremental profits relative to capital spent).
6. Valuation. What is the current price relative to profits, dividends and buyback, what is the current price relative to profits / dividends in 5 years? What return could you achieve if you pay the current price relative to the shareholder yield (dividends + buyback) + long-term growth? How does it compare to government bonds, dividend yields on equity market + 3-5% (level of GDP growth + inflation)?
7. Risks. Where can you be wrong in your analysis, what could go wrong? Are you extrapolating the favourable conditions from the recent past far into the future? Is the business in a cyclical industry? What could cause the stock to drop 20%? Would you still be happy /comfortable owning the company after the drop? Will it be able to survive 5% drop in GDP, materially higher inflation, interest rates? Would you like to own this business for the next 5 years, 10 years, 20 years, for the rest of your life?
Other practical tools include:
8. Sourcing ideas. It is more likely that a mis-priced company would be in a sector / country that generates little interest for the broader market currently. This could be out-of-favour industries especially if investors avoid them for non-fundamental reasons or based on broad concepts ('uninvestable sector') or simply 'boring' sectors or countries / sectors that are just not on many investors' radars.
- Reading financial press to identify such sectors or companies going through a turnaround is a useful tool.
- Reading annual reports and conference call transcripts of companies that catch your attention can help to better understand the business as well as key competitors. Often, a competitor may turn out to be an even more interesting investment opportunity.
- Screening for stocks is useful, although less than in the past simply because it is such an easily available tool which can be quite easily automated. Some search criteria could be valuation, returns on capital (Magic Formula website maintained by Joel Greenblatt), 13F filings (that track recent purchases of investors with superior track record), insiders' activity.
9. Position size. What share of your portfolio should you allocate to a company that meets your criteria? What share of your net worth is keeping in stocks?
10. Diversification. How many stocks should one keep in a portfolio, is it worth holding stocks from different sectors, countries.
11. Currency risk. In what currency does the company sell its products, what currency are its costs denominated in? What is the currency you measure your net worth, you make your most spending or plan to make in the future?
12. Opening a position. Should you open a full position once you have done all research or buy in stages?
13. Exiting position. When do you sell the position? Has the price of a company reached your fair value estimate? Have conditions in the industry or of a business change significantly compared to your original assessment? Have managers been selling or buying stock in the market?