Filtering for Fortune: How to Choose the Right Businesses to Invest In
"Investing success doesn’t come from making the right guesses, it comes from having the right process." — Michael Mauboussin
You have got to have a process when it comes to investing to make money.
Remember we are looking to build a concentrated portfolio of high-quality businesses. The first step towards that goal is having a process to qualify potential investments and select businesses to purchase.
This is the meat and bones of investing, and it is a process which you will have to love if you want to succeed.
There are over approximately 40,000 public stocks listed worldwide available for you to buy. How do you narrow this down to 5 to 20 stocks?
Knowing where to start can be daunting – that is why I have developed Business Selection Process. It provides a guided approach that aligns with the Focus Investment Philosophy:
The Business Selection Process
The goal of the business selection process is to provide a consistent and efficient way to analyse any business you come across.
Running a concentrated portfolio requires you to have conviction in the businesses in which you are invested. A rigorous process allows you to build this conviction as you cover the following areas:
Personally, you are looking at businesses with meaning to you that are in your circle of competence (Meaning)
You understand the Quality of business you are investing in, the management team involved and assessed associated risks. (Quality, Management, Risk)
You are only purchasing when you are getting Value (Value)
This process has been designed to be used in 2 ways:
Filtering: When first looking at a company the process can be used as a quick filtering mechanism for sorting companies into the too hard bucket or identifying promising candidates for further detailed analysis
Scoring: As a framework to score the business against specific criteria and to build a detailed investment thesis upon
Filtering
With there being thousands of public companies to invest in you need an efficient process to separate the wheat from the chaff.
The goal of using the process as a filtering mechanism is to pick up any company and decide as quickly as possible as to whether it is a potential investment worth further detailed analysis.
To be considered for your watchlist the company needs to pass through each of the following selection filters:
Meaning: Invest in businesses you understand, find interesting and are comfortable supporting
Quality: Focus on companies with strong competitive advantages and consistent performance.
Management: Choose companies led by trustworthy, capable, and well-incentivized capital allocators.
Risk: Prioritize businesses with low debt and predictable earnings to minimize risk.
Value: Seek investments with a significant margin of safety between market price and intrinsic value.
Working your way down the process and if at any point a business spectacularly fails any one of the filters it can be put in the too hard pile. (Don’t worry we will walk through how to assess each in future blog posts)
The only exception is where a business fails the Value filter only. In this case you have a high-quality business which on the surface looks overvalued currently. This should be put on your watchlist as a potential candidate for further review. The market may offer you a better price in the future!
The aim when filtering business is spending no more time than you need too on each.
Depending on where the business fails in the process this could take anywhere from a couple of minutes to a maximum of a couple of hours.
Remember we are not trying to understand every last detail about the business at this stage we are just looking to discount businesses we don’t want to invest in.
The goal of these filters is to create a repeatable and efficient process that allows us to put companies into one of three buckets.
Too Hard: Companies that failed a filter and have been put in the too hard pile. This will represent the vast majority of stocks.
Watchlist: Quality companies at a price that does not represent good value.
Possible buy: Quality companies at a price that represents good value.
Assuming the business survives a first pass of the filters. Our job is to now perform a more detailed analysis and score the business.
Scoring
After a first pass if the business has made it into your buy or watch list you should be dealing with a company which on the surface is of high quality.
Your goal now is to deep dive into the business to build your conviction.
To do this we again look at each area but through the lens of additional scoring criteria (Scored between 1-10)
Each should be scored with supporting evidence and written summary. This ultimately forms your thesis for the company.
Performing the hard yards here allows you to:
Build conviction.
Demonstrate you to truly understand the business and turn over a number of rocks.
Score the business and compare it more easily against other potential investments.
At this point we will provide a high-level overview of the scoring criteria which will be elaborated on further in future blog post:
Meaning
Invest in businesses you understand, find interesting and are comfortable supporting.
The purpose of this step is to ultimately answer 2 questions:
Do I want to spend a significant amount of time learning about this business? i.e. does the business align with your values?
Do I understand how the business makes money and the competitive environment it operates in? i.e. is this within your circle of competence?
Only you will be able to answer the question of whether a business has meaning to you. But for you to really understand a business it must have meaning.
To make money you are going to know this business inside out and better than 99% of people looking at the business.
To do this we will look at and assess the following criteria:
Aligned Values
Do you want to spend a significant amount of time learning about this business?
Does the business align with your interests, skills, experience and values?
Circle of Competence
Does the business lie within my circle of competence?
Do I understand how the business makes money and the competitive environment it operates in?
Quality
Focus on companies with strong competitive advantages and consistent performance.
"Time is the ally of great businesses, but the enemy of mediocre ones." - Warren Buffett
We are looking for quality companies that will compound over the long term. To assess this, we will review a number of Quantitative Criteria that can be found within company’s financial statements to see if there is evidence of a competitive advantage / MOAT.
We will then perform Qualitative analysis to explain the numbers through with a focus on barriers to entry and business resilience. These Quantitative and Qualitative Criteria are as follow:
Free Cash Flow per Share Growth (Quantitative)
What is the compound annual growth rate (CAGR) of Revenue, Earnings per share and ultimately Free Cash Flow per share?
Is growth consistent year on year or sporadic?
Margin (Quantitative)
How profitable is the company and how efficiently are earnings translated into free cash flow?
Is there evidence of pricing power within the business?
Return on Invested Capital (Quantitative)
Has the company had a consistently high return on invested capital over many years?
Is the company able to invest capital at a rate higher than its cost of capital?
Capital Intensity (Quantitative)
How much CAPEX and working capital does the business need to operate?
Industry Dynamics & Business Resilience (Qualitative)
Who are the key competitors and what are the key industry trends?
Is the business globally active with a diverse customer and product base?
How resilient is the business to interest rates, credit supply, the economic cycle and industry disruption?
Competitive Advantage: Barriers to Entry (Qualitative)
What barriers to entry are defending the competitive advantage of this company and how durable are they?
Management
Choose companies led by trustworthy, capable, and well-incentivized capital allocators.
By investing in a company, you are handing over the stewardship of the business to the management team. You want to ensure they are working for you and are capable.
One of the reasons we buy quality companies is:
"I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." – Warren Buffett
However capable management can make a significant difference even when running quality companies. As we plan to run concentrated position, we want to ensure that management are also high quality.
To do this we will review:
Track Record
Does the track record and experience of management indicate that are capable and trustworthy?
Are there any red flags?
Aligned Incentives
Are the incentives of management aligned with those of shareholders through significant ownership stakes and renumeration policies that incentivise long term shareholder value creation?
Capital Allocation
Has management demonstrated that capital allocation is a primary consideration in everything they do?
How have they allocated capital across capital expenditures, expansion, debt payments, working capital, acquisitions, share buybacks and dividends?
Risk
Prioritize businesses with low debt and predictable earnings to minimize risk.
By this point you have a compounding machine who is run by an incentivised and capable management team. On paper this looks like it could be a great investment.
But first we need to understand if there is anything that could derail this investment.
To do this we look first look at potential risks and then make an assessment of the predictability of earnings (and therefore the confidence we have in any valuations):
Balance Sheet Risks
Does the business have a healthy balance sheet and manageable level of leverage?
Are there any “hidden” liabilities such as leases and pensions that need to be considered?
Perform an Asset Valuation to determine the replacement or liquidation value of the company's assets.
Other Risks
Explicitly call out key risks and the impact they may have on the business.
What could break down the barriers to entry and erode the competitive advantage the business has?
Predictability of Earnings
How secure are the current level of earnings?
Has past growth been consistent enough to predict and estimate future growth?
Value
Seek investments with a significant margin of safety between market price and intrinsic value.
Having reviewed the above 4 criteria in detail we can be confident that we are dealing with a high-quality business which at the correct price will be a suitable investment. The business should be well and truly on our watch list.
We now need to assess whether we are getting value at the current share price:
Earnings Power Value
Calculate the intrinsic value of the business based on its current cash profits.
Determine the percentage of the current share price made up on EPV and future growth.
Total Value
What growth rate is required for the intrinsic value to reach the current share price?
What is your best estimate for intrinsic value when incorporating growth and what margin of safety does this leave?
Conclusion
By working through the above steps, you can be confident that you have looked at the business from all angles and can build the conviction needed to invest in a meaningful way.
Scoring the business also allows you to compare other investment options and make informed decisions.
In our next blog posts, we will deep dive on each area (Meaning, Quality, Management, Risk & Value) giving you the tools to perform this analysis yourself step by step.
To wrap up the business selections posts I will also perform a detailed analysis on a quality company I hold.
Disclaimer
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