The Checklist – Part IV Both Mohnish Pabrai and Guy Spier are advocates of using “checklists”. Mohnish Pabrai reportedly has 100 items on his checklist, though his checklist has never been shared publicly. In getting started with checklists, they both refer to The Checklist Manifesto by Atul Gawande. Guy points out with investing, unlike flying, the results of the checklist don’t have to be perfect. Mohnish says you’ll never get all your boxes checked. Mohnish began making his checklists after studying the mistakes of Warren Buffett. My own checklist begins with the six ‘filters’ as laid out in the book Seeking Wisdom by Peter Bevelin and modified for my use: Filter 1. Can I understand the business? Will people continue to buy this product or service in the future? Who are the competitors? What is the position within the industry? Who is the real customer? Filter 2. Does the business have a sustainable competitive advantage? Are the advantages becoming stronger and more durable? What can destroy these advantages? Is there strong brand loyalty? Are there barriers to entry? Is there a risk of obsolescence? How much capital is needed to produce incremental revenue? What is the Return on Invested Capital (ROIC), Gross profit margins, net profit margins? Is the company capable of raising prices higher than inflation year after year without losing sales?* (I’ve included a blog post I wrote on the compounding power of raising prices at the end of this eBook.) Filter 3. Is management competent and honest? Filter 4. Is the price right? When determining the price to pay, I look at Free Cash Flow Yield (FCF) and the B ratio. I’ll also consider the average price my “Masters of the Universe” paid. Filter 5. Disproving my analysis. What can kill this business? Is it easily ‘disrupted’ by technology? Which competitor would you bet on if this company went away? How difficult would it be to re-create this business if you had access to billions of dollars? Is there recession sensitivity? Filter 6. What are the consequences if I’m wrong? Am I vaguely right here, or precisely wrong?
If a company makes it through the filters, I then move to the checklist. My checklist is by no means complete and is subject to change from time to time as new lessons are learned and incorporated. Item 1. Gross Profit Margin. A company with a long term competitive advantage tends to be one with high gross margins. I look for companies that have a gross profit margin greater than 40 percent. Item 2. Net Profit Margin. A company with a healthy net profit margin indicates a competitive advantage. A low net profit margin is usually indicative of a highly competitive business. I look for companies with a net profit margin greater than 10 percent. Item 3. SG&A. I look for companies with Selling, General, and Administrative expenses less than 50 percent of gross profit. The higher the percentage of SG&A to gross profit usually indicates a highly competitive industry. Item 4. Intangible Assets. Assets like intellectual property (IP) trademarks, copyrights, and patents that give a competitive advantage. Item 5. Long Term Debt. Can the company ‘self-finance’ expansions or acquisitions? What is the nature of the long term debt? Did a leveraged buyout create the debt? What is the debt to equity ratio? Item 6. Retained Earnings. Retained earnings grow net worth. What is the rate of growth of retained earnings? Is the company using earnings for dividends or share repurchases? Or retaining for growth? Item 7. Capital Expenditures (CAPEX). What portion of earnings are used for CAPEX? Compare net earnings to CAPEX. Add up the total CAPEX for a five or ten year period and compare it to net earnings over the same period. CAPEX of less than 50% is good, and less than 25% is even better. Item 8. Return on Invested Capital (ROIC). I use the general equation for ROIC: (Net Income – Dividends) / (Long Term Debt + Equity). This metric is often referred to as an indicator of the size and strength of a company’s ‘moat’. I look for companies that generate ROIC of 15 to 25%.