Introduction

Describe how the business operates, in your own words.

Do we want to spend a lot of time learning about this business?
Explain what the business does to a fifth grader. How does the business

make money?
What are the three or four most important factors for the business and for

our investment thesis?

Invert, always invert. How do you kill this company?

Its three years from now and were selling our position at a loss. Write a
brief story describing why/how the investment lost money. What errors
might we have made from a behavioral perspective? What might we have
misinterpreted from the business perspective?
Did we misjudge the
potential for structural change within the industry?
What about
competition? New entrants? Was this a melting ice cube? Did we misjudge
the speed of change? Why?

The story can also include cognitive errors made in selling the position too
early or too late, or failing to re-evaluate it because it was going up. What
was the opportunity cost?

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Risks & Opportunities

What are the key risks the business faces?

In bad times, cyclical companies with heavy debt loads may face
insurmountable problems. A company should own twice as much as it owes.

Avoid overly leveraged companies.

Analysts are overly focused on short-term earnings gains than future longterm success. Missing earnings is not fatal, and tends to create opportunity
for the value buyer; if the trend continues, however, the shares will likely

continue to fall.
If a company has excessive pension liabilities or there exists a contentious
labor environment, it may be best to put these companies on the no-thankyou list. If a company is facing strong competition from a more efficient

competitor with lower costs, it is best to move on to the next candidate.

Steer clear of financial reports that seem overly complicated. Approach
your list of investment candidates with a healthy dose of skepticism.

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Stamping Out Irrationality

How have we done recently? Are we suffering from an inability towards
inaction? Or are we pressing to find the next winner to make up for past
mistakes?

How did we source this idea? Has the source impacted our confidence in the
thesis? Would we buy this company if this was not owned by anyone we
admired? Why havent we previously invested in this company? Are we

anchored to a specific price?

Do we have a variant view? Can we articulate the short thesis? What is the
risk-reward and the probability of each? How does our assessment differ
from consensus opinion? Do we understand why the stock is undervalued?
Is there a catalyst for this to change?

Can we hold this investment forever? What is our expected holding period
for this stock? Does changing the holding period affect our comfort in
establishing a position? How? If the stock market stopped quoting prices for

10 years, would we still want to hold the position?

Under what circumstances would we sell this position before the projected
holding period is over? Under what circumstances would we hold this
position longer than the projected holding period? Name some scenarios in
which we would increase our position? Decrease the position?

How is this position going to lose money? What is the likelihood of

permanent capital loss? Under what conditions would a permanent loss of

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capital occur? Have we seriously considered the scenarios in which this

company could die?
Do we have the risk appetite to see this stock cut in half? Do our clients?

Are we willing to put a significant amount of capital in this business? If no,

why?
Are demographics a headwind or a tailwind?
What factors will drive the success of this investment?
How do they impact the upside and downside potential in the stock?
Does the overall portfolio need more exposure to this part of the economy?

Does the business fall within our circle of competence?

What framework have we used to categorize the opportunity?

Be careful to estimate upside and downside potential on historical data as a

starting point, but on the downside be especially conservative in expecting
outcomes that are worse than have previously been recorded.

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Assessing Advantages
To keep the analysis manageable, move one step at a time. Begin with one force
potential entrants and barriers to entry not five. If there are barriers, then it is
difficult for new firms to enter the market or for existing companies to expand. No
other feature has as much influence on a companys success as where it stands in
regard to these barriers. Start simply and add complexity later. Whenever things
become confusing, step back and simplify again. Clarity is essential for strategic
analysis.
It is essential to determine whether a company benefits from a competitive
advantage and to identify the sources of that advantage. There are three basic
steps to doing such an assessment:
Identify the competitive landscape in which the firm operates.
What markets is it really in?
Who are the competitors in each one?

Test for the existence of competitive advantages in each market.

Do incumbent firms maintain stable market shares?
Are they exceptionally profitable over a substantial period?

Identify the nature of any competitive advantage that may exist.

Do the incumbents have proprietary technologies or captive customers?
Are there economies of scale from which they benefit?

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The first and most important step is to develop an industry map that shows the
structure of competition in the relevant markets. There are two telltale signs of
the existence of competitive advantages:
Stability of market share among firms. The key indicator of this is the
history of the dominant firm in the segment. If the leading firm has maintained
its position over a period of many years, that fact strongly suggests the
existence of competitive advantage. The history of entry and exit in a market

segment provides another clue.

Profitability of firms within the segment. After-tax returns on invested
capital averaging more than 15-25% (i.e. 23-38% pre-tax) over a decade or
more are clear evidence of the presence of competitive advantages. Identifying
historical profitability for particular markets often requires extrapolation. The

best way is to look at the reported profits of pure play companies.

The third step is to identify the source of these advantages. Do the firms
in this industry benefit from proprietary technologies or other cost
advantages? Do they have captive customers thanks to habit formation,
switching costs or search costs? Are there significant economies of scale in
operations, combined with at least some degree of customer captivity? Or, do

the incumbent firms profit from government intervention such as licenses,

subsidies, regulations or some other dispensation?

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Barriers to Entry
Strategic analysis should begin with two key questions: In the market in which
the firm currently competes or plans to enter, do any competitive advantages
exist? And if they do, what kind of advantages are they? The analysis is made
easier because there are only three kinds of genuine competitive advantage
demand, supply and economies of scale and two straightforward tests to
confirm their existence market-share stability and high return on capital.
Supply Advantages: One way a market incumbent obtains a competitive
advantage is by having a lower cost structure that cannot be duplicated by
potential rivals. Sometimes lower costs stem from privileged access to crucial
inputs. Access to low-cost inputs is only a source of competitive advantage when

the market is local, either geographically or in product space. Otherwise, it is not

much help as a barrier to entry. More frequently, cost advantages are due to
superior, proprietary technology that is protected by patents or by experience or
some combination of both. Process patents may be equally powerful. But patents
expire.
Demand Advantages: For an incumbent to enjoy competitive advantages on the
demand side of the market, it must have access to customers that rivals cannot
match. Branding by itself is not sufficient to establish this superior access.
Competitive demand advantages require that customers be captive in some
degree to incumbent firms. There are only a limited number of reasons why
customers become captive. Taken together, habits, switching costs and search
costs create competitive advantages on the demand side that are more common
and generally more robust than advantages stemming from the supply side or
cost side.
Habit: Habit leads to customer captivity when frequent purchases of the
same brand establish an allegiance that is as difficult to understand as it is
to undermine. Habit succeeds in holding customers captive when purchases
are frequent and virtually automatic. Habit is usually local in the sense that

it relates to a single product, not to a companys portfolio of products.

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Switching Costs: Customers are captive to their current providers when it

takes substantial time, money and effort to replace one supplier with a new
one. When the applications involved are critical to the companys operations
few want to abandon a functioning system. These costs are reinforced by
network effects. Standardized products are one antidote to high switching
costs.

Search Costs: Customers are also tied to their existing suppliers when it is
costly to locate an acceptable replacement. High search costs are an issue
when products or services are complicated, customized and crucial. All

these details foster an aversion to change. The more specialized and

customized the product or service, the higher the search cost for a
replacement.
Economies of Scale: The truly durable competitive advantages arise from the
intersection of supply and demand advantages, from the linkages of economies of
scale with customer captivity. The competitive advantages of economies of scale
depend not on the absolute size of the dominant firm but on the size difference
between it and its rivals, that is, on market share. If average costs per unit
decline as a firm produces more, then smaller competitors will not be able to
match the costs of the large firm even though they have equal access to
technology and resources so long as they cannot reach the same scale of
operation. The larger firm can be highly profitable at a price level that leaves its
smaller competitors losing money. The cost structure that underlies these

economies of scale usually combines a significant level of fixed cost and a

constant level of incremental variable costs. As the scale of the enterprise grows,
the fixed cost is spread over more units, the variable cost per unit stays the same
and the average cost per unit declines.
Measured by potency and durability, production advantages are the
weakest barrier to entry; economies of scale, when combined with some
customer captivity, are the strongest. The economic forces behind all three

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primary sources of competitive advantage are most likely to be present in

markets that are local either geographically or in product space.
Most companies that manage to grow and still achieve a high level of profitability
do it on of three ways. They replicate their local advantage in multiple markets.
They continue to focus within their product space as that space itself becomes
larger. Or, they gradually expand their activities outward from the edges of their
dominant market positions. By definition, in any market in which companies
enjoy a competitive advantage, there will be a short list of legitimate competitors.

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Five Forces
The essence of strategy formulation is coping with competition. The state of
competition in an industry depends on five basic forces, which are diagrammed
below. The collective strength of these forces determines the ultimate profit
potential of an industry.

Good analysis looks rigorously at the structural underpinnings of profitability.

Distinguish temporary or cyclical changes from structural changes. A good
guideline for the appropriate time horizon is the full business cycle for the
particular industry. It is average profitability over this period, not profitability in
any particular year, which should be the focus of analysis.
The point of industry analysis is not to declare the industry attractive or
unattractive but to understand the underpinnings of competition and the root
causes of profitability. As much as possible, analysts should look at industry
structure quantitatively, rather than be satisfied with lists of qualitative factors.
Many elements of the five forces can be quantified: the percentage of the buyers
total cost accounted for by the industrys product (to understand buyer price
sensitivity); the percentage of industry sales required to fill a plant or operate a
logistical network of efficient scale (to help assess barriers to entry); the buyers
switching cost (determining the inducement an entrant or rival must offer
customers).
The strength of the forces affects prices, costs, and the investment required to
compete; thus the forces are directly tied to the income statements and balance
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sheets of participants. Industry structure defines the gap between revenues and
costs. Intense rivalry drives down prices or elevates the costs of marketing, R&D,
or customer service, reducing margins. How much? Strong supplies drive up
input costs. How much? Buyer power lowers prices or elevates the costs of
meeting buyers demands, such as the requirement to hold more inventory or
provide financing. How much? Low barriers to entry or close substitutes limit the
level of sustainable prices. How much? It is these economic relationships that
sharpen the understanding of competition.
Finally, good industry analysis does not just list pluses and minuses but sees an
industry in overall, systemic terms. Which forces are underpinning (or
constraining) todays profitability? How might shifts in one competitive force
trigger reactions in others? Answering such questions is often the source of true
strategic insights.

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Economic Evaluation
Is it a good business?
How do they make money?
What segments does it operate in?
What are the fundamentals of each?
What are the operating metrics of the business that we need to monitor?
Have we diagramed the companys value chain and competitive landscape?

How does the company compare financially with other companies in the
same business?
Does it earn the same returns on capital?
Does it have more or less debt than its peers?
How does the marketplace value the company?

To what degree is the business cyclical, countercyclical, or recessionresistant?

How much confidence do we have in forecasting ten years of owner

earnings?

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Income Statement Analysis

Determine where the revenues are coming from.
Does the business
generate revenues that are recurring or from one-off transactions? Are the
revenues and cash flows sustainable or under/overstated due to boom/bust
conditions? A well-performing division may be masking problems in the core

business or conversely, a poorly performing division may hide overall

strength.
What is the outlook for pricing? How does inflation affect the business? A
company with a product that is in demand can easily raise prices to

generate more profit.

What is the outlook for units? Can the company sell more? The simplest
way to raise the bottom line is to sell more! What is the outlook for the
gross profit margin? Can the company increase profits on existing sales?
Rising expenses as a percentage of sales may indicate that rising costs that

cannot be passed on to the customer are squeezing long-term profit

potential. Gross margins should be fairly stable the steadier the gross
profit margin, the better. What is the outlook for SG&A? Can the company
control costs? Every dollar saved flows to the bottom line and helps restore
profitability.
Can the company be as profitable as it used to be, or at least as profitable
as competitors? What are its competitors doing differently?

Does the company have one-time expenses that will not be paid in the
future? Does the company have unprofitable operations they can shed? If

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these divisions can be sold/closed, earnings will rise as the losses are
eliminated.

What is the return on invested capital for the business? A company with a high
Return on Capital has a greater chance of financing growth with self-generated
cash. Be mindful of the trends. At a minimum, look for stability.

How does working capital impact the cash flows of the business? Does the
business have high or low capital-expenditure requirements? Are there

temporary tail/headwinds enhancing cash flow?

Consider the net profit margin earnings divided by total revenue. If a company
can grow margins over time, every dollar of goods sold has a leveraged impact. A
falling margin may indicate bloated overhead and careless management, or
cutthroat competition.
To what degree does operating leverage impact the earnings of the business? If
the company does raise sales, how much falls to the bottom line? Often, the
cost of gaining market share can actually cause margins to fall or reduce

profits.

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Balance Sheet Analysis

Does the balance sheet match up with the income statement over time? Are the
accounting standards that management uses conservative or liberal? Does the
accounting reflect reality? If there are questions, complete the Financial

Shenanigans checklist.
Does the company employ leverage on the balance sheet? Is the businesss
balance sheet strong or weak? Is debt proportional to operating income?

Does the company have a manageable amount of leverage? Is the debt to total
capital ratio less than 0.5x? Is the interest coverage ratio more than 2x?

When is the earliest maturity for the companys debt? When is the latest? How
are the maturities spread out? Are they bunched together or far apart?

Does the company depend on access to the capital markets to stay alive? If this is
a financial company, then we must really trust their risk management. How long
can the company withstand a closure of the capital markets? Does the company

have any restrictive covenants that could put the company into bankruptcy?

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Growth Potential
Has historical growth been profitable and will it continue? What are the future
growth prospects for the business? What will it look like in 5 years? What will it

look like in 10-20 years?

What is the management teams motivation to grow the business? Is the
management team growing the business too quickly or at a steady pace? How
much can the company grow over the next five years? How does management

intend to achieve that growth? Growing revenues is not enough if those sales
arent generating profits.
Does the business grow through mergers and acquisitions, or does it grow
organically? How does management make M&A decisions? Have past acquisitions

been successful?
Does the business have an easy additional vertical or horizontal market using
existing assets? In what foreign markets does the business operate, and what are
the risks of operating in these countries?

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Evaluating Management
Does the business have trustworthy management? What is managements track
record? Does management have integrity? Are they Outsiders and do they
possess the following traits?

The complete lack of an ego.

Highly capable and energetic individuals.
A singular focus on core truths they believe in.
Deeply in love with their company and shareholders.

What are the companys core principles and how are they communicated? Is the
business managed in a centralized or decentralized way? Does management value
its employees? Does the management team know how to hire well? Where are top
executives coming from? Internal promotions or competition? If the latter, which
ones? Do we have access to employees? Competitors? Who can we speak with to

get a better sense for what its like to work here?

What type of manager is leading the company? Is he a lion or a hyena? How did
he rise to lead the business? Has management been tested by a rough business
cycle? Is the CEO self-promoting? Does the CEO love the money or the business?
Does the CEO manage the business to benefit all stakeholders? How would you

evaluate this business if you were to become its CEO? Can you identify a moment
of integrity for the manager?
Are managers clear and consistent in their communications and actions with
stakeholders? Does management communicate consistent goals over time? How

do these goals compare with peers? How have they changed? Do they make
sense? Does management issue guidance? If so, do they under-promise and overdeliver? Or, sadly, vice-versa? Is the company comfortable with Wall Street
estimates? What does the company expect its competitors to do? Does
management think independently and remain unswayed by what others in their
industry are doing?
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Are the CEO and CFO disciplined in capital allocation decisions? Do they buy
back stock opportunistically? Are there distributions of earnings? If they retain
earnings, how is their record of capital allocation? Does management plan to buy
back stock and is it actually buying in shares after the announcement? What will
the company do with excess cash generated by the business? Does it plan to
increase dividends? Invest in new stores or factories? Acquire companies or buy
back stock? The proper use of excess cash flow can add substantially to

corporate earnings and increase profits years ahead. Does the management team
focus on cutting unnecessary costs?

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Ownership & Incentives

Have the managers been buying or selling the stock? Do they have skin in the
game? Does managements share of the company represent a significant
investment of net worth? How did they acquire their holdings? What is their
ownership relative to their cash compensation? What are insiders doing? Look for
patterns.

If management owns about 10% to 30%, thats great.

If management owns greater than 30%, still good but might think company
is private.

How is management compensated? How does management evaluate itself? How

difficult are their performance hurdles to meet? Do they use long-term metrics?
Do they use the right metrics? Look at compensation per dollar of sales, profit and

employee. How do they stack up relative to peers?

What qualifies a director to serve on the board? What abilities does a director
bring to the committees they serve? How were they recruited? Do they have a
relationship with the company? What percentage of their income do board fees

represent for each director? How does this compare to their stock ownership?
What are the effects on the business of bringing in outside management? Are
there activists with significant positions? What is their agenda and is it a positive
or negative for the company? Have we talked to them? What is the likelihood
they are successful? What if they are not? What are the other significant active

fund owners of the company, and how long have they owned the company? Have
we talked to them?

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Valuation
Many investors insist on affixing exact values to their investments, seeking precision in
an imprecise world, but business value cannot be precisely determined. Reported book
value, earnings and cash flow are only the best guesses of accountants who follow a set
of standards and designed more to achieve conformity than to reflect economic value.
Business value is imprecisely knowable and changes over time, with macroeconomic,
microeconomic, and market-related factors. Any attempt to value business with precision
will yield values that are precisely inaccurate. Markets exist because of differences of
opinion among investors. To be a value investor, we must buy at a discount from
underlying value.
Analyzing each potential opportunity therefore begins with an
assessment of business value. Investors should use several methods to value a single
business in order to obtain a range of values.

Net present value (NPV) is the discounted value of all future cash flows that a
business is expected to generate. A frequently used, but flawed, shortcut of
valuing a going concern is private market value.
Private market value is based on the valuation multiples that sophisticated,
prudent business people have recently paid to purchase similar businesses.
Investors must ignore private market values based upon inflated securities prices.
Liquidation value is the expected proceeds if a company were to be dismantled
and the assets sold off. Breakup value, a variant of liquidation analysis, considers
each of the components of a business at its highest valuation.
Stock market value is an estimate of the price at which a company or its
subsidiaries considered separately, would trade in the stock market. This is only
useful as a yardstick of value.

NPV would be most applicable in valuing a high-return business with stable cash flows
such as a consumer products company; its liquidation value would be far too low. When
future cash flows are reasonably predicted and an appropriate discount rate can be
chose, NPV analysis is one of the most accurate and precise methods of valuation. There
is no single discount rate for a set of cash flows and no precise way to choose one. The
appropriate discount rate depends on an investors risk profile, the perceived risk of the
investment under consideration and on the returns available from alternative
investments.
It is essential that investors choose discount rates as conservatively as they forecast
future cash flows. At times when interest rates are unusually low, investors are likely to
find very high multiples being applied to share prices. Investors who pay these high
multiples are dependent on interest rates remaining low. When interest rates are
unusually low, investors should be particularly reluctant to commit capital to long-term
holdings unless outstanding opportunities become available.

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Liquidation analysis is probably the most appropriate method for valuing an unprofitable
business whose stock trades well below book value. The liquidation value of a business is
a conservative assessment of its worth in which only tangible assets are considered.
Some investors calculate net-net working capital as a shortcut - defined as net working
capital minus all long term liabilities.
Earnings per share has historically been the valuation yardstick most commonly used by
investors. But corporate managements are generally aware that many investors focus on
reported earnings and a number of them massage reported earnings to create a
consistent upward trend. Analysis of reported earnings can mislead investors as to the
real profitability of the business. It is important to remember that the numbers are not an
end in themselves. They are a simply a means to understanding what is really happening
at the company. Book value is the historical accounting of a shareholders equity, the
residual after liabilities are subtracted from assets. What something cost in the past is
not necessarily a good measure of its value today. For every business that cannot be
valued, there are many others that can. Investors who confine themselves to what they
know have a considerable advantage over everyone else.

A good investment needs two facets to be in place. First and foremost, we require
downside protection through a Margin of Safety. However, a Margin of Safety
alone is not enough. Core positions should have an upside earnings engine in the
form of a wide moat in addition to downside protection.
Does the price make sense?
Whats our best estimate of the downside?
What would the company be worth if it were sold?
Is the business growing? If so, then maybe pay up to 20x reasonable cash
flows.
How profitable is the growth? How consistent is the growth? Whats driving
the growth?
If the business isnt growing, then it should be worth about 8x to 10x

reasonable cash flows.

Consider where we are in the cycle.
How was the backdrop different than today during fair skies or rough waters?
Are there temporary headwinds/tailwinds depressing/enhancing free cash
flow?
Is the revenue/free cash flow sustainable or overstated/understated due to
boom/bust conditions?
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Does the business have a good free cash flow valuation but a low price to sales
ratio?
Is there an easily identifiable improvement to margins that could boost price to

sales?
Are there additional assets that are missing from the free cash flow
calculation?
Does the company require additional capital investment merely to remain
competitive?
If were using EBITDA, did we make sure that the EBITDA - maintenance capex
makes sense?

Does the company own any real estate that is being overlooked by investors?
Is there an identifiable catalyst that will help realize a more reasonable

valuation?

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History Lessons
How has the business evolved over time?
How has the industry evolved? Has the company kept pace with change?
Discuss management changes, acquisitions, spin-offs and other relevant
corporate events.
Has the companys strategy shifted with time? Review previous investors

experiences if relevant.

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Resources & Contacts

SEC Filings
Investor presentations
Annual Reports
Transcripts
Proxies
M&A
13Fs
S1s
Media Sources
Wikipedia
Economist
Google Ninja
Google Trends
Blogs
YouTube
WSJ
Barrons
Fortune
Forbes
Smart Money
Business Week
Financial Times
Local Business Journals
Industry & Trade Journals

Investment Sources
VII
VIC
OWS
SumZero
Wall Street
Morningstar
Bloomberg Industry
S&P Industry Reports
Network
YPO
LinkedIn
BMC Board
CFA Institute
CFA NC Society
External Managers
Macro
IMF
BIS
World Bank
CIA
St Louis Fed

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