- Is this a good business? What are the key success factors to superior performance in this industry? (Value Added Research “VAR”)
- Define the market opportunity. How do competitive products address this opportunity?
- What are the barriers to entry (“moats”)? (VAR!)
- What is the relative power of: (VAR)
- Who controls industry pricing? Does the company/sector have any pricing power?
- How (and how much) can a good company differentiate itself from a bad one in this industry?
- Do you understand this business? Test yourself and describe it to a ten year old. DO THIS!
Business Model (VAR)
- What is the selling model: razor/blades? services? one-off contracts?
- What are the economics of the base business unit? How does it stack up against competitors?
- Why is the company good (or bad) at what they do? Can they sustain it?
- Is this company growing by acquisition? How sustainable is that?
- Be able to easily describe the entire sales process – from order to fulfillment.
- What is their background, and what do their former colleagues, investors, classmates, say about them? Have they been successful in the past? (Very important)
- How are they compensated? Are their interests aligned with shareholders?
- Have they been good at allocating capital?
- Are they buying or selling stock? How much as a percentage of their holdings, and why?
Company/Cultural Issues (VAR)
- Is this a great company? Is it built to last? What could change this assessment?
- Can you imagine holding stock in this company for twenty years?
- If you had access to unlimited capital, how would you feel about your chances of successfully competing against this company?
- Compare to a weak competitor in the same industry. What is the difference and why?
Financial Measures First Step: Check against all the accounting shenanigans in Howard Schilit’s book (Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition)
- What is the company’s capital structure, and how does it compare to its peers?
- What are the trends in inventory turns, days payable/receivable, and working capital?
- What are its coverage ratios on interest payments?
- What are the company’s capital requirements and cash flow characteristics?
- How is the company choosing to invest its capital? CapEx? Buybacks? Acquisitions?
- Does the company need to access the capital markets? How soon/often?
- Regarding the company’s sales model, how visible are earnings quarter-to-quarter, and year-to-year?
- Is this a fixed or variable cost business? How much cost leverage?
- Do earnings grow as a function of unit sales growth, price increases, or margin improvement? How sustainable is this growth?
- Looking forward, what is the company’s valuation in terms of:
- Market Value/Earnings
- Enterprise Value/EBITDA
- Free Cash Flow Yield (After-Tax Free Cash Flow/Market Value)
- Market Value/Sales
- What is the company’s growth rates in terms of earnings, EBITDA, and FCF?
- What are consensus earnings estimates, versus your own expectations?
- What are the key leverage points in our own and the street’s earnings models? What has to go right, and where is the most chance for surprise?
- Are their accounting policies conservative and in line with their peers?
- What are the big unknowns? How much can the company control/influence these risks?
- What could cause this investment to be a total disaster? How bad could it be?
Other (Timeline/timing issues) DO A TIMELINE!
- What are the catalysts (triggers) for the company’s proper valuation to be realized?
- What good news, and what bad news, will affect the company in the coming year?
- Who owns the stock? Momentum funds? Big mutuals? Hedge funds?
- How difficult is it to build a significant position (float, volume)?
- Draw a time line of expected events and dates. What might go wrong and when?
Investment Framework: Short Questions
1. Is this a bad business?
- Who has the power – customers, suppliers, competitors?
- What are the barriers to entry?
- What kind of reinvestment of capital is needed to grow?
- How is the business changing?
- What is the historic and current rate of success in this business?
- What are the major risks to the business plan?
2. What is the major misperception?
- Why does it exist?
- Who is responsible for it?
- What stakes do the various parties have in keeping the stock price high?
- How popular is the industry? rising tides lift all boats – for awhile.
3. Assess management
- Industry reputation?
- Past history of success or failure.
- Straightforward or cunning?
- Check out insider ownership and selling.
- EBIT/EV as a percentage.
- (EBITDA-CAPEX)/EV as a percentage.
- Growth of inventories to cost of goods sold – are inventories rising faster?
- Growth of AR to sales and AP to sales.
- Any accounting changes – smaller reserve for bad debt, revenue recognition, etc.
- Cash flow/Int. expense.
- Review Howard Schilit’s red flags
5. Sentiment: Are more people bullish or bearish on the stock?
- Do full media search for articles. Make list of analyst recommendations.
- Short Interest? SIR (remember, the stock that is already short is potential buying power) Be careful if there is universal bearishness.
- What is the expected trigger on the misperception? Do a time line.
- Who owns the stock – long term or short term, momentum investors?
- Has the souffle already risen once?
- Can the rising stock price be self-fulfilling for awhile (financing opportunities, etc)?
- Where does the company stand in terms of the fantasy, transition, reality paradigm?
7. Add when the story starts to unfold — regardless of stock price.
- Watch for earnings warnings, excuses, etc. Where there’s smock, there is often fire.
- Is the company or wall street analyst group in denial of the problem?
- Watch the ratios, insider selling etc.
- Even if the stock down significantly from its high, if answering all these questions convinces you that it is still a short, do not cover and consider adding. See below
- Does waiting for the new financials feel like waiting for Christmas? IF “YES” —–> ADD.