I hear Phil and Danielle Town discussing Ackman's checklist/principles and I wanted to write a little bit about it simply because I think there are a few items I want to add to my own checklist. If you are a value investor like myself, you will benefit from studying Bill Ackman. Guaranteed.
I want to go over his principles, then cover each one in a little more detail, so we can dig into why these should be on your checklist and why they should be added to the Buffet/Munger/Pabrai Law's that I've been studying. If you're reading this you want to invest more intelligently, and Bill is a smart dude.
Here are his 8 principles:
1. The business has to be simple and predictable.
2. Have a dominant market position.
3. Limited exposure to extrinsic risk that we can’t control.
4. Free Cash Flow generative.
5. Large Barriers to entry.
6. Good governance.
7. High Return on Capital.
8. A strong balance sheet that does not require outside capital.
Simple And Predictable
This is a great start. If you open your news app or are a dinosaur who still reads actual newspapers, you'll see full sections on tech. That's great and all, and I love tech, but tech companies are not always simple and predictable. You want to try to avoid the flavor of the month most of the time and look at companies that aren't particularly exciting.
Everyone loves Amazon, Google, Facebook, etc., and they are priced accordingly. You can argue over whether or not these businesses are simple, as for some people they might sit comfortably in the centre of their circle of competence, and for others on the edge. If you had to compare a business that sells homes, for instance, you can't tell me that would be less simple than a business like Google. And you can still get 100 bagger's from the most boring businesses out there, you just have to do the work to find them and hold them for a few decades.
Next is predictable. This is huge. If you find a business that has one great year of 100% income growth, that's great, but can you project that income growth out for the next 5-10 years? I would say no. Perhaps, it can reduce to 15% over that 5-10 year period and you would still be very happy, but if you don't think that's easily predictable, it's a pass.
A lot of people get into the stock market because they think it's an easy way to make a lot of money. It isn't for most people because they buy businesses they do not understand and do not understand the underlying economics of the business. They also don't take price into account. If you want to make money, you need to buy an asset for less than it's worth. If you can't predict what a company will be worth a few years down the road (obviously this will be a rough estimation, but as Charlie says "I'd rather be roughly right, than precisely wrong"), you have no business buying it.
Have a dominant market position.
Another point that I think removes high-flying tech companies from the radar. Again, if you think you have insights into a specific industry and can predict that a specific company with a short history will be dominant, then perhaps you can execute. But for most people, finding a company that is currently dominating and will dominate into the future is your best bet.
Just look at Ackman's portfolio today, you got a home renovation type store; a hotel franchise; a bunch of fast-food spots; a taco producer; a pizza joint; and whatever Howard Hughes and Agilent are. The point is that many of these simple businesses are dominant in their industry and you've probably heard of all of them and use them on a regular basis.
Try and find these types of businesses. If they have a dominant market position, you will be able to sleep better at night with your investments. Simple financial metrics such as margins, ROIC, ROE, are great technical tools to use in conjunction with your fundamental analysis of a company to deduce if a company has a dominant position in its industry.
Limited exposure to extrinsic risk that we can’t control.
This will test your knowledge of what you know about a company. If something comes up in the future that could threaten the outlook of your company, you should have a very good idea of what that could be, and the probability of it happening. You should be able to have more knowledge on the downside of your companies than short sellers of that stock.
If you can understand the downside of your company, usually through inversion, you will be able to analyze the probabilities of such an event happening. If you deem these events as very low probabilities, then you're good to go. If you can find companies that are in industries that aren't highly regulated, and won't be for the foreseeable future, that great. If you own something in a highly regulated industry, then research the industry regulations of the countries they're operating in to get a better idea of what you might be dealing with.
So if you're lazy, buy pizza joints, if you like difficult-to-understand companies, prepare to do your homework!
Free Cash Flow generative
If companies generate free cash flow, it means there's money left after they re-invest in themselves. If companies are doing so well that they are rich in free cash flow, it means they don't have to spend as much as their competitors to take or maintain market share. If their market share can't be touched, that means they have a wide moat. You want these businesses in your portfolio.
This is exactly what all the greats were/are after and it's why you will constantly hear Buffet touting Free cash flow. Free cash is very much similar to Buffet's Owner Earnings metrics (Operating earnings - deferred taxes - maintenance CAPEX). Look for companies that are increasing free cash flow.
Large Barriers to entry
I like Phil Town's moat breakdowns: toll bridge moat, brand moat, secret moat, low-cost operator moat, and switching moats (network moat is a spinoff of switching moats). If you can understand these different types of moats, and which moat your company has, then you will have a very good understanding of how easy or difficult it is for competitors to enter the market and try and take market share.
The goal is to find really good businesses, which have one or more of these moats making competition less of an issue. It's hard to do this because if a company is doing well, there will be eyes on it, trying to understand why and how to enter that industry to get a piece of those tasty profits. If you can find a business that cannot be competed with viably, you'll be a happy camper if you hold onto that company long-term.
If you want some technical metrics for the moat, I like Phil Town's: which is a 10% or greater increase in revenues, income, EPS, free cash flow, and operating income, preferably over a 5-10 year sample size.
Good governance
Look for great management. What have they done in the past? What successes or failures have they accomplished in their current or former company? Try and dig up some dirt on them on social media, the news, books. Li Lu had a great example when he was analyzing Timberland, where he essentially went and spent time around the family that owned the business to get to know them better. I'm not sure I'm ready for that level of analysis, but if I had the time and money to do something along these lines, it would be an interesting experience.
This might be one of the hardest areas. Even if you meet someone, read about them, or talk to acquaintencanes, it's hard to know how they would act in situations where their integrity is called into question. So I think things like having a squeaky clean record all around, and seeing how they talk about their company is important.
I think finding good management that have equity in the company is also a huge tell. If someone has no skin in the game of a company, they will be more likely to use the company as their personal bank account rather than act in the interest of shareholders. I think we all just have to use our best judgement to the best of our abilities in this area. I don't know if you can ever have 100% conviction that managements won't do things in their own best interest, but if you can reduce the likelihood to as close to 0% a possible, you'd be off to a great start.
High Return on Capital
This has already been discussed above in terms of some forms of technical analysis on the financial statements. You will want to look at the ROE and ROIC of the companies you are looking in. If you can see a constant level >10% ROIC, you know that this business is able to successfully invest in it's operations and give good returns.
Higher numbers are great. 15-20% is excellent. Companies that are way over this, are usually one offs. If a company has a a 5 year history of ROIC at -4%, 8%, 2%, -10%, 89%, you will generally want to stay away as clearly there is some things going on. Again, if you understand the company really well, and maybe it's moving towards a different type of business model, and you can see this new model being a game changer, then maybe you can invest. But for the most part, if you see these types of numbers you should stay away.
The gist of looking at returns is you can see the health of a company. It allows you to see that the company isn't having to spend more money to stave off competition. If the company is beginning to improve you will even see returns increase, which is awesome!
A strong balance sheet that does not require outside capital
You will always want a strong balance sheet for your holdings. I think about this often. I have two holdings: SRG and BHC which have less than stellar balance sheets. If you were to just look at these companies quickly, you'd lose interest very fast if you wanted strong balance sheets. But I was able to see hidden assets the market was discounting that clearly destorts the valuations of these companies, which is why I'm an investor.
If you look at the rest of my portfolio, all companies have pretty pristine balance sheets with debt that is very manageable or non-existent. The reason for the strong balance sheet is downside protection. You don't want your businesses to default on their loans, because that means you have a high likelihood of you investment turning to garbage. So having low to no debt is a simple defense against this.
As for outside capital, you want to be able to have your company grow without a constant influx of capital to keep the business afloat. A perfect example of this is Berkhire Hathaway's textile segment. Buffett pumped millions of dollars into the company just to keep it afloat in the presence declining business economics. He realized that it unfortunately would be fruitless to keep putting money into something that wasn't spitting enough out to make the investment worthwhile. So he cut it and moved on.
You should be looking for companies which do not require capital to run day-to-day operations. There are numerous zombie corporations where they aren't earning enough to cover their interest expenses. This means they will need to look for outside capital to fund these expenses. You do not want to get involved with these types of companies. Companies that can function properly and have a great deal of cash to grow are the pinnacle of success. Companies like Alibaba fit this bill to a T. They have billions in cash on their balance sheet, which can be deployed for new seed businesses, growth opportunities or acquisitions, without haveing to seek outside capital.
For me, the points on having dominant market position and limited exposure to outside risk are two areas I'm trying to improve on. The rest of these points, I feel are already well embedded into my investing framework. Being an investor in China forces me to look at the regulatory risk that some of my holdings (BABA and QFIN) face. If I don't study these with some detail and regularly keep up with what's happening, I won't feel as comfortable having a significant portion of my portfolio in these holdings. I'm always looking for reasons my initial thesis has holes in it, or if something is happening that could derail my hypothesis.
I find the more and more I learn, the more afraid I get. But I think this is part of learning. As Munger says, if he finds something that can destroy one his long-held beliefs he's ecstatic that a wrong is now righted! This a mental model I look forward to reaping rewards from in the future!