A short check list composed by an investment analyst at a fundamentally driven hedge fund

Here's a check list i just found on the internet. It's quite comprehensive and i'd like to borrow the headings and summarise them myself. The  check-list comes from Oliver Mihaljevic.

 A Huge Sustainable Competitive Advantage—A Franchise

In theory, when a business operates profitability it attracts competition. This is in the nature of capitalism. When the competition enters, sales get spread over more shops and so profitability declines. Profitability may also decline because the increased competition has led to increased price competition, among other things. When this occurs, the industry profitability will decline to negative economic profits and then companies will begin shutting down. However, a business with a sustainable competitive advantage or economic moat will allow the business to keep competition away. This may also allow for a franchise type of business (also known as franchise value or economic value).

Within the value investing framework, franchise doesn't mean a shop like Subway, franchise is the name given to a business that can earn above normal profits for extended periods of time (i.e. may not be mean reverting if you believe in that). This can be done by charging a higher price and not losing business to other similar firms (Think Coke.) In my opinion a brand is one of the most powerful competitive advantages a business could have. This is because for one, a strong brand name is extremely hard to replicate. As a side note, i believe a brand is only beneficial for investors if it allows the company to charge a higher price and not lose customers or results in larger sales volumes. On top of this, the brand may not be bought. For example, if it's been internally developed, the brand may not be directly recognised by accountants in the balance sheet. According to Ben Graham in his classic text "The Interpretation of Financial Statements" he says that the value of an intangible may not truly reflect its potential. Rather, he suggests you look at the earnings power of it.

This is what Warren Buffett saw when he started buying large stakes in The Coca Cola Company in the 80s. Everyone was looking at the same financial statements but Warren saw that the company had a brand name that was worth billions, potentially trillions which wasn't directly nor fully reflected in the statements. The opposite of a franchise is a commodity type business (think Airlines). These businesses  are characterised by excessive competition and no price coercion what so ever. Typically, you want to stay away from these businesses without economic moats (if you want to understand economic moats to a much greater extent i suggest you read Pat Dorsey's - The Little Book That Builds Wealth.)

 A Growing Stream of Free Cash

Free cash flows are the flows that will eventually end up to owners of the business. In recent times, the DCFF/E model(s) has become popular because earnings are subject to management discretion. For example, a company can directly reduce expenses through changing the useful life of a depreciable asset such as PPE (by increasing the useful life from say 5 years to 10 years will reduce the depreciation expense.) As the value of the business is simply the amount of cash one can get out of it, growing free cash flows are ideal (not going into too much detail here).

Simple, Understandable

I like businesses which are simple. Like Warren, i too, can't understand complicated businesses. A simple business is much easier to understand allowing you to also obtain a stronger grip on its future prospects. Peter Lynch once said that he liked simple businesses that any idiot could run, because someday one will.


Stable—The Basic Business Changes Little Over Time/ predictable earnings

A stable business such as Coca Cola means that earnings are more easily predicted. A business which is susceptible to constant change isn't ideal because it means earnings are much harder to foresee with a similar degree of certainty.

Consistent, Repeated Purchases of Product or Service

A wonderful business is one that sells the same product over and over again. Think Wrigley's chewing gum. It is attractive because it allows the business to not need to outlay capital expenditures or research & development and all the rest of it. Essentially, it reduces the expenses of the business.

This is just a short summary of Mr Mihaljevic's more comprehensive list. I elaborated a little more on the first point because i believe it's a very important one which i spend most of my own time on analysing.