Some quarters ago, I wrote about the sensibility of employing checklists in investing. Since then, I have been thinking about how to screen investment candidates in in the initial stages so as to effectively narrow the universe according to my requirements. There is always a compromise in using this approach: investments that have a higher probability of failure will be filtered out, but at the risk of missing enormous opportunities that don’t make it through the screens. What I arrived at was a short list of characteristics I would require in any long-term investment: M.C.A.R.V.
- Capital Allocation
- Reinvestment Runway
Let us briefly walk through each requirement.
- Moats: These are characteristics that allow a business to enjoy above average profits over a long time period despite the constant efforts of competition. Without moats, we would have little confidence that a company’s current earnings power will have longevity.
- Capital Allocation: This is the act of deploying and reinvesting cash resources to grow the value of a corporation. For a public company, there are only five basic levers in the toolbox: investment in organic growth, acquisitions, debt reduction, issuing dividends, and share buybacks. It is uncommon to find management teams who have a long and successful track record of intelligently allocating capital.
- Reinvestment Runway: If a company has moats and an intelligent capital allocator aboard, that isn’t sufficient. The company needs a runway of opportunities to redeploy earnings, and at a high enough rate of return, to grow its cash flow generation. Without this ingredient, it will be difficult for a self-sufficient business to provide adequate growth over the long run.
- Valuation: Price is an all-critical input for any investment. Now that we have identified a strong business (moats), run by managers who are likely to re-invest earnings intelligently (capital allocation), and with ample opportunity to re-invest said earnings, we must decide on a price at or under which the idea will provide a compelling return. As value investors, we aim to underpay in order to create a form of downside protection, while simultaneously setting up a situation that has favorable odds of success.
My conviction is that an investor increases the chance of winning (in the long-term) and reduces the likelihood of permanent loss if the above list can be satisfied. In other words, if one can quickly identify the above attributes in a stock idea, the chances are good that a high-quality investment has been landed upon. Because the first three requirements are qualitative, it would be next to impossible to mechanically screen through a large population and capture the best opportunities.
Think of any investment blow up you’ve had over the years; did any of them contain all four of the attributes named above?
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