Recreating a Billionaire's Stock Buying Checklist

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2:21It's better to be, I'm going to blank on it. It's better to be, help me out here. Approximately right than precisely wrong. Thank you, yeah. It's better to follow that advice than anything else. So yeah, that's my pick. Love this podcast because it crushes your dreams and getting rich quick. They actually got me into reading stats for anything. You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now. All right, folks. Welcome to Investing for Beginners podcast.

3:05Today, Andrew and I are going to talk about a checklist. We're going to talk about Monish Pabrais, maybe not his exact checklist, but a checklist built on the ideas that Monish Pabrai has prepared for us. I read a book that he wrote many years ago called The Dondo Investor. And in that book, he talks a lot about checklists and the importance of checklists. And he kind of gave a framework for checklists. And so I wrote a blog post that Andrew recently updated that was a blistering 5 ,000 words. He has made it more manageable for everyone to read. And we will include that link at the end of the show so you can check it out.

3:45But we thought we would talk through the checklist and we're going to do it a little different. We're going to do it like we are fantasy drafting our football team. So we have, I think, questions. So I want to say 30, 34 questions in that range, 34. Yep. And we're just going to kind of go through this and pick the ones that we like the best. So you don't have to listen to all three and four, but you can read the blog post and check them all out. So with that, Andrew, first serve or first pick is yours. Where would you like to start, sir? This is a lot of pressure because I know just how important that first pick is.

4:21I'm going to hope for my Jonathan Taylor. Here we go. There's different pillars. This one has to do, it's technically under management, but I feel like it encompasses the entirety of everything we're trying to do. So the one I'm picking is what are the future prospects of the business? We have to remember as investors, we are not buying what a business has done up to this point. We are buying what is the business going to do in the next 5, 10, 15, 20 years. And that's really everything kind of boils down into that. The past can be helpful in giving us hints and clues as to what makes a business strong or what's driven its growth and help us pick out businesses that are great versus businesses that are average.

5:13But at the end of the day, that famous quote, you've heard it over and over again. And if you haven't, you should memorize it. past performance does not guarantee future results. So true in the stock market, so true with businesses. So when I'm looking at a business, I want to know what are its future prospects and am I doing as much as I can, as much research, as much intuitive thinking, all of these things to try to really determine that because everything can change so much. You want to make sure that these other items on the checklist are taken care of because it all points to those future prospects.

5:58Great one. Yeah, really good job. Really good job. That was probably your Jonathan Taylor. So it's going to be hard for me to follow up with that. So I will do my best. So this one is, I think the one I'm going to pick next is going to be, which I think is always critically important, irregardless of what company you decide to investigate. And that is how does the company make money? If you don't understand the business and what it is they do, it doesn't matter. You have to understand how the company makes money. And sometimes it's brutally simple. A company like Kroger, they make money from selling groceries.

6:45Duh. sometimes it's not so simple and sometimes you have to think about a little more deeply what exactly it is they're doing uh i know that warren buffett is famous for never investing in tech and that was always kind of his mantra and then he he doubled down on apple and had a huge return uh on that investment and but the thing is he understood the business and he understood what it is that they did, he may not understand the tech. Heck, I don't understand the tech. I don't understand how the iPhone works. It's a fascinating piece of technology, but he does understand customer behavior. And because he understands that, he can understand the business and that allows him to buy a company like an Apple, even though he's been a staunch anti-tech person up to that almost his entire investing career.

7:39So having said that, if you cannot understand what the business does and how it makes money, you have no way of knowing whether the company is doing well or not, really. Yes, you can see what... Oh, earnings are up 13%. Great. Okay. Well, what happens when earnings are down 14 % and it really has nothing to do with the business? It's macroeconomics related or the tide went out and the company just went down with everything else. If you don't understand that, then you'll lose money or vice versa. If you're looking at a company and the stock market does, the tide does go out, but this company is still operating on all cylinders, hitting all their marks, and you don't understand how the business works, you may miss a golden opportunity.

8:29So to me, this is numero uno that you need to understand how a company makes money. And if you don't, then you need to go back and figure it out before you go any further. Yeah, it would be like trying to play a game of football without having any blocking or tackling. You got to, you got to. Yeah, you got to, you got to. All right, I'm going to try to go for, I'm going to reach, I'm going to go for a sleeper in round two. So that'll be a big mistake because it's not going to be as gangbusters as our first two picks were, but I'm going to pick identify the key risks the business faces. This is in the financial pillar of this checklist that we are referencing.

9:08It is very easy and very natural to once you learn how a business makes money, you learn how successful they have been, what's made them successful. It's very easy to start drinking the Kool-Aid. I've done it all the time. We all do it. If you can start at the risk factors, you almost flip the equation. You invert the way you're thinking about the company. And it can actually illuminate a lot of things about the business itself. So for example, if you are like a vendor for Apple, let's continue with the Apple example, a company like Skyworks. Skyworks has Apple as so much of a customer that Apple makes up so much of its business that they have to list that concentration in their annual report.

9:58so if I was new to Skyworks and I'm trying to decide is this something that I want to buy or not which by the way we covered really nicely Tyler Nash did a great episode on this go back in the archives we talked about Skyworks it's a fascinating company but if I wanted to learn everything about the ins and outs of Skyworks and I learned about you know everything that made them unique but I didn't think about the key risks first. I might spend a lot of time that I could have spent on something else that's a better opportunity because I didn't think about key risks. So key risks, it's not something you can perfectly do every time and it's not going to cover everything.

10:45You'll never be able to figure out every single key risk because that's just the way the world works. There are just risks we can't quantify all the time, but it can really help you download a big picture of the business. And hopefully management's being transparent about that. And if they are not, maybe their lawyers are. But that can kind of help you. For me, it helps me visualize where does this company sit in the bigger picture of its industry? Not just its industry, but its value chain. So that That means the customers it has, the vendors it has, the people to the left and to the right and up and down from them can be a great way to kind of understand.

11:26For lack of like a nicer word, like the power dynamics between companies, that stuff does play a role in how companies perform. And looking at key risks can help you put your mind to that kind of stuff. That's a great one. Heads I win, tails I don't lose that much. Right? That whole idea of, yeah, to quote Manish, you know, that's his, that's his, you know, famous phrase. And I guess when I think of risk, I always think of that, like that idea of you're trying to protect the downside and that can be so important. And like Buffett always says, right? Rule number one, don't lose money. Don't forget rule number one, rule number two.

12:10So yeah, I love that. All right. I'm not sure if I can top that, but I'm going to try. This is going to be more of a stretch pick, shall we say? So this is still in the business pillar, but this is one that I think is very important. and it probably gets glossed over a little more than it should, is does the company have a durable competitive advantage? In other words, does it have a moat? So if you tie this in with what's going on with understanding the business, the future growth, and the risk, those are all very, very critical pieces of the pie to figuring out whether this is a good investment or not.

12:53some companies don't have a durable competitive advantage or as Warren Buffett would call a moat, which means that they can't defend themselves against competition. And if you're investing, if you're trying to invest in a company that you hope is going to generate above average returns for a long period of time, it has to have a moat to do that. Because if it doesn't, if it's doing things that are successful and profitable, other people are going to try to figure out how to compete with what you're doing. Either they will try to mimic what you're doing, or somebody will come along with a better, cheaper, faster process and will disrupt what that company is doing.

13:33And so the stronger the moat is, the better the company is. And you think about a company like a Visa or a MasterCard, they have some of the arguably largest moats in the world. And it's evident by the fact that there's been people coming at them for the last 20 some years and haven't been successful so far and hopefully won't be as an investor in both companies. Hopefully they won't be for a very long time. But that's what makes those businesses so awesome. That's what makes a company like Costco so awesome is they have this amazing moat around them. And yes, the stock price is air quote, super expensive.

14:13But in part, that's because people recognize that this is a really durable, competitive advantaged company and the different layers that they have give them a strength of business. And that's why we as shoppers go there. Andrew and I have waxed poetically about Costco many times and the benefits beyond just the hot dog and some of their great food. It's also the cheap prices and there's many, many things that go into it. But this to me is a very, very important. So that's why I chose this as my number two pick. Yeah, love that. So I'll build on that then. Staying in the financial pillar, one of the ways you can identify a moat durable competitive advantage is the return on invested capital or ROIC.

14:59So this checklist item is what is the return on invested capital for the business. this can be a great indicator of a company that's doing something really, really well and has competitive advantages. If we talk about the Costco example, what return on invested capital can do is it can tell you how efficient a company is, which tells you how easy is it for a company to grow. So let's use Costco and then let's pretend and Andrew's going to make an Onco, and he's going to try to compete against Costco. So if Costco's ROIC is like 25%, that means they're making 25 % ROI when they open the store. And if Onco's ROIC is 10%, you can see I'll have to make two and a half more store openings to be able to get a similar profitability level to Costco.

15:55And if we're in an industry where size matters and the amount of profits matters and scale matters and how many stores you get to matters, Costco is going to have an easier time because they have a higher ROIC. Why? Because they're more efficient. Why? Because they have durable competitive advantages. So it's one of these weird things where it's like, what was first the chicken or the egg? Sometimes it can be that way. But a lot of times it can just be a great way to identify and kind of check the narrative. Like, okay, I love Costco. I shop at Costco. Is it really as great of a business as everybody on YouTube says?

16:32Well, we can look at return on invested capital and try to make that decision for ourselves. So ROIC is a fantastic metric. And you want to look at it not just on an island, but you also want to compare it to itself over time. Is it getting better? Is it getting worse? And also, like I mentioned with the whole joke about competitors, you can compare it with competitors to try to get insight into how profitable or efficient a company is versus its peers. I'm excited to share our friends over at the Plink app released a major upgrade featuring a sleek new look, real-time insights, smoother trades, and tools that help you feel more confident with every move.

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19:22That's a great pick. ROIC can tell you so much about the business and what's going on with the company. And that's going to segue me into my next pick, which is, are the CEO and CFO disciplined in making capital allocations. So as Michael Momison said in one of his papers, capital allocation is job number one for a CEO. And the better they do this, the better the company is going to be. And ROIC is one of those metrics that you can use to help you measure how well a company does reinvesting their capital or making capital allocations. And the reason why this is important is because hopefully every company that is making something makes money.

20:09And if they make money, they have choices of what to do with that money. And if you're investing in Google, for example, you want Sundar Pichai to make great capital allocations because he's got a lot of money to play with. And the better decisions he makes, the faster and the better, arguably, that Google can grow. And as shareholder, we want to see that. It also gives them more optionality to do things like pay a dividend or buy back shares, which are also great capital allocation choices for a CEO. And one of the hard parts about... It's a little squishy, if you will, to try to assess management.

20:55And because capital allocation is so important. There's not a lot of hard, fast metrics besides ROIC that allow you to look at how well management allocates capital. And the reason why this is so important is because if they don't do a good job and they burn all that cash, then eventually the company is going to struggle. Competitors are going to come for their lunch. There's going to be disruptions that they're not going to be able to fight off. And as investors, we will struggle to see a good return on our money because the company is being run poorly. And one of the challenges to finding good CEOs is finding good CEOs, not just people that talk well, but also can allocate capital really well.

21:45And a challenge with this is that many CEOs, once they achieve that level of management, don't come from a place where they're learning how to be a capital allocator. Maybe they came from marketing, or maybe they specialized in the operations of the business, or maybe they specialized in something else, or maybe they didn't grow up in this business. They worked in a competitor or another industry even, and they're being brought into this particular industry. And so they don't have the necessary understanding of the business or the industry, of the economics. And so they're already kind of behind the eight ball.

22:25And that's one of the things that sets Warren Buffett apart among many things. But he is arguably the greatest capital allocator we've ever seen. And that's one of his strengths. And that's one of the things that when he leaves will be a top priority to figure out whether Greg Abel can match the goat. And that's a tall order to achieve. So the reason why I chose this is because this is critically important for us as investors. If you invest in a company that's being run by a ham sandwich and they run it like it's a ham sandwich, then you're going to struggle to get a good return. But if you find a company that's run really well, Sati Nadella by Microsoft, that's part of his strength, is he's really good at figuring out what to do with the money.

23:14And that's why, in part, why the company has done so well since he's taken over. So that, to me, is why this is so important. And knowing not just what to do with the money, but also when to not outlay money. Buffett's done a great job of that, right? Just sitting on cash for a long time, and then, bam, there's Apple stock. Right. Yeah, exactly. Or buying back shares. He doesn't see any other options, so instead of buying another company, he buys back shares. So yeah, that's awesome. Yep. This one, I'm going to go back to the business for a second. I think if leadership management does a good job of running a business, I think this is one of the natural outflows.

23:59And some businesses are more explicit about this and public about this than others. Some managers are more explicit and public about this than others. but the checklist item is what pain does the business solve for the customer and this kind of gets back to how does a business make money and then what is their cash cow and how is that all related so i'm reminded of this because of um some stuff i've been reading about our new favorite bank which we're not going to say on on the air but they are that is one of their big missions is they are customer obsessed. And it reminds me of Amazon back during the dot-com boom.

24:45Jeff Bezos, everything was about the customer. They were customer obsessed to the max. And some other companies are also following with that kind of philosophy, but it really is the whole point of the business. I mean, yeah, I mean, there's shareholders, there's all these moving pieces around a business. But at the end of the day, either the moat helps you serve the customer or the way you serve the customer is the moat. So like with Costco, as long as they can continue to provide value to people that they can't get anywhere else, helping that family of five save hundreds of dollars a month on their groceries.

25:27Costco knows that that's the pain point that the family wants to save money and they know that as long as they continue doing what they do to save money and share that with the customer, then the moat is intact. So for every business, it's going to look a little bit different. But that's where I think the Peter Lynch quote, know what you own, plays into this. I think just kind of being a customer and seeing the other side of it. You can't do that with every business because there's some B2B businesses and things like that, but having an understanding of a customer, the customer's pain points and management needs to know what that is too and not deviate and try to force feed a different business or mental model on a customer who doesn't want it because that just doesn't work either.

26:13So I think it's one of those things I probably don't think about enough and it's so basic and elementary, but it really is the key for especially consumer facing businesses. Figure out what is the pain point and is the company solving it and are they continuing to solve it or are they getting worse at that value proposition? That's a great one. And I agree. It probably flies way under the radar more than it probably should. And if you think about the company you were mentioning in Amazon in particular, I think that was one of the things that really set Jeff Bezos apart was his ability to focus on the customer and what pain point are they trying to fix?

26:56What are they that they did kind of came back to that pain point. Like, what are we trying to do here? And I think that's his focus on that and his obsession, I guess, is I think what really set them apart and allowed them to become Amazon that we know now today. So yeah, that's a great one. I want to throw, I'm going to go back to the financial pillar. And since I haven't really taken a bite here. I want to talk about assessing the strength or weakness of the balance sheet. So the balance sheet is, you could say all the financial statements are important. The balance sheet is as important as the income statement.

27:38The income statement probably gets the most air quote press because people always talk about earnings. They talk about revenue and people will talk about free cashflow, which is obviously critically important. But the balance sheet really can tell you how strong a business is. And just simply looking at what is the combination of the assets to the liabilities to the equity, and how does that relationship work? And the stronger the company is, arguably the more assets they're going to have on the balance sheet because those are what are going to generate income or revenue for the business down the road.

28:17and you can tell a lot about a company's capital allocation priorities and where and how they choose to do things. For example, if a company is spending a lot of money on things like they want to grow the business, they want to grow the inventory, for example, and you also see a lot of debt on the balance sheet, that could tell you that maybe the company is using the debt to finance the acquisition of all the inventory that they are hopefully going to sell. And in some cases, different business models that can work just fine. But if you don't understand the relationship and the correlation between the two, and you aren't tracking that, you could get caught off guard.