We Study Billionaires - The Investor’s Podcast Network - TIP656: Mastering Stock Selection with an Investment Checklist w/ Clay Finck

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the Investors podcast. I'm your host, Clay Fink, and today I'm going to be giving a comprehensive overview of how you can build an investment checklist to ensure you're covering everything you need to know prior to taking a position in a company. To do so, I'm going to be covering what I learned from reading this book called The Investment Checklist, The Art of In-depth Research by Michael Schurne. The Investment Checklist shares 59 checklist items we can use in our own due diligence

Starting point is 00:00:30 process, and the book goes into incredible levels of detail, so I think you're really going to get a ton of value from tuning into this discussion. During this episode, I'll be covering how to understand the basics of a business, how we can evaluate the strengths and the weaknesses of a business, which financial and operating ratios are most important, how we can evaluate the quality of earnings and the quality of a management team, and how we can evaluate the growth opportunities that lie ahead for a company. At the end of the episode, I'm also going to discuss the live events we'll be hosting for our TIP Mastermind community as well, which is going to be in New York City the first weekend of October. I hope this episode will help you become better at understanding

Starting point is 00:01:08 what really makes businesses tick and whether they're going to make for a good company to hold in your portfolio. With that, let's get right to it. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. So diving right into the book here, I decided to cover this book on the show because I thought it did a really good job of giving readers an overview of what to look for exactly in a business

Starting point is 00:01:57 and how to properly do fundamental research. I think it can be incredibly tempting to just find an idea and fall in love with it really. quickly. Then say you buy into the company's stock, only to be disappointed sometime later because you didn't properly assess the business. Plus, if you don't know your businesses really well, then when the stock price inevitably drops, which it happens for most companies, then you may get scared out of your position and lose money, or maybe you don't even know if you should be holding onto the shares or not because you don't really fully understand the reality of the situation because you didn't do that proper research. So once you're able to do proper fundamental research,

Starting point is 00:02:36 then you can understand the true value of a business and the risks inherent in owning such a business, and then you can make an informed and intelligent decision from there. On the flip side, I think some investors can even go overboard and spend too much time analyzing a business. They scour through every filing they can related to the business, related to the industry, not realizing that ultimately it's really just a few key factors in a lot of cases that end up driving the success or the failure of that investment. So I think investment checklists are good because they can really help slow us down

Starting point is 00:03:11 and ensure that we aren't making any critical mistakes before we purchase an investment. Sometimes I've found that I think I really understand a business well. Then when I go through some of my checklist items, I realize I didn't understand the business as well as I thought I did or I end up running into some things I didn't initially consider. A checklist can also help you focus on really what's my business. most important within a business and ensure you're buying into an investment with a really long-term view. It can also help us guard against our bias to be too optimistic or get way too excited about a company. It's really human nature to overweight the information that we want to be true.

Starting point is 00:03:50 So a checklist can be used to help ensure that we consider not only the potential upside, but also the potential downside that's at play. So before we dive into the meat of the book here, I'll do my best to cover a lot of what I think is most important, but I really think you're going to get the most benefit by actually reading the book, which I'll be sure to get linked in the show notes if you're interested in checking it out for yourself. So when considering investments to purchase, it's really important to keep in mind that great investment opportunities are rare. And consistent success in the stock market can be incredibly difficult. Most investors are really far too optimistic in thinking that they're going to be able to make money in stocks year after

Starting point is 00:04:30 year after year. If only the market was so easy and forgiving. Billionaire investor, Monish Pabry, mentioned on our show that the majority of Warren Buffett's success came down to just 12 decisions. So we should go into this knowing that most of our investments probably aren't going to be home runs and we need to set proper expectations. I'll briefly touch on chapter one here, which covers how to generate investment ideas. Oftentimes, the best time to invest in a company is really when there's a mass sell-off and forced selling at play in the markets. You think about COVID-19 being a prime example when all stocks really dropped massively in March of 2020. The problem, though, is that these big market dislocations are largely unpredictable, and they can come when you

Starting point is 00:05:15 really least expect them. I'm sure many people expected a big market drop in 2022 with, you know, the recessionary fears, but those predictions never came to light. So we can't really time when these are are going to happen, but it's important to be emotionally, mentally, and financially prepared when they end up due coming. Stock screeners are one popular way to source investment ideas. You can filter on all sorts of metrics, revenue growth, earnings growth, return on invested capital, market capitalization, and so on. Another way to look for companies and industries is to look for sectors of the market that are out of favor. So you can go to the new lows list for that. Oftentimes, there's a good reason, though, that a stock is at a 52-week low, but occasionally you

Starting point is 00:05:55 might find something interesting where a drawdown is overdone. Another great resource is ValueLine. They give a great overview of companies and they also share the news lows list that I mentioned in companies they find to be good opportunities in the market as well. I'm personally not a subscriber to ValueLine, but I have very fond memories of visiting family members growing up who just loved investing in stocks and there was just hundreds of pages of Value Line at their desk and he would end up getting these new issues each month or each quarter. Other ways to get ideas I would mention is your investor network. So I like getting ideas from our TIP Mastermind community. Many members are totally open with sharing their portfolios or sharing their watch lists,

Starting point is 00:06:36 sharing ideas that they currently find interesting. Or you might have friends that you deem to be knowledgeable investors. And then I also like using Dadarama, which pulls the 13 Fs of super investors, which shows the buys and sales they're making each quarter. But one drawback, with that is it's typically U.S. listed companies, and since these are large asset managers, they tend to be larger companies as well. Once you find a business to analyze, Shurn recommends taking a structured approach to evaluating the business. So the first question you should ask yourself when you start analyzing a business is, do you want to spend a lot of time learning about this business? If you don't have a significant interest in the business itself, then it's

Starting point is 00:07:15 going to be really difficult for you to do enough due diligence to fully understand the company or to be interested to continue monitoring that business for the years ahead. Another aspect is that a lot of businesses are just really difficult to understand. I could probably spend two years studying some biotech companies and still not be able to properly understand or value them. So I'm not going to even consider, say, a biotech company. Say a company like Walmart or Costco, on the other hand, I feel is much easier for most people to wrap their minds around since they're already familiar with the business and how

Starting point is 00:07:50 it generally works since a lot of people have been there in person. So the first question from Shurn, am I interested in this business and do I want to spend a lot of time learning about it? I like the next question he has here from Shern. How would you evaluate the business if you were to become the CEO? This reminds me of another mental model I came across, which is how would you analyze this business as if you were about to inherit it from a family member and become the full owner? So if you were to become a full owner of this business, you want to understand everything about it. You would want to study the company in the industry's history. You'd look at how the industry has changed over time and get to know not only the company, but all of their

Starting point is 00:08:29 competitors as well. You know, what makes this company different than all the others? You'd look at the business from the customer's perspective. Why do customers buy from the business? Why don't they choose the competitor? Why do some customers choose competitors over your business? What types of customers does the business attract? When you take a genuine interest in a business, these are the types of questions that pop up in your mind. From there, you'll want to be able to describe how the business operates in your own words. When you read a company's 10K, you should find the business segments, distribution channels, marketing strategies, regulatory requirements, industry sizes and trends, etc. When you have to write how the business operates in your own words,

Starting point is 00:09:12 that requires a really good understanding of the business itself. Next, you'll want to understand how a business generates its earnings. It sounds really simple, but if you can't understand how a business makes money, then you clearly have no business investing in it. If you had asked most investors in AIG how they generated their earnings around 2006, they probably would have gave you a pretty vague answer, thinking they understood the business when they really didn't. AIG, they actually shifted from their core insurance business into these obscure financial

Starting point is 00:09:43 instruments, otherwise known as credit default swaps. Most investors depended on past history of the business, assuming that that solid reputation and that solid history is going to carry them forward. But they were mistaken as AIG later entered bankruptcy. Next, you'll want to analyze how the business has evolved over time. In understanding of the company's history is helpful in better understanding the business and why it's been as successful as it has. One place to learn more about this is simply on the company's website. Most times, companies give a sense of their history. Many great long-tenured businesses have books written about them.

Starting point is 00:10:19 For example, this year, I discuss books on Copart, Old Dominion Freight Line, and Starbucks. Shurn also mentions the International Directory of Company Histories, which profiles over 8,500 companies. Next year is to get a sense of the foreign markets. What foreign markets is the business in? What are the risks of operating in these foreign markets? It's easy as investors to assume that what worked in one country is going to work in another, but we should be cognizant that it really isn't easy to grow in new markets,

Starting point is 00:10:50 and high initial growth rates shouldn't be blindly forecasted into the future. You'll also want to get a sense of how committed management is for continued growth internationally and how much they're investing in such growth. Let's say you have a U.S.-based business that's starting to expand internationally. You want to understand, you know, is that international expansion actually? profitable, and hopefully management is breaking down the revenue and earnings by geography to show investors what sort of value international expansion is adding. The two main types of risks shure and highlights here when expanding internationally are

Starting point is 00:11:23 country risk and currency risk. When a business earns more than 10% of its revenue from a particular country, you'll want to understand the risks of doing business in that particular country. China, for example, is a tricky country to operate in because of the government's involvement in business affairs. For example, I'm sure the CCP would prefer that domestic car manufacturers do quite well relative to the foreign competitors such as Tesla. So maybe they're going to impose special rules or regulations on Tesla, making it less profitable for them to do business there relative to a place like the U.S. And then, of course, currency risk. This is the risk that the currency

Starting point is 00:12:00 really trades against you. So if a company collects their revenues in a foreign currency, but reports their revenues in U.S. dollars, then that can be disadvantageous if that currency gets weaker relative to the U.S. dollar. Or if you buy a stock that operates 100% in a different country, then you're taking much more currency risk in that situation. So that's something important to consider there as well. Chapter 3 covers understanding the business from the customer's perspective. Shurn writes here that customers are the lifeblood of a business. In fact, the quality of a business is the determined by the quality of its customers. If customers are not satisfied with the business, they will eventually find alternatives, or an entrepreneur will create an alternative if one does

Starting point is 00:12:45 not exist, end quote. Then he writes, one of the main pitfalls in researching a business is viewing the business from your own perspective instead of viewing the business from the customer's perspective. This is one of the areas where investors make the most mistakes, end quote. Just think about a company like Tesla. If for whatever reason you like Tesla, you like Tesla, the cars or you like Elon Musk, odds are you're going to view the company more favorably. Or if you don't like Tesla or you don't like Elon Musk, then you aren't going to view them as favorably as maybe a lot of their customers. What you personally think about a business really has zero impact on the reality of the

Starting point is 00:13:22 business and its prospects going forward. Shurn says that the best way to start thinking like the customers of the business is to speak with them. Why do they buy from the company and what is most important to them in making that buying decision. And consider if they plan to continue buying from that company. Of course, it's not really reasonable to interview, say, 100 or 1,000 different customers for most people listening to the show, but for professional investors, I think interviewing customers and talking with them is really essential for understanding the business. Then sure lists a number of questions we can go through

Starting point is 00:13:53 related to the business's customers. First, who is the core customer? Oftentimes, a small number of the customers are going to represent a large percentage of the revenue. For example, Whole Foods used to disclose that they believed that 75% of purchases were made by 25% of customers who shopped exclusively at Whole Foods. Knowing the core customer can also help you better understand whether a company caters to their core customers specifically or if there's more of a strategy where they're trying to appeal to a lot of different types of customers. You'll also want to consider whether the customer base is concentrated or diversified. If a lot of a business's revenue comes from just one customer, then they're really a substantial risk if that customer were to

Starting point is 00:14:36 leave for a competitor or just drop that product or service. Sometimes customer concentration can also be viewed as a positive. For example, one business I own, one of their biggest customers is a federal government. And part of my investment thesis is that the federal government's ability to spend and their ability to take on price increases is going to expand into the future, which hopefully is going to generate higher revenues and earnings for the business that I own shares in. Generally, for most businesses, it's better to have a diversified customer base, though, I would say. So the next one here he shares is, is it difficult or easy to convince customers to buy products or services? This reminds me of a mental model I learned when working here at TIP, which is a push versus a pull marketing.

Starting point is 00:15:23 The best businesses are really able to just attract customers without having to push their products really hard on them. So I was also reminded of this when I was speaking with a podcast listener in Omaha. He works in software sales and he was just telling me about, you know, his job was great. He really enjoys it. And part of the reason was because the product just sold itself. He didn't have to try and push it on customers. That's really a fantastic position to be in as a salesperson or as a business because I think it signals that customers truly need the product. there aren't many options in terms of substitutes from competitors, and it potentially might signal pricing power as well. Luxury companies are also another great example of this. I think a company like Kermez doesn't really need to push their products at all.

Starting point is 00:16:08 The Birkenbag doesn't even sit on the shelves at their stores, yet customers would do anything to have the opportunity to buy one for tens of thousands of dollars. If we turn that around, if a company has a sales force that is just constantly pushing the product to customers and trying to sell them, then that likely signals that the brand isn't that great and there's other alternative products available in the market that are good substitutes for customers. Next, we can consider the customer retention rate. It's often said that it's better to sell to an existing customer than to try to acquire new customers.

Starting point is 00:16:42 A loyal customer base also generates more predictive sales, which can improve. improve profits over time. So say, for a subscription business, retention rates are especially important. Here's another great point from sharing here. What are the signs of business is customer-oriented? Consider how a company interacts with its customers. Ask yourself if the business is easy to work with or not. To share a negative experience I've had with a business as a customer, once upon a time I subscribe to the Wall Street Journal. I recall that they just made it incredibly difficult for me to cancel my subscription with them. And then when you try and cancel, they'll try and throw multiple deals at you to try and get you to stay on as a subscriber. And then they send you mail every

Starting point is 00:17:25 week. I still get mail to this day from them. And they just crowd your inbox with promotions if you're an email subscriber. So this might be a bit exaggerated by personally did not have a great experience interacting with that business and interacting with their customer service. And then you flip that on its head. You look at a company like Costco. I think this is just a great example of how a business should treat its customers. They pledged to never mark up their products by more than 15% of what they buy it at. The checkout experience is generally pretty quick and the employees are very friendly. There are also studies that suggest that companies with high rates of customer satisfaction produce higher stock returns than the broader market. Another great

Starting point is 00:18:06 question to ask yourself is what pain does the business alleviate for customers? This helps you better understand the needs that the business is solving. And then here's another great question relating to the mode of the business. To what degree is the customer dependent on the products or services of that business? So Mark Leonard from Consolation Software, he recognized that the vertical market software businesses he was purchasing were really high quality, in part because the software these businesses sold were mission critical. These software products weren't just nice to have. They were absolutely necessary to these businesses' customers. For example, one software company might have a very niche software at, say, a bowling alley with very specific needs.

Starting point is 00:18:49 Without that software, they wouldn't be able to serve their customers. And better yet, the cost of that software is minimal, say it's 1 or 2% of revenues. So not only is it absolutely necessary, but it's a very low percentage of their overall budget. After you've analyzed a business and relationship with its customers, you'll also want to get a good understanding of its competitive advantages. The better a business's competitive position, the higher the probability that they're going to be able to sustain those cash flows over time and prevent competitors from stealing that market position. To help determine the strength and the sustainability of a competitive advantage, you need to ask yourself two questions. First, how easily can someone else copy or replace

Starting point is 00:19:32 this advantage, and second, how quickly might they do it? Common sources of competitive advantages include network effects, brand loyalty, patents, regulatory licenses, switching costs, and cost advantages stemming from scale, location, or access to a unique asset. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about

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Starting point is 00:23:49 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. To learn more about competitive advantages, I would point you to Hamilton-Helmer's book, Seven Powers, which discusses competitive advantages in tremendous detail. Shuren explains here that the best type of sustainable competitive advantages are structural. He writes, when customers have limited choices in the products or services they can use for extended periods of time, the competitive advantage

Starting point is 00:24:21 is likely structural. A structural competitive advantage can be a result of regulation, a prime location, or better distribution networks. For example, think about a prime piece of real estate in your community where there is easy access, visibility, and location. This location typically will be able to charge higher rents to retailers because it's a good area where more customers are likely to shop, end quote. It's really difficult to find businesses with sustainable competitive advantages. Most competitive advantages eventually expire, and with advances in technology,

Starting point is 00:24:53 I think most competitive advantage periods are shortening. One good indicator of a competitive advantage is pricing power, which is the ability to increase prices without losing customers. Businesses with strong brands like Apple and Louis Vuitton are able to continue increasing prices while also gaining market share, while commodity-like businesses have no ability to increase prices at all. Oftentimes, commodity-like businesses need to decrease their prices just to remain competitive. Common characteristics of pricing power include high customer retention rates,

Starting point is 00:25:27 customers only spending a small amount of their budget on the product or service, customers themselves having profitable business models, and the quality of the product being more important than the price itself. Another good signal of pricing power is simply to just look at the prices of the business relative to their competitors and see how they line up. The book here also gets into analyzing the industry the company operates in. Scherner argues that investing in the right industry is so important because a large part of your potential rate of return is often attributable to the industry you're invested in as opposed to the specific company. Some industries, frankly, are much easier to make money in, and if it's easy for a business

Starting point is 00:26:06 to make money in that industry, then that increases your odds of a successful investment in that industry. One common characteristic to look for is just to look at the average return on invested capital within an industry. Typically, if there's higher than average return on invested capital, then it's generally easier to make money in that industry. And it also won't be a wide range between the different companies. It'll be a pretty narrow range.

Starting point is 00:26:30 want to consider the industry dynamics. How do companies compete with each other in the industry? How fast is the industry growing? How cyclical is it? You may also want to look at how entrenched businesses are within the industry. My co-host, Kyle Greave and I just recorded an episode on Old Dominion Freight Line. And the trucking industry is just brutal as you continue to see existing players go bankrupt or get bought out, which can be beneficial for the stronger players in the industry like Old Dominion. It can also be just really tough for them to continue to earn. earn that high return on invested capital because in some ways they're in a commodity like business. One of the other points Scherne includes here is can competition from low-cost countries impact

Starting point is 00:27:12 the business? So this reminds me of Buffett's investment in Dexter Shoe. Buffett thought that Dexter Shoe had a great competitive advantage when really it didn't. He had stated that Dexter had a strong competitive advantage and it was one of the best managed companies he had ever seen, and he expected it to be a great investment. He then realized that Dexter faced intense competition from low-cost foreign competitors, especially from China and Brazil, and Dexter, they saw their profits drop from $85 million in 1994 to negative $46 million in 2001. So Dexter ended up being a worthless investment for Buffett because they largely sold a commodity and they couldn't handle the lower-priced competitors coming into the market from foreign

Starting point is 00:27:56 countries. Next here, Shurn dives into analyzing the operations and the financial health of the business. The first question he poses here is, what are the fundamentals of the business? We need to determine what the business fundamentally does in order to be successful. So in the case of Old Dominion, for example, they need to continue to please their customers with exceptional transportation service at a fair price. The better they can execute on that strategy, the more valuable the business is going to ultimately be. We can also look at the company's mission statement and see if what they do aligns with their mission or their reason for existing. Sometimes you'll find companies stray a bit outside of their lane and lose focus on why they exist in the first place.

Starting point is 00:28:38 Then you'll want to consider the operating metrics that need to be monitored. So operating metrics can help you gauge whether the fundamentals of a business are improving or deteriorating, and they can help you better understand the true performance of the underlying business. So going back to Old Dominion, again, one of the key metrics is their operating ratio, which tells you how efficient they are at operating their business. In the case of Costco, you'd probably look at their store counts, how their store counts have grown year over year. And then you can look at the number of paid memberships, of course. And then when you look at many retailers, a lot of them look at things like like for like or same source sales, which shows the growth in sales for their existing

Starting point is 00:29:18 stores. Oftentimes, a company is just going to share the metrics that are most important to the business, but you should also determine for yourself what you believe are the most important metrics for that business. Next, we want to consider the risks for the business. A good place to start for risks is actually the 10K, which has a section titled Risk Factors. That outlines management's view on the known risks to the operations of that business. There are so, so many different types of operational risks to a business. You have commoditization, you have der, Regulation, shifts in technology, the emergence of new competitors, brand erosion, shern lists a bunch of them in this section, and risks are just so important to understand too.

Starting point is 00:29:58 I'm reminded of the point that Godham Bade has made to me that if you can eliminate the downside, then all you really have is upside. So to remove the downside from an investment, you need to understand the potential risks and how likely those risks are to come into fruition and how that might impact future cash flows of that business. In thinking about the risk, we want to constantly ask ourselves, how can things go wrong? What could go horribly wrong with this business? Another way to limit the overall risk of a business to your portfolio is to limit your position

Starting point is 00:30:30 sizing. Let's say you come to like a business and you like its prospects, but you understand there are some risks that just can't be foreseen. So you may limit yourself to putting in, say, 5% of your portfolio into that one company. So if things turn out wrong or you underestimated the risk, then the downside to the overall portfolio is limited. Another risk can be related to the balance sheet. So if a company is over leveraged, then they may be susceptible to being affected during an economic

Starting point is 00:30:57 crisis when things are tight, and their ability to pay off debt and pay their employees is highly impacted. An economic crisis is also like the best time for companies to capitalize on great opportunities. Some might be able to buy up a competitor for pennies. on the dollar or buy back their own shares at highly discounted prices. So a strong balance sheet with a lot of cash allows them to do just that. The book goes into a lot of detail in determining the financial strength of a business, you know, things like debt that's off the balance sheet, things like lease obligations, warranties, or unfunded pension liabilities. To help assess the financial

Starting point is 00:31:33 strength, we can look at the coverage ratio, which we can calculate as the EBITDA divided by the annual interest expense. And then other ratios we can look at, including include current assets to current liabilities and debt to equity. Next, let's touch on the return on invested capital. This is a very important metric to understand. Return on invested capital illustrates how much profit a business generates relative to the amount of money that's invested in the business. You might be wondering, why is this so important?

Starting point is 00:32:03 A company might earn a lot of money, but if it requires a significant amount of capital to create those earnings, then they might be earning well below their cost. of capital. For example, earning 1% on capital invested is generally a poor investment, even if the business is earning $1 billion. Return on invested capital gives you a sense of the quality of the business. Charlie Munger shared with us that over the long term, the returns of the business tend to correlate with the returns of the stock. What also counts just as much as the return on invested capital is the company's ability to reinvest earnings at a high return on incremental

Starting point is 00:32:39 invest in capital and how long it can do that for. When a company can reinvest a lot of capital at high rates over long periods of time, the incredible power of compounding really starts to kick in and accelerate that flywheel. However, we need to be careful about projecting returns forward because generally companies are going to see declining returns over time as they scale up and then they start pushing against the law of large numbers and they may see increased levels of competition in light of the high return on invested capital. Next, we want to evaluate the earnernerable. Next, we want to evaluate the earn earnings and the cash flows? Scherner has six major checklist items he covers in this section, so to determine the value

Starting point is 00:33:16 of a business, we need to try and figure out what earnings might be at some point in the future, say three or five years from now. Scherner first wants to determine whether the management team uses conservative or liberal accounting standards. If management uses aggressive accounting, then they may inadvertently overestimate the true economic earnings of a business. One simple check we can use is to simply compete. compare the cash flow from operations to the net income. Cash flow from operations shows the actual

Starting point is 00:33:45 cash that's generated in that business, which is a figure that management really has less flexibility in trying to manipulate, whereas net income has a lot of subjective estimates included. So if you see a wide difference in the net income and the cash flow from operations, then you really want to understand why those differences exist and if they logically make sense. If a business is being disrupted or say they're in the midst of a decline, then there's really a temptation for management to want to manipulate earnings either to try and hide the fact that they aren't doing as well as they'd like or to try and hit their quarterly EPS targets. Ways in which management can do this include improperly inflating sales, understating expenses,

Starting point is 00:34:26 manipulating discretionary costs, changing accounting methods, using restructuring charges to increase future earnings, or using reserves to manipulate earnings. So to use an example here, Riverstone Networks was a telecom company that inflated their sales numbers in 2006 by improperly recognizing revenues. They had agreements with customers saying that payments to Riverstone were contingent upon the resale of Riverstone's products, but Riverstone booked them as sales even though they didn't actually receive a payment. So fraudulent revenues ranged from anywhere between 14 to 20% of revenue during that time period, and investors could have potentially caught this by seeing that they had large increases

Starting point is 00:35:07 in the accounts receivables line item. So when accounts receivable is growing faster than sales, then this might be worth exploring further. Next, we can look at how the company generates revenues. Do they need to generate recurring revenue or are there a lot of one-time sales? It's, of course, easier to project revenues forward if a large percentage of sales are generated from recurring revenue because a lot of the customers are going to be carried forward year after year, assuming the retention rates are good. On the one hand, when you look at something like an iPhone, Apple needs to keep figuring out how to sell these things over and over again. But on the other hand, a lot of people are like me in that they don't really look at the price of an iPhone or

Starting point is 00:35:47 look at the competitors. They just pick the iPhone that makes most sense for them. So Apple just doesn't necessarily control whether I get a new phone after year one or after year five of owning the previous phone. So you'll also want to consider the cyclicality. of the business and determine whether the business is countercyclical or recession-resistant. A lot of companies are exposed to economic cycles and can really get hammered if we were to enter a deep recession. So home builders are a great example. It's really difficult to know the economics of a home builder one or two years out because the demand for homes is very much driven by macro factors like interest rates, cost of materials, employment, and then the health

Starting point is 00:36:28 of the overall economy. More broadly, a business is considered to be seen. cyclical if it does well during an expanding economy and then it does poorly when the economy is shrinking. These include industries like home furniture, apparel, vacation travel, automobiles, and then a host of other industries. And then another way to think about this is to consider what products consumers are willing to delay during tough economic time periods. So most families are going to keep buying their household items like meat, bread, milk, household items because they really need them. And if they have a job, they're going to keep buying those items. Something like a new car can easily be delayed for one or two years if times get tight and

Starting point is 00:37:09 things are uncertain for a family. So as opposed to cyclical businesses, countercyclical businesses do well when the economy is contracting. These can include industries like discount retailers or medical care. So one of the reasons I liked Constellation Software when I first looked at it in 23 and ended up buying my first shares was because they can have the potential to do really well during recessions. So the first reason as to why that is is because they sell mission critical software that's very sticky. So their customers don't just want their products. They absolutely need their products. And then the second reason is that since they're a highly acquisitive company, recessions are really a time where they can make a purchase from a desperate seller and

Starting point is 00:37:50 then get really high returns than they would otherwise be able to during a normal economic time period. I would consider consolation to be a recession-resistant business. They might be affected to some degree, but not near as much as something like a retailer or a home builder. So some key factors to look for when determining how recession-resistant a business is, is by looking at the amount of recurring revenues they have, the percentage of the customer's budget that's spend on products or services, and the percentage of its customers that are exposed to business cycles and how sensitive their customers are to economic cycles. And then there are the rare companies that operate somewhat independently of the economic cycle. These are companies like

Starting point is 00:38:30 tobacco companies, pipelines carrying oil and gas, student housing reits, and funeral homes. We should also be cautious when looking at past recessions to determine if a business is recession resistant or not because past recessions in how businesses fared aren't always indicative. For example, during the 1990s, Las Vegas casinos were considered to be recession resistant because they did well in past recessions. But the reason they did well in the previous ones is because casino demand was growing so fast and then the supplies casinos were quite limited. So then when the great financial crisis hit, Las Vegas casinos experienced their worst operating

Starting point is 00:39:09 results ever because there was an oversupply of casinos in Las Vegas. So next year, Shurn recommends determining what degree does a business have operating leverage? So a business with high operating leverage is one in which earnings increase at an amount greater than their growth of sales. So going back to Old Dominion once more here, over the past 10 years, Old Dominion's revenues have grown at 7.7% per year, and their earnings have grown at 16.6% per year. What really drives this level of operating leverage is when a business has high levels of fixed cost and low levels of variable costs.

Starting point is 00:39:44 So there's some pros and some cons to operating leverage. I think one of the problems with high operating leverage, though, is that it can make it difficult to project earnings in the near term. So in a good year, you might see revenue go up 10 percent and earnings go up 20 percent, but the opposite could also occur. Revenues might decline by 10 percent, and then earnings might go down 20 percent because they have that high level of fixed costs that they're having to pay no matter what, regardless of what the revenues are doing.

Starting point is 00:40:12 The book walks through a few examples to help illustrate how we can identify fixed and variable costs, but I'm going to jump that to make sure we can cover all the material here. Next, Scherun covers how working capital impacts the cash flows of the business. So working capital is a fancy term that accountants use to explain the amount of cash a business uses to fund its day-to-day operations. Businesses with low working capital needs have the ability to do other things with that cash, you know, reinvest in future growth or distributed to shareholders. On the flip side, if a business requires high levels of working capital to grow, say they

Starting point is 00:40:46 have to purchase a lot of inventory or whatnot, then that can limit their ability to grow in itself because the business is requiring more and more capital to finance that growth. Costco's business model is brilliant, partially because they're able to operate with negative working capital. So with most companies, I think you'd expect that the retailer would pay for the product and then sometime later, the product would then be purchased off the shelves and then the retailer would get paid. If it's, say, one month between the transaction, then the retailer has, you know, that capital tied up during that time period that could otherwise be used for something else. Costco, on the other hand, has such a dominant market position that they've been able to negotiate

Starting point is 00:41:26 terms with suppliers such that they can pay suppliers later than when they get paid by Costco customers. You know, that's somewhat mind-boggling. But this is because they have so much leverage over suppliers because the suppliers receive so much value by being on Costco's shelves. And then finally, the last point here from this chapter is on capital expenditure requirements of the business. So a capital-intensive business is one that requires a large amount of capital or assets to maintain their existing level of revenues. Common examples in terms of industries are semiconductors, steel, mining, a lot of these commodity-like businesses, oil and gas, traditional manufacturing companies. And then on the flip side, it's generally preferable to own companies

Starting point is 00:42:08 that are capital-light, not capital-intensive, say software companies being the most prominent examples, but capital-light businesses also have the potential of being easier to disrupt. Warren Buffett also shared with us the importance of understanding the importance of maintenance versus growth CAPEX. So maintenance CAPEX is what they need to spend to maintain their current operations, while growth CAPEX is spent in order to grow the business. Companies tend to not break these line items out, so it's on us as investors to try and distinguish between the two.

Starting point is 00:42:40 One common rule of thumb we can use is that maintenance CAPEX tends to closely resemble the annual depreciation and amortization charges. So also keep in mind that accounting rules might not be closely reflective of reality. So say for an airline, they might depreciate their planes for 15 years. But maybe a lot of their planes only last for 10 years or maybe they end up lasting more than 15 years. So depreciation is, of course, just a rough approximation used by accountants. Cappex is extremely important to understand because it greatly plays into your returns as

Starting point is 00:43:13 an investor. And to the point earlier on return on invested capital, that is all the important. also really, really important. Now let's talk about assessing the quality of a management team. This is something that can be so difficult to do. And Sharn does an amazing job in this book. He actually has three chapters just on management alone. So this is a really great resource for learning how to assess management.

Starting point is 00:43:36 Shurn writes here, most investors overlooks the human aspect of operating a business. Yet in most cases, the future success of a business is directly tied to the quality of its people. Instead of focusing on management, many investors spend their time determining whether a business has a competitive advantage or if it's trading at a low valuation because they believe that products or operational strengths are what set the most successful organizations apart. The truth is that over time, these advantages can be imitated. And if the talented managers who created these advantages leave the business, then the business will struggle to continue to innovate and create value. End quote. Knowing the type of management team that you're partnering with is going to help you

Starting point is 00:44:19 forecast what that business will look like in the future because the top managers are responsible for designing the business, deciding how they're going to allocate capital, they'll determine the future growth rate of the business, and they'll be choosing the managers below them that will set the tone in the culture of the organization. Management teams take time to properly evaluate, and we shouldn't come to quick conclusions on the quality of a management team. Sometimes you can find articles or interviews that are with the managers of the business that maybe even in local newspapers or nowadays we have things like YouTube and podcasts. Insurance suggests looking for four basic things in a management team. You have passion,

Starting point is 00:44:57 honesty, transparency, and competence. All managers make mistakes, so you want to try and see if they learn from their mistakes and they're able to recover from them as well. Let's take a quick break and hear from today's sponsors. No, it's not. It's not. your imagination, risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, VANTA gives you continuous

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Starting point is 00:48:13 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. You'll want to consider the tenure of the management team. Managers who have executed for more than 10 years, you can likely put more trust in relative to a new management team. Founders, owner-operators, and long-tenured managers would be preferable to someone like

Starting point is 00:48:44 a hired hand. Long-tenured CEOs can be really difficult to find. Shurn shares a stat in the book that just 28 CEOs in the S&P 500 were CEOs for more than 15 years, and then the typical CEO has held their title for only 6.6 years. He also shares that investors should be cautious with managers who are new to the business, but are still long-tenured in the industry itself. In a lot of cases, it can take a significant amount of time to get to know a business really well.

Starting point is 00:49:13 You see this with a company like Starbucks, for example, where Howard Schultz, he was very successful in growing that business. Then after he left, Starbucks began to struggle to be who they once were, and Schultz had to rejoin the company multiple times to take them to new heights. Since it can take a lot of time to get to know a business, I generally like to see managers who are brought up and trained from within. So Kyle and I, we did that episode on Old Dominion and Old Dominion's current CEO, Kevin Freeman. He's been with that business since 1992. So, of course, an outsider might be a better person for the job in certain situations, but I can be fairly certain that the existing management team knows Kevin really well and that he's likely the right person to lead the company as CEO.

Starting point is 00:49:57 Making that sort of judgment call can be really difficult when hiring from the outside. And I would argue that few people would know Old Dominion's customers as well as someone that's been with the company for over 30 years and has worked in various roles within the business, whether be operations or sales. So compensation is also a really important topic, really important to understand how senior managers are being compensated and how they gain their ownership interest in the company. So this information for the most part can be found in the proxy. statement. The compensation package can give you a sense on whether management is incentivized to think long-term or think short-term in their decisions within the company. For example, if the CEO owns $100 million in stock and he's paid $100,000 per year, then he or she is more likely to make longer-term decisions. On the flip side, if the CEO's paid $5 million a year and only owns $1 million in stock, then they're more likely to make short-term decisions just to ensure they're going to keep their job. Shurn claims that some of the best long-term performing stocks have been run by CEOs with low cash compensation and high stock ownership. The two most obvious examples that come to mind

Starting point is 00:51:06 are Warren Buffett at Berkshire Hathaway and Mark Leonard at Constellation Software. Scherner shares some other examples here in the book, one of which is Russell Gurdon. So he was the CEO of a trucking firm called Heartland Express. Gerdon earned $300,000 per year in cash compensation, and that was an amount that didn't change over $20,000. years. He owned 34% of the business. He did not receive stock options. And from 1986 to 2010, shares of Heartland Express increased from $0.43 to $16. That's a compounded annual growth rate of 16.3% per year far outpacing the market. Sharon explains that we should be wary of managers who hold stock options as that is one of the most common ways for management to be compensated.

Starting point is 00:51:51 And it represents a payoff with some poor incentives. If the stock price, doesn't increase, then there's no payout to the managers. But if it does increase, then there is a payout and they do benefit from additional compensation. So if the stock price were to go down, then the managers don't necessarily feel the pain if they make poor management decisions. And then some people refer to stock options for managers as something like a free lottery ticket. If they're lucky, it's going to pay off big, but otherwise it's not going to hurt them. So that can cause them to take really unnecessary risks. Instead, we want managers with compensation plans that reward long-term performance. Ideally, compensation is tied to factors that make the business

Starting point is 00:52:30 better rather than making it bigger. Shurn gives the example of ExxonMobil, where at the time of writing, half of an executive officer's restricted shares vested over five years, and then the other half must be held for 10 years or until retirement. This means that management is going to be rewarded if the stock price does well over a 5, 10, 20-year time period, and they won't necessarily carry as much about how the stock might do over the next one or two years. Markell is another example that the audience is well aware of. Markell, as the time of writing, was incentivizing managers based on the growth in book value per share over a five-year measurement period. And then another good thing to see is managers increasing their stake in the business by purchasing shares on the

Starting point is 00:53:16 open market and not being handed out the shares by the company. Bruce Flat, the CEO of Brookfield Asset Management, has continually increased the shares he owns. to use one example. Insider buying and selling can also be an interesting indicator to take a look at when managers make major insider buys, I think that's especially worth taking note of because managers generally know the business better than anybody. And if they're making a sizable purchase, then I think that can be indicative of where the company might be heading in the near term. So in the 1998 book, Investment Intelligence from Insider Trading, insider activity was examined from 1975 to 1995, and it found that stocks bought by insiders and not sold for 12 months

Starting point is 00:53:59 ended up outperforming the market by 7.5% on average. Managers could, of course, try and signal that they think the stock is undervalued when it's all smoke and mirrors, but generally, I find it to be a pretty good sign when there's a sizable purchase relative to the executive officer's net worth. Insider selling, I don't really put as much weight on since it's common for founders. for example, to cash out after they've had a good run with the business. Maybe they want to diversify their assets a bit or simply just fund their own lifestyle, but I think it's still something just to keep an eye on.

Starting point is 00:54:33 Management is one of the topics in the book that, again, is really thoroughly covered. Here he covers a chapter on how they're operating the business, and then another chapter on the positive and negative traits to look for. So diving right in. One question he asks in his checklist is, does the CEO run the business to benefit all stakeholders? So the stakeholders, not just being the shareholders. So these include parties like the employees, the customers, the shareholders, managers, the suppliers, and so on.

Starting point is 00:55:01 Oftentimes, the benefit of one party comes at the expense to the other party. So a good CEO can really find a good balance where really everyone wins, so to speak. And this is a balance that's really difficult, if not impossible, to strike just right for some companies. Sharon has another good bullet point here that says, does the management team improve its day-to-day operations, or does it use a strategic plan to conduct its business? So what Shoren is really getting at here is that while a broader vision and strategy can be important, a business ends up improving through hundreds, if not thousands of small

Starting point is 00:55:37 incremental improvements. Just because a strategic plan sounds good doesn't necessarily mean that the company is going to be able to execute on it. It reminds me of the saying that we should focus on the little things, because over time, those little decisions ended up making all the difference. I think sometimes a business like a turnaround can bring in a new CEO that paints a good picture of the future to shareholders, but ultimately fails on executing that strategy. So in the end, it's the execution that matters.

Starting point is 00:56:06 Henry Singleton went as far as believing that the best plan was no plan, which I think is taking it a little bit too far. From the 1960s, shares of Teledyne compounded at over 20% per year, over that 20-year time period and Singleton has said, we're subject to a tremendous number of outside influences, and the vast majority of them cannot be predicted. So my idea is to stay flexible. I like to steer the boat each day rather than plan way ahead into the future, end quote. Management also needs to make sure they aren't fixating too much on a specific outcome, say hitting a certain sales target or hitting some arbitrary number that they've told shareholders and now they have that consistency

Starting point is 00:56:47 bias where they want to hit exactly what they said. But that can really come at a disservice to value creation over the long term. The next point from Schern here, does the CEO or CFO issue guidance regarding earnings? So I've heard from a lot of guests on the show here that they like to see managers who don't issue guidance because that really signals to them that the managers aren't interested in making these short-term forecasts just to appease to Wall Street or appease to short-term shareholders. Guidance is essentially when managers predict the earnings per share or give some other business metrics like revenue over the next year or next quarter. And what's kind of interesting is that the majority of publicly traded companies are going to issue guidance. So issuing

Starting point is 00:57:30 guidance can, of course, lead to companies optimizing for the short term rather than the long term. But in the short term, businesses can really face a lot of volatility and forces that are just outside of their control. So I think for some businesses, Short-term guidance can actually be harmful if it ends up coming at the expense of the longer-term growth. Another point from Scherner here, he has, does management value its employees? At the end of the day, business is about people. And if a business doesn't take great care of its people, it's going to be extremely

Starting point is 00:58:01 difficult for the business to do well over the long run. He writes, most investors view the CEO as the sole person who operates the business, while the employees are viewed as commodities that can be downsized at any point. Nothing is further from the truth. The primary function of a manager is to obtain results through people. If a manager is unable to achieve results through people, then they're not a good manager. Try to understand if the management team values its employees because the only way it will obtain positive results is through these people, end quote.

Starting point is 00:58:34 So to get a sense of this, one thing I like to do is just go to Glass Door reviews. That way you can oftentimes read feedback from real employees that have worked at the company. You can look for certain things within a company. You can try and figure out if management actually cares about their employees. If they talk about their employees on conference calls and in their letters, you can look at how employees are compensated, what their benefits packages are, other perks like training programs. Maybe some companies offer some sort of stock instead of plan to employees so everyone is aligned financially. I recently did a book review on the story of Starbucks and Howard Schultz was someone who was really big on empowering employees. So he gave

Starting point is 00:59:11 great healthcare benefits to employees. He gave a huge stock incentive program in the very early days of the company. Another great example is Costco. So during the great financial crisis, the Costco CFO, Richard Galanty, he was asked in an interview whether he considered increasing the amount that employees pay for their health care to try and save $10 or $20 million that year during that difficult time period. And the managers decided not to pass along that cost to the employees saying that they didn't want to add an additional burden to them during those tough times. So there's a lot here in the book in relation to treating employees, but I think another item that I wanted to mention here is to see how management reacts when times are tough.

Starting point is 00:59:53 If management gets record high salaries and bonuses while they're doing layoffs, that's probably not a good sign. Or think about how they do layoffs. Is it sort of a last resort thing or is it something they commonly do. So Old Dominion, for example, they do their best not to let go their truckers and they really treat their employees really well. They have a really great training program for their drivers. They would rather take that short-term hit on the bottom line than let people go and put that strong culture at risk that they have in place that is really a strong competitive advantage for them. Questions related to this that you could add to your checklist include, does the business have a strong culture? Does the business have identifiable and shared values?

Starting point is 01:00:34 And what is the employee retention rate? The next major checklist item here is management disciplined in making capital allocation decisions. So you'll want to consider how management has allocated capital in the past and how is it allocating that capital today that is being generated in the business. So there are five things that management can do with the capital generated. They can reinvest back into the business. They can hold cash on the balance sheet, pay dividends, repurchase their own stock, or go out and make an acquisition. It's difficult to find managers who are not only good at operating the business, but also good at allocating capital and finding the best use of that capital.

Starting point is 01:01:11 The reason this is so hard to find is that these are two totally different skill sets, and being proficient at one doesn't necessarily mean that they'll be proficient in the other. Sharon writes here, the best way to determine if managers are good at allocating capital is to review their historical decisions, whether they're buying back stock or making new investments, you can identify a good capital allocator by looking for examples where they're disciplined, end quote. Another item I like to look for is how they think about and handle share buybacks. So many companies just do their buybacks each year really with no consideration of the stock price they're paying for those buybacks. What I really like to see is when companies are really opportunistic in their share buybacks.

Starting point is 01:01:53 Since markets are oftentimes efficient, usually shares in most businesses are fully priced, but occasionally from time to time, the market throws a fit and pushes the share price down too far. So this is what happened in 2022 for many companies as the broader market fell. And Old Dominion pointing to them again, they significantly increased their level of share buybacks. So when I look back at 2021, they repurchased $500 million in shares. But in 2022, they up that all the way to nearly $1.3 billion. And since the 2022 lows, the stock is up over 60%, which tells me that there's a pretty good chance these share re purchases were very likely to be value accretive to existing shareholders.

Starting point is 01:02:34 Then there's one more chapter here I'll cover for management on judging their character. So great managers are passionate about their operating business. They act with an honesty and integrity. They don't fudge the accounting numbers and they have the humility to acknowledge when they've made a mistake. So the best predictor of future behavior is past behavior so he can look for patterns in behavior in judging the character of management. I'm reminded when I had Sri Viswanathan on the show, he mentioned how the further back he can look in a business's history and a management and how they've operated, the more

Starting point is 01:03:07 confidence he can put in what the future might look like. Buffett was once asked how he determines which managers to partner with, to which he responded. The biggest question I ask myself is, do they love the money or do they love the business? So the best in any field will tell you that passion is a necessary ingredient for long-term success. Building a successful company is typically a very slow and boring process. Without that passion, these managers just likely wouldn't make it. Shurance states that you can identify passion by answering the following six questions. Is the business a career or just a job for the manager?

Starting point is 01:03:44 Would the CEO refuse to sell the business no matter the price? Is the manager interested in money or motivated by money? Does the manager focus on media appearances instead of the business? What type of philanthropic endeavors is the manager involved in? And are the manager's lifelong learners who focus on continuous improvement? I think really you want to listen to what managers have to say and then try and figure out if their actions are aligning with what they're saying. I like to look for these sort of soft, more subtle cues to get a sense of who someone is.

Starting point is 01:04:16 for example, Warren Buffett lives in the house he bought in 1962 and he takes a salary of $100,000. He's clearly not running Berkshire to just become rich for himself. It's the same thing with Mark Leonard. He's now an extremely wealthy guy and he wrote to shareholders that he'll finally be flying first class for all these years, but he'll be paying for that himself. When management travels, you can look at if they fly first class or they're staying in luxurious hotels on the company's dime or do they do non-business travel on their own dime and stay at modest hotels.

Starting point is 01:04:47 There's a saying that how a person does one thing is how a person does everything. So you can look for sort of these little things to how they live their life. To Shurons point on continuous improvement, it can be tempting in business to see what competitors are doing and try and shift your focus based on what they're doing. Looking at competitors is important, but I believe what's more important is focusing on what you can control, trying to gradually improve over time. Michael Bloomberg once said, We've got to improve just to stay even.

Starting point is 01:05:17 Each of us at Bloomberg has to enhance their skills. Every element of all our products must be improved. Most companies never upgrade until they're forced to do so, end quote. The last point I'll mention here on management is, are they self-promotional? Shurn writes, you need to be careful about investing in businesses run by CEOs who are self-promoting or those with larger-than-life personalities. These are CEOs who are often popularized in the media and consistently show up on business magazine covers because they're announcing headline-grabbing growth projections or transformational news.

Starting point is 01:05:52 These CEOs make themselves the brand rather than the business, end quote. I personally like to see managers with a long history of good performance, and you just like to see managers who really aren't promotional at all. If managers are keen on promoting themselves, then I think that can show that they potentially have a big ego, although there are always exceptions of promotional CEOs who are actually good managers. This is just one consideration amongst many, many factors. I also like to follow the line of thinking that great managers should let the strong operating performance do the talking, and they're eventually going to get the shareholder base that they deserve. They don't have to go

Starting point is 01:06:30 out and self-promote all this time. I think they're going to attract the right shareholder base. All right, so the last chapter I'll be covering today is on evaluating growth opportunities. So I'm also big on investing in companies with a lot of potential to reinvest and potential to grow the business over a long time horizon. It's important to understand the company's growth opportunities ahead, as well as the risks that might be associated with pursuing a high level of growth because you typically have to pay a premium with these great companies with a lot of potential. And if you're wrong about the growth, then you can really get hammered on a near investment.

Starting point is 01:07:04 The first checklist item here is considering how a company grows. Most companies grow organically by reinvesting in their existing business units, but some companies, like Serial Acquires, for example, they primarily grow through acquisitions. This checklist item is pretty self-explanatory. There are line items in the accounting statements for things like acquisitions. Then you can look at items like R&D, CAPEX. You can even look at marketing expenses to see how much they're allocating capital there. The second item here is what is management's motivation to grow? Some managers just want growth for the sake of growth, but not all growth is created equal and not all growth is worth pursuing. Managers should be cautious in expanding to lines of business that are outside their core

Starting point is 01:07:49 competencies, which increases the chances that they're going to make mistakes. Third here, you'll want to consider whether historical growth has been profitable and if that level of profitability is going to continue. Oftentimes, companies grow and it fails to translate to higher profits. So during the tech bubble, for example, there were countless companies that grew, grew, grew rapidly, but it wasn't profitable growth. One thing you can do is assess the company's KPIs. So how have those KPIs changed over time and then ensure that profit margins have remained at least steady in light of a company's growth. Fourth, we have the future prospects for the business in the MD&A section in the 10K management often discusses the growth opportunities ahead for a business.

Starting point is 01:08:33 Projecting what future growth will look like is really very difficult, and we should be careful in assuming that future growth is going to look just like the past. You'll want to understand the source of a company's growth. Are they stealing market share from others? Which players are they stealing market shares from? Or are they solely benefiting from the growth of the overall industry? Or maybe even they're growing by expanding into new segments. It's certainly nice to have a secular tailwind at your back.

Starting point is 01:08:58 For example, Amazon has benefited massively from people shifting from physical brick and mortar stores to shopping online. So since Amazon's a leader in e-commerce, they're a really big beneficiary of that secular trend. A lot of companies grow with increased levels of research and development and continually innovating. This can be tricky when looking at, say, a tech company like Nvidia and determining how profitable these investments are going to be. So for me, the more predictable the future growth rates, future return on invested capital, the better I am off as an investor as I'm able to forecast what earnings are going to be three to five years from now with some degree of confidence. So in terms of the total addressable market and looking at market share numbers, some companies

Starting point is 01:09:42 actually disclose these amounts, but you'll want to try and verify the numbers for yourself and not take what the company says at face value. So I own a company out of Sweden called Evolution A-B. My co-host, Kyle Agreeve and I covered it back on episode 604. So in Evolution AB's annual report, I love how they have this stated goal of growing faster than their competition. So I sort of see this as two tailwinds playing out at once. So I see the market they operate in is growing quite fast, which is live casino.

Starting point is 01:10:11 And they not only want to grow with the market, but they also want to steal share from their competitors. So they're seeing, how fast is the market growing? How fast are we growing? So if they're higher, then they're achieving their goal. So when I look at 2023, they estimated that the total online casino market grew by 15%. And then evolution grew by 23%. They also share numbers on the total casino market and the trends that are happening in the space,

Starting point is 01:10:36 which is something else I also like. I feel like I get a sense that they want to actually inform their shareholders on what the business is, what markets they operate in, and how they sort of fit into the big picture. So the last checkpoint item here is, is the management team growing the business too quickly or at a steady pace? So generally high growth is really, really tough to do for a sustained period of time. Morgan Housel shared with me on the show back on episode 602 that however fast something grows, that's the half-life in which it can be destroyed. I recall back to my episode on Nick Sleep back in late 2022.

Starting point is 01:11:12 Sleep in his letters talked about how he sort of gets deterred by really fast grow, say, higher than 20% or so, maybe even higher than 15% is what he, I can't remember the exact numbers he stated, but he was pretty cognizant of fast growth because it's really difficult to have high, high levels of growth for really long period of time. So when you look at a Costco, for example, they grew in the 10 to mid-teens rate. And I feel like he was pretty comfortable with that because they could be really strategic in their growth and be really disciplined. So like I mentioned there, very fast growth can point to a lot of discipline and they may be pursuing growth at all cost without consideration of the durability and how profitable that growth is.

Starting point is 01:11:51 Another consideration with growth is like you might have a company that grows at, say, a rate of 30% in revenues, but that might mean that they need to increase their employees at the same rate. So if you extend that out, after two and a half years, a company's doubling its employee base, which is definitely no easy task. So we really need to be cognizant of what levels of growth is reasonable and what level of growth we want to find in companies. It can be really difficult growing, say, above that 15, 20% mark. Anyway, that's all I had to cover for the book. I also wanted to briefly touch on our

Starting point is 01:12:24 TIP Mastermind community for those that might be interested, since this is the type of content in this episode that crosses over quite well with the things we're doing in the community. So for those who aren't familiar, our Mastermind community is the community we put together for portfolio managers, private investors, entrepreneurs, and high net worth individuals. It's a great place to network with like-minded value investors, get connected with TIP hosts, including Stig Broderson, Kyle Greve and myself, share stock ideas and get ideas from others, share your portfolio, attend our live events in New York City, Omaha, and London. And then we also host at least one Zoom call per week, where we socialize, do stock presentations, chat about the markets,

Starting point is 01:13:04 and we also typically do a Q&A with a podcast guest roughly once a month. So recently we brought on Chris Mayer, we've had Gottem Bade, John Huber, Toby, Carlisle, a lot of very popular guests from the show have joined us. And then my co-host, Kyle Grieve, he also does a quarterly portfolio of review and Q&A with the group, which a lot of members really enjoy as well. So if you've listened this far into the episode, then there's probably a good chance that the group is at least somewhat interesting to you, especially if you manage your portfolio full time, or at least say you manage it 10 to 20 hours a week. So our group has a lot of current fund managers or audience members who really have aspirations

Starting point is 01:13:40 to one day manage money full time. We're also nearing our live events in New York City. So those are scheduled from October 4th through the 6th. We have a couple of dinners and socials planned for the group, and around 20 or so members are registered to attend. So it's going to be really nice to be able to meet a lot of people you see on these calls in person. We did the same thing last year and had an amazing time.

Starting point is 01:14:01 A few members who are registered for the meetups are fund managers, a couple of which also put a big focus on owning really, really high-quality businesses. many of these types of companies we discuss on the show and ones I'm invested in. We also vet each member. So you know that the community is full of really high quality people and you won't be wasting your time when reviewing material or attending our events in person. We want to keep the group small. So we're capping it at 150 members. And since we're just hitting September here, we're looking to add five more members this month.

Starting point is 01:14:32 So if this is of interest to you, you can add your name to the waitlist at theinvestorspodcast.com slash mastermind. or you can also shoot me an email at clay at theinvestorspodcast.com, and I can get that application over to you. And then if you'd like to attend our live event in New York City, be sure to apply by the end of September 2024. All right, that's all we had for today's episode. I hope you picked up a few tips on how to analyze a company or enhance your own investment checklist. If you felt this episode was valuable, I'd really appreciate it if you shared it on your social media platform of choice or simply share it with just one friend. it really helps support the show and helps us provide this content to you free of charge. Thanks a lot for tuning in and I hope to see you again next week. Thank you for listening to TIP.

Starting point is 01:15:17 Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP656: Mastering Stock Selection with an Investment Checklist w/ Clay Finck

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