Matt Franz : Zealous For Knowledge

A Simple Investment Checklist

You have to be like a man standing with a spear next to a stream. Most of the time he’s doing nothing. When a fat juicy salmon swims by, the man spears it. Then he goes back to doing nothing. It may be six months before the next salmon goes by.

Charlie Munger

This is my favorite investing quote. It demonstrates how investing requires both patience and aggression. Of these, patience tends to be more difficult. If you spear every plump salmon you see, you’ll have no room for the fat one when it swims by.

Phenomenal track records are made by waiting for phenomenal investments and doing nothing in the interim. What does a phenomenal business look like? It has:

  1. Untapped pricing power.
  2. Anti-fragile capital structure.
  3. Management with skin in the game.
  4. A price which affords a margin of safety.

A stock with all four is a phenomenal investment. You should put a significant part of your net worth into these.

A stock that meets three criteria is still good, but not phenomenal. You should pass. If you always buy good investments, you won’t have capital left for the phenomenal ones.

Let’s look closer at the criteria, one by one.

1. Untapped Pricing Power

The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.

Warren Buffett

There are two types of pricing power. The first is the ability to raise prices above inflation without sacrificing volume. This type of pricing power is akin to having an infinite ROI. More money comes in without any capital going out. Examples? Disney theme parks and See’s Candy.

I consider businesses like Visa and Moody’s to have weaker forms of this type of pricing power. They charge a percent of transaction value, which naturally inflates over time, but have near zero marginal costs.

The second type of pricing power is the ability to lower prices below the competition’s cost of production without sacrificing your own profitability. This creates a positive feedback loop. Lower prices attract more customers which produces economies of scale and allows even lower prices. Costco, Amazon, and GEICO are masters of this.

2. Anti-fragile Capital Structure

The way to get rich is to keep ten million in your checking account in case a good deal comes along.

Charlie Munger

A fragile company will go bust during a downturn. A robust company will weather the storm intact. An antifragile company will emerge stronger. Berkshire Hathway is a perfect example because it currently has over $100 billion of cash. If the stock market collapses Berkshire will be able to deploy huge amounts of capital at attractive rates of return. This will massively increase its earnings power.

You’ll sleep well owning antifragile businesses, especially during recessions.

3. Management With Skin In The Game

Show me the incentive and I will show you the outcome.

Charlie Munger

A manager has skin in the game when a significant part of their net worth is in the stock. This way their incentives mirror your interests. These managers tend to use less debt, minimize expenses (since it’s their money too), and think longer term. Horizon Kinetics found that these businesses outperform the market. A good example today is Mark Zuckerberg, whose salary from Facebook is $1.

4. A Price Which Affords A Margin Of Safety

The purpose of a margin of safety is to ensure that you don’t lose money, even when you’re wrong.

The first three criteria all focus on the quality of the business. But investing is not as simple as choosing to buy the best businesses. Every business is undervalued at a certain price and overvalued at another.

A business which meets the first three criteria is well above average. But if you pay an above-average price and it turns out that the business isn’t all that you expected, you’re going to lose a lot of money.

If, instead, you pay a below-average price for what you think is a phenomenal business, you have room to be wrong. Worst case, it will turn out that you paid a fair price for a below-average business. Best case, you got a wonderful business for a steal.

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