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The Investment Checklist: The Art of In-Depth Research



"Every wise investor will keep The Investment Checklist next to their financial instrument panel and consult it whenever they make a decision to buy or sell a stock."—Robert P. Miles, author, The Warren Buffett CEO

"Michael Shearn has written an indispensable book. It will raise the game of every investor who reads it. Fortunately, not all of them will." —Judd Kahn, co-author, Competition Demystified and Value Investing: From Graham to Buffett and Beyond

When you base your stock purchase decisions on isolated facts and don't take the time to thoroughly understand the businesses you're buying, costly investment mistakes are usually made. Instead, your investment purchases should be based on understanding the value of a business through in-depth research.

That's why Michael Shearn—founder of Time Value of Money, LP and the Compound Money Fund, LP—has created The Investment Checklist. In it, he shares the successful approach he's used over the past decade to generate and research investment ideas, assess the quality of a business and its management team, and ultimately improve his overall investment performance.

Along the way, you'll be introduced to specific "checklists" that will enhance your ability to understand the dynamics of the business you're interested in and the people operating it, value the potential investment, and make the most informed buy or sell decision possible. Each chapter also contains countless examples that show you exactly how the author's checklist has helped him make the right investment moves over the course of his successful professional career.

Whether you're just starting out and thinking about what you want to invest in, or already have a portfolio that you want to manage more effectively, The Investment Checklist has the tools and insights you need to improve your investment endeavors.

Michael Shearn founded Time Value of Money, LP, a private investment firm, in 1996, to devote his attention to selecting and researching stocks and private investments. He launched the Compound Money Fund, LP, a concentrated value fund, in 2007. Shearn serves on the Investment Committee of Southwestern University, which oversees the school's $250 million endowment. He is also a member of the Advisory Board for the University of Texas MBA Investment Fund. Shearn graduated magna cum laude from Southwestern University, a small liberal arts college in Georgetown, Texas, with a BA in business, with an emphasis in accounting and finance. He lives with his wife and two daughters in Austin, Texas.

Preface xi

Acknowledgments xix

Chapter 1 How to Generate Investment Ideas 1

How Investment Opportunities Are Created 1

How to Filter Your Investment Ideas 14

Using a Spreadsheet to Track Potential and Existing Holdings 19

Chapter 2 Understanding the Business—The Basics 21

1. Do I want to spend a lot of time learning about this business? 22

2. How would you evaluate this business if you were to become its CEO? 23

3. Can you describe how the business operates, in your own words? 26

4. How does the business make money? 28

5. How has the business evolved over time? 29

6. In what foreign markets does the business operate, and what are the risks of operating in these countries? 30

Chapter 3 Understanding the Business—from the Customer Perspective 39

7. Who is the core customer of the business? 41

8. Is the customer base concentrated or diversified? 42

9. Is it easy or diffi cult to convince customers to buy the products or services? 43

10. What is the customer retention rate for the business? 44

11. What are the signs a business is customer oriented? 46

12. What pain does the business alleviate for the customer? 49

13. To What degree is the customer dependent on the products or services from the business? 49

14. If the business disappeared tomorrow, what impact would this have on the customer base? 50

Chapter 4 Evaluating the Strengths and Weaknesses of a Business and Industry 53

15. Does the business have a sustainable competitive advantage and what is its source? 54

16. Does the business possess the ability to raise prices without losing customers? 68

17. Does the business operate in a good or bad industry? 73

18. How has the industry evolved over time? 77

19. What is the competitive landscape, and how intense is the competition? 79

20. What type of relationship does the business have with its suppliers? 89

Chapter 5 Measuring the Operating and Financial Health of the Business 97

21. What are the fundamentals of the business? 98

22. What are the operating metrics of the business that you need to monitor? 100

23. What are the key risks the business faces? 105

24. How does infl ation affect the business? 111

25. Is the business’s balance sheet strong or weak? 113

26. What is the return on invested capital for the business? 123

Chapter 6 Evaluating the Distribution of Earnings (Cash Flows) 137

27. Are the accounting standards that management uses conservative or liberal? 138

28. Does the business generate revenues that are recurring or from one- off transactions? 146

29. To what degree is the business cyclical, countercyclical, or recession-resistant? 148

30. To what degree does operating leverage impact the earnings of the business? 152

31. How does working capital impact the cash fl ows of the business? 162

32. Does the business have high or low capital-expenditure requirements? 167

Chapter 7 Assessing the Quality of Management—Background and Classification: Who Are They? 173

33. What type of manager is leading the company? 176

34. What are the effects on the business of bringing in outside management? 180

35. Is the manager a lion or a hyena? 183

36. How did the manager rise to lead the business? 186

37. How are senior managers compensated, and how did they gain their ownership interest? 192

38. Have the managers been buying or selling the stock? 202

Chapter 8 Assessing the Quality of Management—Competence: How Management Operates the Business 209

39. Does the CEO manage the business to benefi t all stakeholders? 210

40. Does the management team improve its operations day- to- day or does it use a strategic plan to conduct its business? 213

41. Do the CEO and CFO issue guidance regarding earnings? 219

42. Is the business managed in a centralized or decentralized way? 222

43. Does management value its employees? 225

44. Does the management team know how to hire well? 239

45. Does the management team focus on cutting unnecessary costs? 247

46. Are the CEO and CFO disciplined in making capital allocation decisions? 248

47. Do the CEO and CFO buy back stock opportunistically? 250

Chapter 9 Assessing the Quality of Management—Positive and Negative Traits 255

48. Does the CEO love the money or the business? 256

49. Can you identify a moment of integrity for the manager? 264

50. Are managers clear and consistent in their communications and actions with stakeholders? 268

51. Does management think independently and remain unswayed by what others in their industry are doing? 275

52. Is the CEO self-promoting? 276

Chapter 10 Evaluating Growth Opportunities 281

53. Does the business grow through mergers and acquisitions, or does it grow organically? 281

54. What is the management team’s motivation to grow the business? 282

55. Has historical growth been profi table and will it continue? 283

56. What are the future growth prospects for the business? 284

57. Is the management team growing the business too quickly or at a steady pace? 296

Chapter 11 Evaluating Mergers & Acquisitions 305

58. How does management make M&A decisions? 305

59. Have past acquisitions been successful? 310

Appendix A Building a Human Intelligence Network 323

Evaluating Information Sources 324

How to Locate Human Sources 324

How to Contact Human Sources—and Get the Information You Want 328

Create a Database of Your Interviews for Future Reference 329

Appendix B How to Interview the Management Team 331

Ask Open- Ended Questions 332

Be Aware of the Danger of Face- to- Face Assessments of Managers 333

Appendix C Your Investment Checklist 335

Notes 339

About the Author 351

Index 353