Lean Investor Company Selection Process
Many investment professionals offer a glimpse of how they pick companies to buy. I have spent 10 years compiling a list of questions and hurdles I use to compare and choose each company in my investment portfolio.
This list has helped me to quantify my investment approach and improve my company selection process. I'm a disciplined value investor and I look for opportunities to take advantage of everywhere. Leave no stone unturned and good luck. Please send me your feedback and any other measures or metrics you use to help choose suitable investments.
I'm examining Oracle (ORCL) as an example of how I evaluate each company. By the way, Oracle is one of my top investment picks for 2013.
The Lean Investor investment approach consists of the following strategy:
1. Buy companies not stocks - evaluate the company as if you were buying the whole business as the owner. Would you buy the entire company and hold it forever?
A. I think Oracle has an outstanding business and is the industry leader in databases. They are still growing and evolving to dominate the industry. I'd love to own all of Oracle. Pass.
2. Buy when others are afraid and sell when others are excited.
A. Not entirely appropriate for examining Oracle, but I use this nugget of wisdom to remind myself not to follow the crowd. N/A
3. Invest with a 5-10 year investment horizon.
A. I'm confident that Oracle will be a great company 10 years from now like it is today. Oracle has a 10 year history of growing earnings every year. They even kept growing through the current recession and they look to keep growing for the foreseeable future. Pass
4. Don't let short-term market events affect judgment.
A. The main fear investors face with Oracle is that some technical change will suddenly make Oracle irrelevant. One recent change in Oracle's industry is a move to cloud based computing. Not surprisingly, Oracle is making the necessary changes to help lead the race to cloud computing. Pass
5. Invest only in companies you understand.
A. Oracle operates in three computing areas: computer hardware, software, and services. Oracle has been pushing to break into new areas like cloud computing and social interaction and collaboration in companies. Oracle is busy growing beyond just being a database manager for companies. Oracle is staking its future on "big data" and working to add data consulting, data applications, and middleware. Oracle has been busy growing through acquisitions. They have most recently acquired SUN Microsystems. In all, Oracle has acquired 41 companies in the last 5 years while focusing on cloud computing. Oracle makes money from selling lower margin hardware and higher margin services like software. Pass
6. Look for moats - barriers to entry give companies a competitive advantage. I really like using Morningstar Stock Investor.
Signs of a good economic moat:
- Cost advantage - No
- Intangible assets - No
- High switching costs - Oracle enjoys very high switching cost. Pass
- Network effect - Oracle has some network effect benefits going for the company.
- Efficient scale - No
7. Read the 10k filing of each company before you buy. Pay attention to:
A. Auditor Changes or Disagreements - Middle of Part II
B. Risk Factors - Middle of Part I
C. Legal Proceedings - Near risk factors
D. Consolidated Financial Statements - Near the end in the notes
E. Management's Discussion of Results - Beginning of Part II
A. Oracle has a very diverse business in the computer software and hardware industry. I have read the entire 10k on Oracle and there were no major red flags. In fact, the 10k strengthened my investment conclusion about the company given their business diversity, rising sales and earnings, and gross margins. Pass
A. ORACLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
May 31, 2012
The following table presents summary results for each of our three businesses and for the operating segments of our software and hardware systems businesses:
Year Ended May 31,
New software licenses:
Sales and distribution expenses
Software license updates and product support:
Software license update and product support expenses
Total software business:
Hardware systems products:
Hardware systems products expenses
Sales and distribution expenses
Hardware systems support:
Hardware systems support expenses
Total hardware systems business:
Total services business:
8. Try to avoid commodity businesses with little pricing power.
A. Oracle is not a commodity business and delivers high margins and high return on equity. Oracle has an established economic moat because of its high switching costs and network effect. Pass
9. Do not invest in companies that require a lot of assets or debt to operate. No capital intensive businesses, i.e.: airlines.
A. The software business isn't an asset heavy business and Oracle has minimum debt. Pass
10. Buy a good business at a fair price, not a bad business at a cheap price.
A. Oracle was selling for around $30 when I first bought and recommended the company. This, in my opinion, is a great business at a fair price. Pass
11. Return on equity greater than 15%.
A. Oracle's ROE has averaged around 31% over the past 10 years. In 2013, it's projected to be around 25%. Pass
12. Return on capital greater than 15%.
A. Oracle's ROC has averaged around 27% over the past 5 years. It's expected to be 21% in 2013. Pass
13. Margin of safety - calculate the discounted cash flow of each company and only buy if the company is selling at a 30% discount from its true value.
A. When I first recommended Oracle it was selling for around $30/share and its DCF value I calculated to be $41/share giving me the minimum of a 30% margin of safety. Pass
14. Look for high profit margin companies.
A. Oracle's net profit margin is increasing yearly and is around 34%. Pass
15. Look for companies with great management.
A. This is clearly an area I identified as Oracle having a major advantage. Larry Ellison who founded the company in 1977 is still in charge and helping to run and guide the company. Then president Mark Hurd came from Hewlett Packard (HPQ) and NCR. Hurd was forced out of HP in 2010, but his industry knowledge was immense. Oracle's management has a history of aggressive growth and they have started to pass back some of the company's value through a dividend that was initiated in 2009. Pass
16. Look at a company's cash flow and not its earnings. Cash flows are more difficult to manipulate.
A. Oracle's cash flows have been growing in lock step with their sales and earnings for the past 10 years. Cash flow has grown by 21% per year for the past 5 years. I project that cash flow will grow by 10% per year for the next 5 years. Pass
17. Dividends matter - look for companies with solid predictable earnings that pay growing dividends. I like to see at least 5-10 years of increased earnings.
A. Oracle started paying a dividend in 2009 and has been slowly and steadily raising its dividend. Oracle's dividend yield is around 1% and the company appears to payout around 10% of its yearly earnings as a dividend. Pass
18. See the forest from the trees - are you focusing on a few good points of the company or business and missing the bigger risks or problems the company faces?
A. This is a complete judgment call based on your own analysis. Given the amount of research I have done regarding Oracle I believe I am focusing on the correct things to fairly evaluate the company and its future prospects. One thing I always do after researching a company is that I wait a week or two and then revisit my analysis thesis. If I still feel the same then I will move forward. Pass
19. Evaluate each company using Porter's 5 Forces to test their staying power and competitive position in their industry.
A. Bargaining Power of Suppliers
B. Threat of New Entry
C. Rivalry Among Existing Competitors
D. Bargaining Power of Customers
E. Threat of Substitutes
A. This is one of the best areas to evaluate a company. This analysis involves many factors and threats to a company's business. Pass
20. Where will the company be in 10 years? How predictable are the company's cash flows?
A. Oracle has had very predictable cash flows over the past 10 years. Given Oracle's strong product and service business I expect that trend to continue. In 10 years I expect Oracle to maintain its strong position in the computer industry. Pass
21. What are debt levels? I like companies with little to no debt. My maximum threshold is 40% of capital.
A. Oracle has very little debt. The company has $14.7 billion in debt with about $4 billion of that due in the next 5 years. Oracle has a market valuation of $152 billion so Oracle's debt is about 10% of its market capitalization. Pass
22. When you value invest you must avoid value traps. Is the company cheap for a good reason? Is the industry eroding?
A. The computer software, hardware, business applications, and middleware markets are all growing. The industry isn't eroding. Oracle isn't a value trap. In fact, Oracle is a growing thriving company that is selling at a great price. Pass
This is just a guide that has helped me effectively evaluate each investment target. These Pass/Fail tests are just the first start in a long process. Once a company passes these tests then you must use your own objective judgment to move forward based on all of your knowledge.
As you have probably noticed I have borrowed most of my criteria from Warren Buffett and Benjamin Graham. Sound investment knowledge never goes out of style.
Disclosure: I am long ORCL.