Some of you may wonder how I choose new companies. After all, there are over 8000 public companies out there. Here is what I look for:
1: It must be a business I can understand.
2: There must be a competitive advantage, ideally best in class, addressing an unmet need.
3: Management, must have integrity and talent. Great companies, and great products can easily fail with poor management. With most of my investments, I spend a lot of time meeting with and talking to management, and invest in companies where I have tremendous faith in management.
4: The share price must be significantly undervalued. A great company is not a good investment at any price, only a discounted price.
5: The business must be capable of ramping up production rapidly. For example, a steel mill has a limited production capacity, which cannot be ramped up quickly. A software company on the other hand, can produce another 200 million copies at little cost and very quickly. This aspect creates the possibilitie of a 10X return.
95% of the companies I look at do not get through this filter. The ones that do, often perform well, but not always. They require constant monitoring and communication with management, and a total understanding of the products and business.
Even in dealing with the best management, there is still a tendency for them to put a positive spin on everything. I am constantly looking for what could go wrong, and challenging management to prove to me that they are dealing with their business obstacles effectively.
Another aspect of my strategy is to focus intensely on a couple of promising companies. Many investors will be involved in one or two dozen companies, the goal being diversification. The problem for me is that when I try to investigate more than a couple of companies, I cannot perform sufficient due diligence on all of them. It becomes in part a game of luck. If I'm lucky, they won't do anything stupid. By focusing on one or two companies, and by thoroughly understanding their management, products, and strategies, I can often recognize problems and opportunities before they become public. By forming a strong relationship with management, I am given a significant advantage in terms of understanding what's going on within the company, and how that will play out.
Occasionally, a situation arises where some of my requirements are not met, but the price is so compelling, it warrants a purchase. Flexibility is key.
If you look at the most successful hedge fund managers, you will find a wide variety of investment approaches. Each of these approaches works, because each manager is working within his own realm of expertise and interest. One of my favorite books which paints a very clear picture of the different hedge fund strategies is: More Money Than God. If you want to understand the thought processes and techniques used by the best and the brightest, read this book. Ultimately it's up to you to find an investment strategy that fits your personality, gives you a sufficient margin of safety, and performs well over time.