Due Diligence: How One Great Money-Manager Finds His Ideas

If you want to learn how to become a great investor, study those who have excelled at it. This seems obvious advice, but you'd be surprised how often it is ignored. The number of investment advisors who haven't beaten a benchmark index throughout their careers, yet still pitch investment advice, is mind-boggling.

Last week I sat down with Philip Tasho of TAMRO Capital Partners, a money manager whose funds have easily outperformed their benchmarks over the last decade. I asked him a simple question: How do you find your investment ideas? Here's what he had to say (transcript follows):

Morgan Housel: Can you talk about your due diligence process? How do you go from learning about a company first to the time that you actually buy it?

Philip Tasho: At TAMRO Capital Partners, it's a five-step process. We start with a screening component, because there are so many companies out there, particularly in the small-cap universe. So we screen based on factors which balance the growth and the valuation of a security; they're basically weighted 50-50 in that regard. And we decile it ... it's one through 10. The top one or two are the best, attractive scores, and that helps narrow our universe and start the search.

And once we identify what's in that universe that's attractive, then what we do is we put it in perspective. "What's the long-term return?" And ... the next part is an industry matrix. We have 10 years of data for a particular industry that that company is part of, and then we rank it on total return for 10 years, revenue growth, earnings growth, return on invested capital, leverage issues, profitability, insider ownership, cash flow, capex growth, and operating margins -- 13 factors, so we can put it all in perspective. And as I mentioned, the cream rises to the top.

Morgan Housel: What are some specific red flags that you're looking for that would turn you off from a company during that process?

Philip Tasho: In small companies, a lot of ways that they have grown is making acquisitions, trying to consolidate that niche. If we don't see a follow-through in terms of capex to integrate those companies, they tend to have a relatively low return on invested capital because they're constantly spending money; they're not spending money to integrate it and raise profitability. So you run the risk that, if the acquisitions slow or stop, the profitability is just going to start to plummet. So we're very particular about how companies are funding their growth through capex. 

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