FOOL ON THE HILL
Three Steps to Evaluating Stocks

A disciplined approach to evaluating stocks is especially important today given the market's recent turmoil. In this article, Whitney Tilson shares his own three-step process: identifying his circle of competence and eliminating companies that fall outside it, running the numbers, and looking into such "soft stuff" as a company's management, culture, and sustainable competitive advantage.

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By Whitney Tilson
September 25, 2001

I'd like to add one more trait to my list of personal characteristics and professional habits I believe can be found in successful investors, and it's one I believe is more critical now than ever given the market's recent turmoil: a disciplined approach to evaluating stocks.

Investors typically encounter many investment ideas each week from reading business publications, using stock screens, talking to other investors, and so forth. Analyzing these ideas quickly and accurately is critical to success in stock picking. My approach, no doubt only one among many that can work, is a three-step process.

Circle of competence
Berkshire Hathaway's
(NYSE: BRK.A) Charlie Munger, who along with Warren Buffett has formed one of the great investing teams of our time, once said: "The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much."  What simple -- yet widely ignored -- advice!

Defining your circle of competence, however, is easier said than done. I'm not sure I can succinctly define mine, for example, though I think I have a good understanding of it. I feel to some extent like the late Supreme Court Justice Potter Stewart who admitted he could not formulate a coherent standard for obscenity but wrote, "I know it when I see it."

I'm sure most investors believe that they know and stay within their circle of competence, but I really wonder what percentage of investors in such companies as Cisco (Nasdaq: CSCO), Juniper (Nasdaq: JNPR), and JDS Uniphase (Nasdaq: JDSU) really understand these companies' technologies, products and competitors. 

This isn't to say all tech stocks are outside the circle of competence of average investors, however.  I don't consider myself a technology expert, but have gotten comfortable enough to own the stocks of certain companies whose businesses I think are reasonably easy to understand, such as Lexmark (NYSE: LXK), Dell (Nasdaq: DELL), and American Power Conversion (Nasdaq: APCC). (I only own the former at this time.)

I'll let Warren Buffett have the last word on this topic (from the 1998 Berkshire Hathaway annual meeting):

"I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th, or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that's a seven- or eight-foot bar that I can't clear. There are people who can, but I can't.

"The fact that there'll be a lot of money made by somebody doesn't bother me really. There's going to be a lot of money made by somebody in cocoa beans. But I don't know anything about 'em. There are a whole lot of areas I don't know anything about. So more power to 'em.

"I think it would be a very valid criticism if it were possible that Charlie [Munger] and I, by spending a year working on it, could become well enough informed so that our judgment would be better than other people's. But that wouldn't happen. And no matter how hard I might train, I still couldn't. Therefore, it's better for us to swing at pitches [that are easy for us]."

As I concluded in a March 2000 article, "Different people understand different businesses. The important thing is to know which ones you do understand and when you're operating within your circle of competence...Understanding it -- and not straying beyond it -- is one of the most critical elements of successful investing."

Run the numbers
Once I determine that a company is within my circle of competence, I go to the financial statements to answer two questions: Is this a good business, and is the stock cheap? Regarding the former, the most important things I'm looking for are high margins and returns on capital, a strong balance sheet, modest capital requirements, healthy free cash flow, solid historical growth, and ample room for future growth. 

As for valuation, I begin -- though certainly don't end -- with the following rule of thumb: Pay no more than 10 times earnings for a decent business, and no more than 20 times earnings for even the greatest business.  Given that both the Dow and the S&P 500 are still trading at more than 20x this year's expected earnings, this eliminates an awful lot of stocks. 

The "soft stuff"
By this point, I've discarded at least 95% of investment ideas and can focus my attention on really understanding a company, the hardest -- and most critical -- step.

Sustainable competitive advantage
The single most important thing I care about is a company's competitive advantage and whether it's sustainable. Buffett agrees. In his November 1999 Fortune interview (subscription needed), he said what I believe to be among the wisest words ever said on investing:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

So how can you determine whether a company has a wide moat around its business, and whether that moat can be sustained or expanded? I've written extensively on this question, so rather than repeating myself, I will refer you to three past columns. In short, however, investors should look for companies with characteristics that will allow them to keep competitors at bay and reap increasing profits as a result. (Among my favorite examples are Coca-Cola's (NYSE: KO) brand and Microsoft's (Nasdaq: MSFT) control of the operating system.)

Management
Buffett once said, "A good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row... When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." 

No doubt this is true, but evaluating management is still a critical part of any investment analysis. What should you look for? As I wrote in a recent column:

"I'm looking for ability and integrity. Both are equally important. The former is pretty straightforward: Is the management team capable and well-respected, and does it have a track record of success?  Integrity is harder to gauge, but here are some of the questions I ask: Do managers underpromise and overdeliver? Are they frank in admitting mistakes? Do they appear to be focused on promoting the stock to satisfy the short-term whims of Wall Street, or on building long-term value for shareholders?"

The only thing I would add is that "a track record of success" means both generating strong cash flows and allocating them sensibly. The former is common, while the latter is rarer, as evidenced by the excessive compensation and ill-conceived acquisitions that pervade corporate America. (For more on evaluating management, revisit The Motley Fool's in-depth special feature on the topic.)

Finally, I investigate a company's culture. At firms with strong cultures, employees care about the company, each other, and customers. They share information and cooperate. They feel good about their jobs and are willing to go the extra mile. This can provide a meaningful competitive edge.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway and Lexmark at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/