No. of Recommendations: 34
Hey Fools,

<<<<WARNING -- LONG POST>>>>>>

I've spent a lot of time over the last few months developing my homegrown investment checklist. The goal of this project was to rank all of the stocks that I following (Fool recs and non-Fool recs alike) using criteria that I feel is most important for determining business quality.

Why bother with this arduous process at all? My mission is simple:To fill my portfolio with the highest quality companies that I can find and hold them ‘forever’. However, given the vast number of companies that I follow, it is impossible for me to pick my favorites from memory. Thus, I figured that developing a systematic checklist would be greatly beneficial for helping me to sort through the noise and focus on what matters most.

I would declare Version 1.0 of my checklist to be a big success. I wound up ranking about 250+ companies and posted their individual scores on about 80+ boards across the Fool. I think that going through this process was eye-opening as it brought companies that I would have otherwise missed to the forefront of my attention (PAYC, APPF, MASI) while it ranked others that I previously loved very low (SSW, UA, IMAX). I'm confident that I would be richer today had I incorporated this criterion sooner into my investing process.

As hoped, I received A LOT of great feedback from the community about the pros and cons of the checklist. I made a number of small changes in the pursuing weeks after the project started but, for consistency sake, I largely kept the list intact.

However, the more I thought about it, the more I realized there were some flaws in Version 1.0 Thus, I’ve been working on a more robust checklist in the background.

Today, I think it is finally ready to be unveiled.

Overall, I think that the changes that I've made will make it much more useful for determining businesses quality. I am also laying out more details about how to score a company so that others can follow along at home if they choose.

Before I share the change with you, I want to highlight what I’m looking for in an ideal stock:

Here are the characteristics that I find most appealing:

+A wide and expanding moat
+Lots of organic growth potential
+A high gross margin
+A strong balance sheet
+Good returns on capital
+Growing free cash flow and earnings
+Pricing power
+Multiple futures/lots of optionality
+A management team that cares deeply about company’s mission and long-term health of the business
+High levels of inside ownership
+A great place to work
+Customer acquisition primarily occurs through word of mouth
+Lots of recurring revenue
+Operating leverage that is about to kick in
+Strong past price appreciation (Winners keep on winning)

At the same time, I want to avoid owning companies with the following characteristics:

+No moat, or a weak moat that is under attack
+Heavy customer concentration
+Losing money now and expected to do so for years to come
+Operates in an industry that is actively being disrupted
+Success depends on factors that are outside of the company’s control
?+Extreme levels of stock-based compensation
+Companies that have historically underperformed the S&P 500 by a wide margin
+Companies that exclusively rely on acquisitions for growth
+A binary decision ahead that could ruin the investing thesis

Creating a system that accounts for all of these factors (and weighs them appropriately) has been very challenging to create. I’ve borrowed heavily from many other systems that you are likely familiar with (many thanks to MF Pro, David Gardner, Saul, Brian Stoffel, and many others for letting me borrow from your ideas).

I’ve played around with several different formats to get the formula just right. After a lot of trial and error, I'm quite happy with the setup that I have settled on.

Overall, this is a two-step process. Companies can only earn points in step one and can only lose them in step two.

Here's how it works:

First, I’ve broken down my criteria into 7 broad categories. I’ve assigned each category a number of points with the end goal of having a
Perfect" company earning exactly 100 points.

I had to play around with the numbers A LOT to hit that 100 on the nose, but that’s a constraint that I like since it forces me to make hard choices. Having a maximum score of exactly 100 is something that I find very appealing.

After a lot of tweaking, here’s how the point ranking shook out:

Financials (17)
Moat (20)
Potential (18)
Customers (10)
Company-specific factors (10)
Management and culture (14)
Stock (11)

Maximum Score In Step 1: 100

Step two is to put the company through something that I’m calling (for now) referring to as “The Gauntlet.” This is a thesis-busting checklist that deducts points (potentially a lot of points) for big red flags.

Can you think of a better name? I'm open to suggestions!

The Gauntlet.

Customer Concentration
Industry disruption
Outside factors necessary for success
Big stock market loser
Binary event ahead
Extreme dilution
Growth by acquisition
Complicated Financial statements
Antitrust concerns
Foreign Headquarters
Currency risk

The most you could possibly lose in the Gauntlet is -44 points.

Thus, the best score possible is a 100. The worst score possible is a -44.

OK, so here’s what all of that looks like together, with the details of how they will be scored.

As you can tell, there is still a lot of room for judgment, so I still expect that if two people rank the same stock that the will come away with different scores.

Financials:

Financial Resilience: Basically, I want a company with a strong balance sheet that could easily survive (and thrive) in an industry downturn. However, some businesses naturally rely on debt (REITs) and could still be very resilient. This is a big change from my former method of just looking at cash/debt. Score is from 0 (Super fragile) to 5 (A fortress). Maximum score - 5

Gross margin: A high gross margin signifies that a business creates a tremendous amount of value for its customers. If it is growing then it can be a sign that the company has pricing power. A high gross margin creates a lot of room for management to care for all stakeholders at the same time and still earn good profits. Below 50% = 0. 50% to 80% = 1 or 2. Above 80% = 3. Max score - 3.

Return on equity: - I want companies that create value as they grow, not destroy it. A decent proxy (but far from perfect) is return on equity > cost of capital. ROE below 10% is a 0. 10% to 20% is a 1 or 2. Above 20% is a 3. I will make a small adjustment upward if a business produces a tremendous amount of cash flow but not earnings. Maximum points - 3.

Free cash flow: I want to reward companies that are free cash flow positive and growing. Negative FCF = automatic 0. Positive but stable and/or fluctuating FCF = 1 or a 2. Positive and growing rapidly = 3. Maximum points - 3.

Earning per share: I want to reward companies that are posting positive EPS. GAAP is preferable, but I’ll also take Non-GAAP EPS. Negative EPS = 0. Positive but stable or growing slowly is a 1 or 2. Positive and growing rapidly (above 15%) = 3. Maximum points - 3.

Moat:

This is the trickiest category of all to score. Moats come in many different forms and ranking them is hard. This isn’t perfect by a long shot, but I think the key question to ask is this:

“Aside from money, what is preventing others from successfully competing against this company?”

The best answers that I’ve seen thus far are:

Network effect: A strong network effect is an incredible competitive advantage. As long as it is a true network effect (like Facebook) and not a faker network effect (like Western Union) it is very powerful. Score range is 0 to 15. Max score - 15 points.

Switching costs: If it would be incredibly painful in terms of time, cost, money, or training to stop using a product/service then I’ll award the full 15 points. Less if it would be painful but not as disruptive. Score range is 0 to 15. Max score - 15.

Durable cost advantage: Having some durable cost advantage over rivals/new entrants (extreme scale, a physical location, vertical integration, effective distribution). Score range is 0 to 15. Max score - 15.

Intangibles:A premium brand (but ONLY IF the brand name causes consumers to pay more). A long-lived patent (Celgene) or government license of some kind (Moody’s). Max score is 15.

Please note that if a business contains more than one of these competitive advantages (like Berkshire) then it can earn a 15.

Moat direction: I want to see some evidence that the moat is widening or at least stable. More services/products/scale/customers/patents are all acceptable ways to widen a moat. Weakening moats get 0. Stable = 2 or 3. Widening = 5 Max score - 5.

Potential:

Optionality:
I want companies that have multiple futures and expand to new markets. This can create a ton of value for shareholders over time (See Apple, Tesla, Netflix, Disney) No optionality that I can see = 0 points. Some optionality within their current industry = 3 points or 5 points. The potential (or recent history) for the company to enter a whole new business that is unrelated to where they currently do not operate = 7 points. (Examples include Amazon with AWS or Tesla with Powerwall). Max score - 7.

Organic growth runway: I want to own businesses with lots of room for organic growth expansion. Ideally, they would have already captured 1% of their estimated market size. If they already own the market (like Apple does with iPhone) then organic revenue growth potential = GDP or less, so they score 0 points. 2x or 3x GDP = 2, 3, or 4 points. 15%+ organic revenue growth potential for years to come up = 4 points. Max score - 4.

Top dog and first mover in important, emerging industry and/or industry disruptor: Company gets points for meeting some and/or all of this criteria. Max points - 3.

Operating leverage ahead: I want to own businesses that are scaling. 0 points if still producing a net loss. 1 point if net loss but showing clear signs of operating leverage. A 4 is a business that is already expanding operating margins and can do so for a few more years. Max score - 4.

Customers:

Acquisition: I want companies that gain customers easily without needing to advertise or spend big on marketing. Word of mouth customer acquisition is key today, especially given the proliferation of social media. Companies that have to spend big to acquire a single new customer are not nearly as ideal as a one that has such good product/market fit that they come without much effort. Please note that "Customer" = the person who PAYS FOR THE PRODUCT/SERVICE. Facebook users are not customers, though I'll award partial credit for a growing network like that. Facebook advertisers are the real customers. Max score - 5.

Dependence: I want to own companies with products/services that are in demand in good times and bad. If sales will fall drastically during a recession then 0 points. A modest fall, stable, or modest growth during tough times = 2 to 4 points. A truly recession-proof business = 5 points. Max score - 5.

Company-specific factors:

Recurring revenue:
I want to own companies with lots of recurring revenue. Examples include razor/blade, consumables, transactional businesses, or subscription. No recurring revenue = 0. Mostly revenue is recurring = 5. Max score - 5.

Pricing power: I want to own businesses that can raise prices at will and not lose their customers. I will also award lots credit to companies that I think could raise prices easily but may choose not to in order to capture additional market share early (Netflix, Chipotle, and Costco come to mind). No pricing power = 0. GDP = 3. Lots = 5. Max score - 5 points.

Management & Culture:
Soul in the game: I want a manager that cares more about the long-term health of the businesses than the short-term. Founders and/or family-run business environments qualify and get maximum credit. CEOs who have spent a decade or more at a company get partial credit. Brand new hired gun CEO = 0. Max score - 4.

Insider ownership: I want management team to have a significant portion of their net worth tied up in the business. For small companies, this means high levels of insider ownership. For large companies, I want to see tens of millions of dollars in stock ownership. I don’t think setting specific percentage targets is important because of the wide disparity in market caps. Tim Cook owns far less than <1% of Apple but I’d guess that 95%+ of his net worth is tied directly to Apple’s stock price. Shouldn’t that count for something? Max score - 3.

Glassdoor ratings: I want the place to be a great place to work, have a highly rated CEO, and be highly recommended to a friend. These factors will help the company with talent recruitment and retention. An ideal score is an overall rating above 4, CEO approval rating above 80%, and recommend to a friend above 80%. Partial credit given for mixed scores. Max score - 4.

Mission statement: I want to see that a business has a purpose beyond making money. It should be simple, inspirational, and clear. 0 points if “creating shareholder value” is a priority. Partial credit is given for OK mission statements. Max points - 3.

Stock:

Performance:
I’m a believer that winners keep on winning. I want to see that the stock has beaten the market over the last 5 years or at least since its IPO. Outperformance by 50% earns partial credit and by 100% earns full credit. Underperforming or matching the market is a 0 or 1. Max score - 4.

Shareholder friendly actions: Pays a rising dividend, buys back a lot of stock, or using funds to pay down debt all qualify. Max score - 3.

Consistently beats expectations: The best companies manage Wall Street’s expectations well and consistently beat them - period. This drives stock performance and multiple expansion. I’ll look at the last 4 quarters and award 1 point for each time the beat by a lot, half a point if it is a small beat, 0 points if they missed. Max score - 4.

Done with step 1!

With a score in hand, the next step is to run it through The Gauntlet. The goal here is to penalize companies that display undesirable traits that increase fragility or could prove to be thesis busting down the road.

The Gauntlet:

Customer concentration:
High customer concentration increases business fragility by a lot. If the loss of one customer could hinder growth then the business is much riskier than a company that boasts thousands of paying customers. If a single company makes up >20% of sales/accounts receivable is a -5. Few/one customer greater than 10% — even if it is a distributor — is a -4, —3, or -2. No concentration risk = 0.

The industry is being disrupted: If you are Cicso and you have an Arista taking market share left and right then its a -5. If you are at some risk of disruption it's a -3 or so (like MasterCard is with cryptocurrencies). No risk that I can see is a 0.

Outside factors: If a company’s success depends on strong commodity prices, interest rates, government spending, a strong economy, a high stock price, or any factor that is not within the company’s control its a -5, -4, or -3. Otherwise its a 0.

Big market loser: Great stocks beat the market over time. Losers seldom turn. If the stock has lost to the market by more than 100% over the last 5 years (or since IPO) its a -5. A 50% loss is a -3.

Growth by acquisition:
Companies that grow only through acquisition get a -4. If acquisitions are regularly made to bolster growth — but organic growth still exists — then it is a -2. Otherwise, it is a 0.

Binary event: Would a big legal ruling and/or government decision down the road ruin the investment thesis? (FDA rejection, patent invalidation). -5.

Extreme dilution: Stock-based compensation is a part of life….i get that. However, if the share count is rising by 5% annually from stock-based comp alone then it's a - 4. Between 3%-5% is a -2. Less than 3% annually is acceptable.

Complicated financial statements: I couldn’t understand Solar City’s financials when they were public. I struggle to understand some banks’ financial now (do you really think you understand what is going on at Wells Fargo, Citi Group, or JP Morgan?) If it is overly complicated, you get a deduction of -3. Otherwise its a 0.

Antitrust concerns: Amazon, MasterCard, Google, and Visa are so dominant that they could find themselves in regulator’s crosshairs down the road. -3 if this threat exists.

Headquarters: HQ in a developing country like China = -3. Israel = -2. Developed country but not U.S. = -1. U.S. = 0.

Currency risk: If >66% of sales are outside U.S. then it is a -2. >33% then a -1. Otherwise it is a 0.

After the gauntlet is over I’ll then have my final score.

Let’s see an example!

Starting with the previous high scorer from my old checklist; Paycom software.

Financials:
Financial resilience - 5 (Tons of cash and all debt is mortgage on new corporate HQ)
Gross margin - 3 (80%+)
ROE - 3 (43%)
FCF - 3 (Positive and growing fast)
EPS - 3 (Positive and growing fast)

Moat:
Switching costs - 15 (switching providers would be a major hassle for a customer)
Moat direction - 5 (constantly layering on new services to make product more sticky)

Potential:
Optionality - 4 (introducing new services/features)
Organic growth runway - 4 (still a small player in U.S. payroll, not to mention rest of world)
Top dog and/or industry disruptor - 1 (Not a true disruptor, but I’ll give partial credit)
Operating leverage ahead - 3

Customers:
Customer acquisition - 1 (High switching costs make it hard to bring a new customer on board)
Dependence - 5 (once on board they tend to stick with Paycom and payroll is a fixed business cost)

Company-Specific factors:
Recurring revenue - 5 (98% of revenue is recurring)
Pricing power - 4 (I doubt providers would switch solely from price increases)

Management & Culture:
Soul in the game - 4 (Founder runs the show)
Inside ownership - 3 (19% and CEO net worth is likely completely dependent on stock price)
Glassdoor - 4 (4.2 overall score, 90% CEO approval, 83% recommend to friend)
Mission statement - 1 (“providing businesses with software that automates and manages the complete employment life cycle”) - Eh.

Stock:
Stock performance - 4 (+450% since 2014 IPO, crushing the market)
Shareholder friendly - 3 (active buyback and low dilution, rare for a fast growing SaaS)
Vs. Expectations - 4 (regularly crushes expectations)

Total Score: 87

The Gauntlet:

Customer concentration?: - 0
Industry disruption?: 0
Outside Forces?: 0
Big Market Loser? 0
Binary Event: 0
Dilution?: -1 (share count +24% since IPO but stable recently due to buybacks)
Growth By Acquisition: 0
Complicated Financials?: 0
Antitrust Risk?: 0
Foreign HQ? 0
Currency risk? 0

Final score: 86 (Likely a very stellar score)

Well….now comes the grueling work of going back and re-ranking all my companies. Thankfully a lot of the categories are similar to my old checklist, so it won’t be starting from a blank slate by a long shot.

As always, feedback of all types is greatly appreciated!

Brian
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