I recently listened to an interesting podcast interview with Bryan Lawrence, founder of Oakcliff Capital, who went into detail about his investment framework. He really impressed me with his clarity of mind and his ability to get straight to the heart of every investment topic, not to mention Oakcliff’s excellent returns.
Lawrence, who is also a friend of Guy Spier, very rarely gives interviews or speeches, so I took the opportunity to synthesize his investment principles in order to integrate them into my approach.
The filter in five questions
Lawrence’s investment framework is based on a filter of five questions. Let’s analyze them one by one.
The first question is: Do we understand this profession?
It is no coincidence that this question comes first. Let’s think about it; is it really wise to continue analyzing a company if you do not fully understand its business model? The answer to a question like how does a business make money is paramount and if the business is too difficult to understand or is too far outside the boundary of our circle of competence, we can just do what Buffett does in this case. That is, we put it in the “too hard” pile.
Understanding a company is much more than reading the business section of its latest annual report. Investors should try as much as possible to get first-hand information about it, such as talking with its customers, suppliers and executives. Analyzing its competitors is also crucial in order to understand if the company has competitive advantages and to what extent it resists their external attacks.
The second question is: Is it a big company?
Everyone wants to own a great business, but what does that really mean? For Lawrence, the definition of a great company is one that has sustainable cash flow, which is equivalent to saying a company that has strong competitive advantages.
A simple test he always performs is to ask if the company’s customers are getting (or at least perceiving) more value than they are paying for. No company in the world can maintain its dominant position if its customers feel that they could potentially get a better deal elsewhere.
An example of his portfolio that he provides is Guidewire Software Inc. (GWRE, Financial). The company, which provides software for the insurance industry, isn’t usually high on the watchlists of other big investors, but what makes it so attractive to him is the fact that most large American insurers, such as Allstate Corp. (EVERYTHING, Financial), cannot function without their products.
Its customers are unlikely to switch to a competitor anytime soon, as it would mean large costs of switching and retraining their employees on a new software product, potentially incurring frequent downtime, and so on.
Other sources of sustainability are, for example, being the low-cost supplier in a specific field (better, of course, if the low costs come from structural reasons) and being part of a duopoly or a monopoly.
The third question is: does it have a management aligned with us (the shareholders)?
Even if a company meets the first two filters, investors still need to understand whether management is shareholder-friendly. Do they have a stake in the business? Are our interests aligned with theirs?
There are, unfortunately, many examples of good companies run by competent management where minority shareholders do not have the chance to be rewarded for their investment and patience. Complicated shareholding structures, murky corporate operations, and lack of profit-sharing plans are signs that you are unlikely to participate in the success of the business.
The fourth question is: is it cheap?
For Lawrence, it’s all about cash flow. The real question is: is the projected cumulative cash flow that the company will earn in the future greater than the current capitalization?
This point probably needs no explanation, but there is clearly still a price at which even a large company with a strong competitive advantage becomes a bad investment.
The fifth and final question is: is there a temporary misconception about making it cheap?
It’s not something every investor normally worries about, but I thought it was smart. If we know that the company sells at a low price, can we also say why? It means being able to fully understand the prevailing view of the market and ask yourself, “Am I wrong or are they?”
Another important aspect of this question is timing. If we know why there is such a large price gap between the current price and the intrinsic value, we can probably also determine when the misconception, and therefore the price gap, will be eliminated (in one direction or in the other).
It comes down to asking if there is a catalyst and, more importantly, how long we have to wait to realize our returns. Indeed, what really matters is not the absolute return, but the internal rate of return of the investment, which indicates how profitable it will be.
Finally, let’s look
warren buffet The four famous filters of (Trades, Portfolio) to see how close they are to Lawrence’s.
“Charlie and I look for companies that have a) a business we understand; b) a favorable long-term economy; c) competent and trustworthy management; and d) reasonable price,” Buffett said.
All great investors have something in common. In this case, there is a large overlap.
Lawrence’s Investment Screener is a powerful tool that can be used to screen the market to find the right investments. Its fairly concentrated portfolio (consisting of just 10 stocks) speaks to the rigor of its “entry” rules and shows how difficult it is to find truly exceptional investments.
Above all, his questions can help force us to look at what really matters when researching a business and ignore information that has too short a shelf life.