June 3, 2020: Sharing learnings from Money Compound Fund’s 2019 Q3 Letter by Michael Shearn. Michael wrote the Investment Checklist but his investment philosophy has evolved since writing his book and this letter is an amazing checklist for analyzing culture, management and business model for compounders.

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Episode Notes:

Compound Money Fund’s 2019 Q3 letter

Michael Shearn’s 6 criteria for investing

1.Solving an important customer problem => why business exists

• Importance = meaningful to large group (not niche)

• Shopify solves back-end function for entrepreneurs vs. Square solves payment acceptance for retailers

• Ask: “What does the world look like without this product or service?” The classic, “Will they miss you if you were gone?"

• It’s the difference of a must have product vs. a nice to have product where there really aren’t much substitute options

• A truly important product doesn’t need to be “sold”. A strong reliance on marketing/advertising to psychology trick the consumer is probably not very important. Examples are Coca-Cola and Amazon’s e-commerce platform

• Word of mouth growth shows an unmet need is being solved. Look to see if there are fans. Loyal fanatics that are cults of the product/service

• Does the CEO talk about solving customer problems or selling more? Is the focus on value prop or monetization? The former is doing important work. 

• What is management’s background? In the weeds building products for customers or marketing/growth just to move needles? 

• How are sales people incentivized? Commissions vs. Salaries? Salaries allow for value prop focus compared to ‘hitting numbers'

2.Words and actions match => trustworthiness of leader

• Does management share things that they don’t have to share?

• Do they admit mistakes?

• Does management actually align incentives with shareholders? Or do they implement some scheme to favour insiders heavily in equity ownerships. Michael uses Shake Shack and Carvana as examples

• Does management keeps things simple or talk like a lawyer? "Tobi Lütke is a perfect example. When asked what Shopify does, he said: “We help you start an online retail business on your lunch hour.”"

• Look at how they handle downturns and how transparent they are. Examine how they respond during times of crisis. Do they say they can’t share ‘details’?

3.Motivated by mastery and service to others, not money or prestige => their why/motivation

• Leaders committed to become the best. To master a craft

• Leaders committed to employees leading a better life

• Is this a business the leader will run for the rest of his life? Looking at stock ownership helps with that as well. Selling off their ownership over a 5-10 year period could signal possible exit plans. 

• "One of the primary reasons we sold shares of insurance software company Guidewire was because CEO Marcus Ryu has been selling most of his stake beginning in 2012, even though he has told investors he is committed to the company for the long-term."

• "We have passed on many businesses simply because the leader said they are focused on maximizing shareholder value in the shareholder letter of the annual report.” => is the leader intrinsically motivated? Obsession over financial KPIs might show an extrinsic-tilt.

• Promotional and trend-following CEOs are also extrinsically motivated. Probably an indicator for the business too. Like bragging about how ‘woke’ and politically correct and left-winged a company may be. 

• CEO comp compared to peers is another clear indication of money as a tool for ego. 

• Who do the leaders admire? Who they follow on Twitter?

4.Competent leader - architect (visionary) and builder (doer)=> the vision and systems to attract/retain talent

• Is there an inspiring vision the company and employees can gather round? 

• Is a win-win relationship created with the entire ecosystem? With suppliers, customers, employees? Does everyone win? Does the leader think about creating such a utopia?

• What are its principles. Not core values. But principles that literally direct action

• Does the culture incentivize employees to go the extra mile? Have they build a company that’s for people who want more than just a paycheque? 

• Do they have a process for firing fast on disruptive employees (those driven by extrinsic scorecard).

• Examine executive turnover, its composition and where they were. Not just depth but what their career journey says about them. Think about the practices they bring forth. 

• Glassdoor gives insight to culture and Trustpilot can give insight to customers

• Decentralization > Centralization. Fight bureaucracy. Is decision making and autonomy pushed to the lowest levels? Talented people don’t do well in a centralized structure

5.Proven and stable business model

• “….prefer to invest in businesses with high gross and free cash flow margins, recurring revenues, and low capital expenditure requirements"

• “...passed on investing in real estate brokerage sites Zillow and Redfin because they are shifting from their traditional high margin business to the capital intensive, low margin business of buying homes"

• Can the business scale? It’s also important to note that it needs to already be in a position of positive FCF. Even AMZN had AWS bankrolling it’s e-commerce business and SHOP had it’s core business bankrolling the continued product expansion. 

• Organic growth > M&A

• Low debt. Don’t waste FCF on paying down debt. Use it for reinvestment to compound value. 

6.Compounder - ability to invest free cash flow back into the business at rates of return in excess of 20%

• "invest in compounding machines, which we define as proven and growing businesses strongly positioned for decades of growth"

• Consider the reinvestment runway and growth prospects

Michael runs a concentrated fund of 4 companies with Shopify and Brookfield Asset Management accounting for more than 50% of the fund.