Billionaire Investor Bill Ackman's Secret 5-Step Investing Checklist

Go through that strategy and go through how it works. When you come, you know, maybe you'll override that portfolio manager or not, but what's the checklist you kind of go through?

So we look for very high-quality businesses, what we describe as simple, predictable, free cash flow generative dominant businesses. A business that Warren Buffett would describe as having a moat around it, right? If you believe that the value of anything financial is the present value of the cash you can take out of it over its life, well, you need to know how much cash it's going to generate over its life.

So the business quality, to us, is the single most important criterion for determining what's interesting, because if we can't predict the cash flows, we don't know what it's worth. We can't invest. So we figure out what it's worth, figure out how good the business is, and how predictable will these cash flows be from a railroad, or a spirits company, or a real estate company, shopping mall business. And then we say, okay, well, where's the trading?

If there's a wide gap between price and value, you can buy for 50 cents it's worth a dollar twenty. Well then we're going to take a hard look and try to understand why it trades at a deep discount. Once we understand the reasons, we decide: well, these things that we can solve, you know, or can we, in light of the situation, the circumstances, can we be influential in changing these levers that can cause this valuation discrepancy to narrow? Is this a business that, while we're causing the valuation discrepancy to narrow, we can also perhaps contribute to the valuation growing? If those things are true, we found something that looks quite interesting for us.

This video is sponsored by the investment research app Quarter. In this video, we are going to go through and analyze the simple investing checklist billionaire investor Bill Ackman uses to decide if he wants to invest in a company. The great thing about this checklist is that you can begin using it in your own investment research process today. Make sure to stick around for this entire video because it is going to make you a better investor. Let's jump right in.

The first thing on Ackman's checklist is that a business needs to be simple. Bill Ackman went to Harvard, but by no means do you need to go to a top university to be able to invest successfully. One of the key aspects of successful investing is only investing in businesses you can understand. Take a look at some of the companies Ackman has in the portfolio he manages: the home improvement retailer Lowe's, the restaurants Chipotle, Domino's, and Restaurant Brands International, the holding company of Burger King, Popeyes, and Tim Hortons. Also in his portfolio is the hotel chain Hilton and the real estate developer Howard Hughes.

All of these businesses are relatively simple and easy to understand. Some might even say these businesses are boring. You should only invest in a business if you're able to deeply understand that business and industry. Investing in companies that are relatively simple helps ensure that you truly do understand the company and the industry.

But isn't this the opposite of how many investors behave? Most people think the big money is going to be made on companies with complex and difficult-to-understand business models. In order to determine the value of a business, which we will cover in more detail later in this video, you have to be able to predict how much cash that business is going to be able to generate in the form of profits in the future. This is why Ackman focuses on businesses that he considers to be predictable.

Predictable means you are able to have a rough idea of how much in sales and profits the company is able to make next year, the year after that, and even five years down the line.

To demonstrate the concept of predictability, let's imagine you are the owner of a 100-unit apartment building. For simplicity, let's say that each unit rents for one thousand dollars a month. This means you will receive one hundred thousand dollars total a month in rent. Simply multiply that by the number of months in a year (12), and you will get your yearly total rent. In this example, that would be 1.2 million dollars.

Rents, at least in the United States, tend to increase between three to five percent on average every year. Given this, it is easy to predict how much rent your apartment will generate in future years. If you are able to successfully increase rents by three percent, that one thousand dollar monthly rent each unit pays will increase thirty dollars to one thousand thirty dollars, bringing your total rent for that year to one million two hundred and thirty-six thousand dollars.

And then the year after that, you can increase rents by another three percent, bringing your total yearly rent that you collect to one million two hundred and seventy-three thousand eighty dollars. Notice how there aren't huge swings in the amount of rent you collect in any given year. It's not like in some years you can collect two million dollars in rent and then the next year only three hundred thousand dollars. Your income from this property is relatively consistent. This is what Ackman means by a predictable business.

Compare this apartment building to a company that produces movies. Let's say this company produces one movie every year. How much money will the movie production company make? Well, it really depends and is hard to predict. If the movie is a hit, the company can make hundreds of millions of dollars. But if the movie flops, the company could actually lose money that year for having spent more money making the movie than what it brought in ticket sales. This is an example of an unpredictable business. In any given year, the amount of money the company makes can be drastically different.

One of Bill Ackman's most successful investments of all time was in the railroad Canadian Pacific. Canadian Pacific is a large railroad that operates a rail network throughout Canada and the northern United States. Let's check Canadian Pacific's financial statements to see if it checks the box as being predictable.

Take a look at the company's historical operating income and free cash flow. For operating income, which is simply its profit before subtracting out interest paid on debt and taxes, you can see the company has had consistent growth in that figure over the last five years. There haven't been dramatic swings up and down in that figure. Additionally, take a look at the company's free cash flow, which is how much cash the company generates that it can use to grow the business, pay out dividends, or buy back stock. This figure is still pretty predictable, being above one billion dollars four out of the five years and never even close to being negative.

If you want to learn about other stocks like Canadian Pacific, check out the investment research app Quarter. I reached out to them to sponsor today's video, as they have become a valuable tool in my own personal investment research process. They make learning about a company, its future growth plans, and the main questions Wall Street analysts are asking the company incredibly easy. The best part of it is that the app is completely free to download and use.

Now let's get back into the video. This leads us into the next point. Bill Ackman looks for companies that already generate cash flow. That contrasts to the overall stock market in recent years, which has favored companies that are not yet profitable. For example, some of the companies that are going public and entering the stock market via SPACs aren't profitable and likely may never be profitable.

Snapchat, Pinterest, and Lyft are all examples of large stocks that aren't profitable or generating any cash flow. Compare that to some of the holdings in Ackman's portfolio. Lowe's generated 9.3 billion dollars in free cash flow in 2020. Chipotle generated 300 million dollars in cash flow in 2020, and Domino's generated 500 million dollars. You get the point: Ackman likes to invest in companies that generate a ton of cash flow.

It's not that companies that are currently not generating cash and that are unprofitable can be good investments; it is just that they are inherently more risky than companies that have a long history of generating large amounts of cash. And since Bill Ackman has a concentrated investment portfolio with only seven stocks in it, he wants to ensure that each stock in his portfolio has a high probability of generating strong investment returns.

Next up is that a company needs to have a durable competitive advantage or what Warren Buffett refers to as a moat. A moat refers to a business's ability to maintain advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders. If a company is making a lot of money with a certain product or service, it's only a matter of time until a competing firm tries to enter the market and attempt to steal away the company's customers and ultimately its profits.

That's just the nature of capitalism. A moat is simply what advantages a company has that protects and prevents a competitor from stealing away its customers. To expand on this concept, when you are identifying moats, you should be thinking in four distinct types of moats: low cost, brand, resource, and network effects.

Low cost – This is where a company has an advantage by being able to produce its products or offered services at a lower cost than its competitors and is therefore able to sell those products to customers at a lower cost. Think of Toyota and Honda in vehicles, Walmart and Costco in retail, Southwest Airlines for U.S. based airlines, or banks such as JPMorgan Chase and Bank of America, where their huge size allows them to operate at a great efficiency. A low-cost moat is very powerful because it allows a company to sell its products for a lower price than its competitors while still being very profitable. This is the type of moat that is usually enjoyed by the largest companies in any given industry.

The next type of moat is what is referred to as a brand moat. This is where a company has such a strong brand that customers are willing to pay a premium price for the product or service. Examples of this include Apple with smartphones, Starbucks with coffee, Coca-Cola with soft drinks, Rolex with watches, and Mercedes-Benz with cars. Companies with this type of moat enjoy higher profit margins than their competitors.

Let's use Starbucks as an example to demonstrate this. Let's say it costs Starbucks one dollar to make a cup of coffee. Let's also assume it costs one dollar for the local corner coffee shop to make a cup of coffee. However, let's say Starbucks is able to sell each cup of coffee at five dollars a cup, whereas the local coffee shop can only sell their cup of coffee for three dollars. That means Starbucks makes four dollars of profit for every cup of coffee they sell compared to the local coffee store's profit of two dollars per cup. This demonstrates the power of a brand moat.

The next type of moat is what I call a resource moat. When I say resource, I am referring to things such as patents, technology, or other intellectual property that a company has that gives an advantage over its competitors. Great examples of resource moats include pharmaceutical and medical device companies with their patents on their healthcare products. If a company has a patent that prevents any other company from making the same product, it's pretty clear right away how powerful that can be.

Another example would be Disney, which owns some of the most recognizable entertainment brands in the world, including Marvel, Star Wars, and all the original Disney characters.

The fourth type of moat, and one that has become increasingly common with the growth of technology companies, is referred to as network effects. Network effects are a phenomenon whereby a product or service gains additional value as more people use it. Think of Facebook as an example of this. As more of your friends and family join Facebook, the more value you, as a user, get out of it. That's why it would be hard for a new social media company to take away Facebook's leading market position. A new social media company would start out with no users, and there is no benefit for people to switch from using Facebook to using that new social media platform. This is a perfect example of network effects at work.

Now, if the business has passed all the other filters – it is simple, predictable, produces free cash flow, and has a moat – the fifth and final criteria that the stock needs to meet is that it is selling at a discount. If you have been following my channel, you know this is a concept I frequently talk about because it is crucial to successful investing.

When Ackman says a stock is selling for a discount, he means the price that is trading for in the stock market is less than what it is truly worth based upon the cash that business will produce over its lifetime. This true value of a stock is referred to as its intrinsic value.

So, essentially, what you, as an investor, want to do is buy stock that is currently trading for, let's say, 70 dollars a share, whose intrinsic value is actually 100 dollars a share. This 30 dollar difference between the intrinsic value of the stock and what you paid for is referred to as your margin of safety.

So, how exactly do you calculate that intrinsic value? Let's use a hypothetical lawn care company as an example. The intrinsic value of any business is based on two variables: the cash that company will produce over its lifetime and the rate at which you will discount that future cash the business generates back to the present day. This will all make sense after you see an example.

Let's say with our hypothetical lawn care company, it will generate one hundred thousand dollars in cash the first full year we own it. We then assume that annual cash flow will grow by twenty percent every year for the next ten years that we own the business. This means that the one hundred thousand dollars in cash flow in the first year will grow to the business producing five hundred and fifteen thousand nine hundred and seventy-eight dollars in year ten.

Additionally, at the end of year ten, we can sell the business for five times what the business produced in cash flow in that year. So we take the five hundred and fifteen thousand nine hundred and seventy-eight dollars in cash flow and multiply that number by five, getting us two million five hundred and seventy-nine thousand eight hundred and ninety dollars. So that means the total cash we will receive at the end of year ten is three million ninety-five thousand eight hundred and sixty-eight dollars.

This is simply the five hundred and fifteen thousand nine hundred and seventy-eight dollars the business made in cash profits plus the two million five hundred and seventy-nine thousand eight hundred and ninety dollars we sold the business for. So now that we have our estimates for how much cash the business will produce for us over the time we own the business, we are now able to discount those numbers back to today.

We do this because cash that we receive in future years is not as valuable as the cash we receive today. This is why if given a choice between me giving you one hundred dollars today or one hundred dollars a year from now, you would pick the one hundred dollars today. In order for you to choose to receive the cash a year from now instead of today, you would need to receive more money to make it worth your while to wait the extra year.

In this example, we are going to use five percent as our discount rate. So after discounting these cash flows by five percent, we get an intrinsic value of three million four hundred and fifty-one thousand two hundred and eighty-eight dollars. This is our estimate of the true value of the business. So, is this how much we would want to pay for the business? No way! We would want to buy it at a discount, because remember, the difference between what we pay for our stock or business and what its intrinsic value is represents our margin of safety.

So for example, if we pay two million dollars to buy this lawn care business, that represents a forty-two percent margin of safety. So essentially, we are buying this business at a forty-two percent discount, a very healthy margin of safety. As you can see, it is very important to be able to have a rough idea of what the future cash flows are that a business will generate. This is why the other criteria early in the video matter.

If a business is simple, predictable, already generates cash flow, and has a moat, it is much easier to determine a reliable estimate of that business's intrinsic value. Now that you see how the intrinsic value is calculated, you can see why it is so difficult to calculate a reliable intrinsic value for a complex business with unpredictable earnings.

The only way to come up with a reliable estimate of a stock's intrinsic value is to be able to reasonably predict the future cash flows of that business. This is much more easily accomplished when the business is simple and predictable.

So, there we have it! I really hope you learned something from this video and can begin incorporating these lessons into your very own investing strategy. Make sure to give this video a like and subscribe to the Investor Center if you aren't already, because it is my goal to make you a better investor by studying the world's greatest investors.

See you guys in the next video!