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Introducing Business Model Diligence!

When MagicDiligence first launched over 9 years ago, the initial goal was simple: Take Joel Greenblatt's Magic Formula Investing screens and do some more in-depth research on the stocks it uncovered, finding the truly great companies in the lists and weeding out the fad stocks, companies with one-time non-recurring revenue events, firms with shaky balance sheets, etc.

Boiled down to the essence, what we were looking for were Magic Formula companies with durable competitive advantages.

Another term for this, used by investing great Warren Buffett, is an economic moat. I actually prefer this term. It is a great way to visualize the concept. Think of each company's business as a castle, one besieged at all times and on all sides by the "armies" of competitors vying for a piece of its profits. If a company does not possess an economic moat, it is very easy for those armies to reach and - eventually - break down the walls of the business castle, eroding profits and sales as they do. A wide economic moat protects the business castle for the long term, allowing it to grow ever stronger over time.

The format of MagicDiligence has changed over the years. We now no longer do stock recommendations. And we've branched out some into alternative non-value screening strategies, such as the Quality Growth Spell.

But the concept of using ranking screens to find attractive stocks with hard numbers, and then doing a little diligence to see if the underlying companies are truly possessive of a long-term economic moat, is still what I want this site to be about.

To that end, today we're introducing a new addition to MagicDiligence for our subscribing members: Business Model Diligence (BMD). Let's go over what it is and what the purpose is.

Introducing Business Model Diligence (BMD)

The "BMD" is designed to quickly help you find what we feel are great business models from the lists of quantitatively driven stock screens.

To keep it really simple, we notate our BMDs using the universal "stoplight" iconography:

  • RED. We consider a RED company's business model to be unattractive. These companies usually do not possess any long-term economic moat, and have unpredictable and/or declining revenues.
  • YELLOW. We consider a YELLOW company's business model to be modestly attractive. These companies clearly have some characteristics of long-term economic moats, and they often have reliably recurring and/or growing revenue streams.
  • GREEN. The GREEN rating is our rarest, and indicates that we believe the business to have a very strong long-term economic moat, along with predictable recurring and/or growing revenue streams.

Logged-in members will see the red/yellow/green pips everywhere on the site. They will show up as a sortable column in all of the Spell lists, allowing you to find the yellow and green stocks quickly. They show up as a column in the output lists of all of our Tools. And the individual stock pages contain the full rationale behind our rating for that company. Which brings us to...

How Do We Determine the BMD?

All companies with BMD will have the full rationale behind the rating on their individual stock page (here is Apple's).

To decide on the rating, we want to keep things as simple as possible and ask two questions:

  1. Does the company have recurring and/or rising revenues?
  2. Does the company have durable competitive advantages (i.e., an economic moat)?

Each rating write-up will attempt to answer these two questions, as well as providing a business and rating summary, in as simple, short, and concise a manner as possible. Warren Buffett has always said he can determine a good business model from an explanation on the back of a napkin. We don't feel there is any need to over-complicate it either.

Recurring and/or rising revenues is pretty straightforward. Some examples of reliably recurring revenues include: automatically renewing subscriptions, rapidly consumed products (think foods, drinks, pharmaceuticals, cosmetics, etc), essential ongoing services, and so forth. We LOVE recurring revenue, it makes cash flows much more predictable. We'll also give a boost for rising revenues, even if they are not strictly recurring.

What about the economic moat? I believe Pat Dorsey's book The Five Rules for Essential Stock Investing and his simplified follow-up The Little Book that Builds Wealth are the two best books ever written on long-term economic moats. In it, he identifies what we'll break down as 6 distinct ways a company can build a long-term economic moat:

  1. NETWORK EFFECT. A company has built an extremely hard-to-replicate network of buyers and sellers. Sellers go there because that's where the most buyers are. Buyers can be there for a variety of reasons. Great examples are eBay, Facebook, or even credit card networks like Visa.
  2. CONSUMER BRAND. A great consumer brand allows its owner to charge more than competitors, builds brand loyalty for repeat purchases, and makes it the "de-facto" choice for new shoppers. Great examples are Apple, Coca-Cola, and Nike.
  3. ECONOMIES OF SCALE. In low margin industries, scale is the only way to survive. Once tremendous scale is built in a low margin market, it is very unattractive for new competitors to try to enter. Examples here include UPS, Walmart, and Exxon.
  4. HIGH SWITCHING COSTS. In some industries, it is extremely painful for customers to switch from a particular vendor. For example, in business critical software, the disruption and re-training costs for switching to a new vendor can be considerable. A classic case here is Microsoft. Banks are another example.
  5. REGULATORY BARRIERS. Occasionally, you can find a business that requires strict government approval that is time consuming and difficult to win (and, sometimes, artificially limited). This creates very high barriers to entry for prospective new competitors. A good example of this are the FDA approval and patent barriers in pharmaceuticals.
  6. UNIQUE ASSETS / LOCATION. Unique assets are when a company has control over a key asset of which there is a limited quantity and no alternatives are available. A good example of this is Waste Management, which owns a large network of landfills of which no more (or few more) will ever get built.

We look at each company's business for these factors and determine if, and to what extent, it has one of these benefits, laying out our thoughts to you.

A Few Other Points and Conclusion

We are rolling out BMD with 25 of the larger, more well-known companies appearing in one of our 4 "Spells". We plan to roll several new BMDs out every week, starting first with the companies in our Spells and then expanding gradually from there.

One key point to stress is that these are business model, not stock, reviews! We are looking at the company only here. The BMD is intended as an additional piece of data to consider when reviewing ranked screens of stocks either from the Spells or from one of your own through the Spell Caster.

I hope you find Business Model Diligence a valuable addition to MagicDiligence! The intent is - as always - to help you find the best businesses in high performing, mechanically ranked stock screens. Any thoughts or comments please feel free to reply to me directly. Enjoy!

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