54 - How to Classify Companies by Business Quality: An Investing System

Mental Models discussed in this podcast:

• Margin of Safety

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode54

What is a quality business? (Classification Guide)

• What is a quality business? 
  • One thing above all else determines whether a business is "high quality." That is predictability. A high-quality business is predictable in terms of future cash flows available to owners.
  • This definition may differ from others you have heard that focus purely on return on invested capital or other quantitative metrics.
  • The reason is simple: The hardest part of investing is predicting the future. Therefore, you should prioritize investing in companies that are easiest for you to predict their future. 
• A quality pyramid of 7 tiers. Each progressively smaller than the tier before it
• Tier 0 - Too Hard Pile
• Tier 1 - Speculations
• Tier 2 - Bad Businesses
• Tier 3 - Average Businesses
• The above tiers are the bulk of companies. If you are rating companies and most of your ratings fall outside of those tiers, then you are either rating companies wrong or you are already narrowed down into a select group of companies. [Buy Line]
• Tier 4 - High-Quality Businesses 
• Tier 5 - Excellent Quality Businesses 
• Tier 6 - Generational Businesses

Business Quality Reports:

Patrons (or Premium Members of DIY Investing) receive free access to my personal investing research and all of the business quality reports that I create. If you're interested in learning more, you can read all about the premium membership here. 

Every listener of this podcast can read this free sample report on Disney.

Summary:

Your goal as an investor it to earn an acceptable return on your investment capital over your investing lifetime. One way to improve the odds of achieving this goal is to classify the companies you research into quality tiers. By always beginning your research with a quality classification, you can limit investing mistakes and maximize your margin of safety during the quantitative part of the investing process