We’ve designed our rating system to be as simple as possible, with just two axes: business quality and price.

We use two different measures because even excellent businesses can be terrible investments at the wrong price, while investing in troubled businesses at dirt cheap prices, handled correctly, can be a great move.

Business quality measures a number of factors: the durability of returns on capital, moat strength, reinvestment runway, balance sheet, cyclicality, and management’s reputation for capital allocation. Five star businesses have a huge moat and lots of runway for growth. These are rare and special businesses. Think Amazon, Costco, Visa, Alphabet and other titans of industry.

Price measures the difference between our fair value estimate and the current price in the market. A 5 star rating means the stock is severely undervalued, while a 1 star rating means the stock is severely overvalued.

Putting these two measures together, we can create a neat picture (see above) of where the opportunities are and aren’t. Much of the map is red. This makes sense. Finding great investments is difficult.

The upper right, 4 and 5 star businesses available at 4 and 5 star prices, is the sweet spot for investing. But these are rare opportunities. If you can find them, you'll need to jump on them. Usually they are available just when the temptation to sell is greatest.

Let’s dig deeper into what’s on the rest of the map.

Deep-value special (3 star businesses at 5 star prices)

These are good but not great businesses which are currently out of favor with the market. It could be a bad quarter or two of earnings, a scandal, or just the trough of a deep cycle.

If a 5 star business is meant to be held forever, these opportunities require more judgment. If you find yourself sitting on 25%+ gains for a company like this, you should take a fresh look and see whether the thesis justifies continuing the position.

Turnaround lottery (2 star businesses at 5 star prices)

These are distressed businesses that have been thrown away by the market. These require a specific and strongly held edge to make it worth the effort. Without a specific catalyst to trigger re-evaluation by the market, you could be sitting on cheap shares in a dying business.

Quality bubble (5 star businesses at 1 star prices)

A quality bubble is when there is zero of margin of safety and you in fact find yourself paying a premium for a great business. Buying in this scenario exposes you to huge draw downs at any bump in the road or weak returns for years to come. While the business may be great, if the market has already priced in the upside, it’s usually best to wait for a cheaper entry point.

Thin margin of safety (Good to excellent businesses available at full price)

Buying with a “margin of safety” simply means buying with enough protection against the downside. In practice, this means around a 25% discount against the fair value estimate. Usually, we can only justify a smaller margin of safety for very strong companies where the bull case scenario offers massive upside. On the map, you see how we tolerate a smaller margin of safety as the quality of the business increases. Ultimately, for these opportunities, it may be best to wait for a drawdown to restore the margin of safety before buying.

This is a rough guide to the investment universe Chadwin caters to. In practice, every company will offer nuances and judgment calls. Our investment memos are designed to help you get the full picture for every opportunity.

Our stock screener makes it easy to filter and sort companies to find opportunities that fit your own investment style, whether that's holding a portfolio of excellent businesses purchased at fair prices, or looking for deep-value gems.