As an investor, you sometimes end up owning a stock that doesn’t meet your standards. A must haves and nice to haves checklist can help you stay disciplined and avoid this situation. The specifics of the checklist will vary depending on your particular investment strategy. The constraints of your strategy will determine your must haves, while your personal preferences will determine your nice to haves.

My strategy is to identify and own a small number of above average businesses for a decade or more. This approach is tax efficient and allows me to spend my time learning about a few businesses I admire. It’s also less frenetic and stressful, which fits my personality.

My first constraint is owning a small number of businesses (usually 5 - 8). With more invested in each individual business, the cost of failure for a single business is higher. With that in mind, we must own businesses that don’t require debt and preferably have little to no net debt (unencumbered cash minus debt). Debt amplifies poor management decisions and makes a business more susceptible to stress and shocks. Lack of debt acts as a buffer against poor decisions and mitigates stress and shocks. Next, we must own predictable and defensible businesses that operate in a market that is slow to change. Failure rates are high in rapidly changing markets. Lastly, for obvious reasons, we must have honest, capable, shareholder friendly management.

My second constraint is owning above average businesses. An above average business is one that earns high returns on capital employed (ROCE). This could be due to a strong brand, network effects, oligopoly, or some other structural advantage. We must own high ROCE businesses.

High ROCE businesses produce excess cash. Management must deploy this excess cash rationally. A great business can be a poor investment if excess cash is irrationally squandered on acquisitions or failed growth initiatives. Rational means setting a high bar for reinvestment and sending any remaining cash back to shareholders in the form of share repurchases or dividends. A great business without incremental reinvestment opportunities can still be a great investment if management is rational with capital allocation.

The final constraint is time. We want to hold for long periods of time. With a great business, time is on your side. The longer you hold it, the closer your return will match the underlying returns of the business. Therefore, we must have a fair price (as opposed to a great price). If we’re right about the business and hold it long enough, the price paid will become less and less relevant.

Nice to haves are more nuanced and personal. Ideally, they improve the business outlook while making ownership more enjoyable. For me, these nice to haves include: a founder CEO with significant ownership, candid communication with shareholders, an idiosyncratic culture that feels out of step with the industry, little or no stock based compensation, a clear reinvestment runway, high revenue growth, exceptional capital allocation, and a great price. I’ve yet to find a business that has all my must haves and all my nice to haves. The closest I’ve come across is Constellation Software. It’s been easier to instead identify businesses with the must haves: doesn’t require debt (and preferably holds little to no net debt), predictable and defensible while operating in a slow changing market, honest, capable, shareholder friendly management, high returns on capital employed, rational capital allocation, and a fair price.

Finally, a warning. Investors will sometimes compromise on their must haves to reach for appealing nice to have(s). In my case, I’ve compromised on debt and high returns on capital employed (must haves) to chase a great price, revenue growth, and a founder CEO with significant ownership (nice to haves). Undermining your core principles may work out, but it’s undisciplined and unnecessary. Stick to your standards. Own stocks you want to own.