After reading Atul Gawande’s The Checklist Manifesto I came to the conclusion that it was time to create a formal checklist for my investments. Many an error would be avoided and a sense of security, along with a reminder of why the ownership was purchased, would be mine for the simple cost of some elbow grease. The onus of this idea comes from my hobby(?) of organizing, streamlining and injecting the maximum amount of effectiveness into essential activities. To be clear, this will not make you rich overnight or cause you to crush the market year after year, rather it is to be constructed to avoid common errors.
Avoiding common mistakes can be a useful starting point for company analysis. When you know what it is you aren’t looking for, you can sleep better as an investor.
So, to begin, I will start with a qualitative section, and the first criteria is similar to what I have heard the Oracle uses:
Do I understand the business?
Most importantly, you have to know what the heck the company does to turn some money into some more money. Making sure you understand the ins and outs of what will make this enterprise tick is essential.
Does the company have a sustainable competitive advantage?
How are they better, and if not better, more unique than their competition? Are they so unique that there is no competition? What differentiates them from their peers? Can they keep it up?
Is the company run by exceptional Management?
Sometimes wonderful companies are run by a mismatched leaders. It is not to say that they didn’t go to the Ivy Leagues, but an ill fitted temperament or vision can ruin a perfectly good operation.
Is there positive insider ownership?
Skin in the game. Does the c-suite see their company as a great investment? Are they proving that everyday by putting their paycheck there? Besides some rational diversification, is anyone constantly and/or meaningfully dumping their shares to greater fools in the marketplace?
Is the Graham Ratio acceptable?
The Graham ratio is a formula I picked up in The Intelligent Investor. It is a combination of two ratios- P/E and P/B. When multiplied together, is the company better, worse, or generally in line with their industry? (lower is generally a sign of cheapness)
Is their EV / EBITDA acceptable?
The so-called acquirer’s multiple. The Enterprise Value of a company is basically what it would be worth if you were to sell the thing today. You must subtract cash from debt and then add the equity. This, in effect, may happen if a sale were to occur. EBITDA stands for Earnings before interest, taxes, depreciation, and amortization. It comes from higher up on the income statement so as to disregard one-time events and some accounting standards, in hopes of lifting the fog surrounding true fundamentals.
Is the Return on Invested Capital acceptable?
ROIC is a ratio of earnings over total capital. It measures how well a company uses all of it’s assets to make money. This is simple, broad, and telling.
What is the trend in their 7-year earning growth?
Cyclical companies can see wild swings in earnings over a business cycle, so it is important to look at the average trend over longer periods of time than a couple quarters of years.
Is their price to Free Cash Flow acceptable?
Similar to the EV / EBITDA multiple, P / FCF aims to see how the equity portion of a company is valued relative to the actual cash generated by the business.
Is their Debt / Equity Acceptable?
We want companies who are not geared to the gills for a few reasons. First, if you’ve ever been in a large amount of debt relative to your income, you know your decision making gets effected in ways that it wouldn’t normally. With other people’s money, you have less skin in the game. In addition, debt stands in line before equity in the capital structure, so if we make a mistake in buying a less-than-stellar business, we may be out of luck come the day of reckoning.
Is their interest coverage ratio acceptable?
Despite low current interest rates, low debt servicing will not last forever. The lower the hurdle relative to the free cash flow yield ( 1/ (P/FCF) ), the better.
Is their Quick Ratio acceptable?
Do you want to know how solvent a company is? The quick ratio will tell you. Cash and receivables are likely your main current assets. When you plop these over your short-term liabilities, you know your coverage. Here’s a softball: If market liquidity were to dry up would you rather have more or less ability to keep the lights on?
What is the trend of the Days Sales Outstanding?
Top-line, or revenue, growth is a must for a company to compete, but what if the sales that are being booked are being delivered on good faith. The longer it takes to get payed, the longer it takes to produce more product, so cash from other corners of the coffers must be swept. So logically, the higher the trajectory of the DSO trend, the lower the effectiveness of using cash to grow the business. As a side note, the company’s standing in the eyes of their customers may be weaker as they feel they can demand more concessions.
What is the trend of the Days Payable Outstanding?
Picking up right where we left off, only with suppliers now, DPO shows how suppliers view a company’s bargaining power. On the flip side of the balance sheet, this ratio measures how many days a business is afforded to pay it’s suppliers. An downward trend could indicate trouble because, like DSO, this takes part in the availability of cash-an example to follow.
Whirlpool, with over a century of goodwill banked from Sears, decided to cut ties to the retail chain recently. Besides the evidence one can gather by sauntering through any of their stores, Whirlpool was afraid the company wouldn’t be able to pay for their inventories. They weren’t the only ones; with a DPO checking in at 23, the company has seen better days. On at least once occurrence over the past decade, Sears had over 38 days to pony up. This is brushing shoulders with the bottom decile of it’s global industry, says gurufocus.
Is there short-term negative sentiment?
This is a biggie for me. When a company misses earnings or has some peripheral headwind that will likely only last a few quarters, the market jumps the name. If the company is worthwhile, this is your chance to lend a hand and help it up.
Are there significant barriers to entry?
Would it be difficult for a new entrant to break into the industry? Are there a lot of capital expenditures needed to get up and running? Can a start-up disrupt the industry? Some examples are Dollar Shave Club vs. Gillette, Netflix vs. Blockbuster, etc.
Are there high switching costs?
Would it be difficult for customers to change to a competitor? As much as we love our freedom here in the US, we want our companies to make it difficult for customers to leave. See Apple vs. Android. Apple makes it very difficult to leave the ecosystem once you are in. Can you blame them? They generally sell style over substance and know that making their system differentiated and making your content difficult to transport will keep customers in the upgrade cycle.
Is there significant brand loyalty?
This must be accounted for. Once a brand makes you feel something, you tend to remember. As smart as we are as humans, we prefer not to waste our energy thinking about every decision we are faced with. That’s why remembering how a brand made us feel in the past is a good indicator of our likeliness to automatically gravitate toward it in the future. Example: Subaru in the northeast United States. “What makes a Subaru, a Subaru?”, the advertisement goes. I couldn’t tell you, but the peace of mind I get when I turn the key has prompted me to own two and it seems like that is not uncommon around the northeast.
Do non-recurring items recur?
This one will let you know how honest the management is. If extraordinary items become ordinary on the income statement, there is something amiss. Are these non-recurring items actually part of the nature of the business? Is the company lacking focus in their main line of operations? Are they constantly writing off parts of the company that have failed?
When taken together, this list illuminates a number of essential blind spots that can materialize when looking through the sea of stocks. From a value investor’s perspective, this checklist has the potential to, at a minimum, help you avoid mistakes. As imperfect beings, avoiding common pitfalls is a necessary energy expenditure. Doing so in the most effective manor is what this aims to achieve.
Now comes the fun part: Once you have screened possible investments using this list, you can use your intellect and unique perspective to implement ideas and create insights that others may not have afforded themselves, due to fear of failure. You now have a safety net that lets you work at ease knowing you have done your due diligence and once diversified, may roam free.
For your convenience, I have attached my checklist formatted in excel below.