Like everything else we do, having a checklist for selecting great companies to invest in is crucial to achieving uncommon gains. A study conducted by the World Health Organization indicated that surgical doctors who used checklists made less mistakes, and as a result more lives were being saved. Great investors like Philip Fisher, Warren Buffet, Charlie Munger and scores of others advocate using a list that fits ones investment philosophy. A checklist is a labor of love and you should bear in mind “…but he that gathereth by labor shall increase” – Proverbs 13:11. Here is a list I use to separate the wheat from the chaff.
- First take a glance at the company’s balance sheet. If tangible assets far exceed liabilities, this company may be worthy of future examination.
- Read the proxy statement of the company before purchasing its securities. This SEC document gives an indication of management compensation, stock option, directors compensation, related party transaction and other pertinent data related to management. Since people is the most important asset of the company getting a clear idea of management leading the company is paramount.
- Read the company’s annual report (10-k). This report gives an almost complete picture of the company’s business transactions and financial health (earnings report, balance sheet and statement of cash flow) for 12 months. It also included data on past years performance. It is advisable that you read at least 3 years of annual reports
- Delve deeper and look well into the matter by reading other SEC documents on the company, newspaper articles, Google search results, etc.
- Always buy when the stock in down, never follow a stock going up. There are thousands of publicly traded companies, no need to chase one uphill. (“Be anxious for nothing“)
- Buy stocks of companies whose sales are increasing.
- It is preferable to buy stocks of companies that are in a oligopoly, duopoly or monopoly or a companies with a strong competitive advantage (moat) over their peers
- Buy companies that invest in research and development (remember Jacob and the goats. He gained competitive advantage over Laban because of his R&D of creating goats with spots).
- Buy at the end of the the 7 lean cows cycle. All industries go through cycles. Never buy a stock when the stock has levitated for some time.
- Buy when the stock is out of favor or the company has experienced a temporary negative situation, that prompted massive selling by the herd.
- Companies are created to generate cash for its owners (YOU), therefore, buy stocks of companies that generate positive free cash flow
- Have some margin of safety on every purchase. Buy when the price is so low that the probability of it going way lower is slim. Famous value investor, Mohnish pabrai, refers to the concept as “heads I win, tail I don’t loss much.”
- Don’t buy because other people are buying the stock.
- Buy stocks of companies whose gross profit margin is higher than their peers. This is usually a sign of outstanding management.
- Operating Profit. 15% is good
- Net Profit Margin. Above 10% is good
- Return on Assets (Net income / total assets)
- Increase in earning per share over a three year period
- Price / Earnings Ratio (P/E). Current price should not be more than 1.5 times average earnings of the past three years
- Return on Equity (Net Income / Total Equity). 15% or higher.
- Current Ratio (Current Assets / Current Liabilities). Should be more than 2.
- Working Capital (Current Assets – Current liabilities)
- Capital Expense / Sales. Below 10% is ideal.
- Quick Ratio
- Debt to assets Ratio (Total Debt / Total Tangible Assets). Should be Below 50%.
- Debt to Equity Ratio (Total Debt / Total Equity)
- Interest Coverage Ratio (Operating Income / Interest Expense)
- Return on invested capital (Net Income / Invested Capital). 10% or higher.
- Free Cash Flow (cash from operation minus capital expenditure or capex)
- Price / Free Cash Flow per share
- Free Cash Flow / Sales. Above 10% is good.
- Free Cash Flow / Net Income. (Note, operating cash flow should mirror net income. The absence of this correlation may indicate a red flag or accounting shenanigans). 1 or above is ideal.
- Price / Book (price of the stock / book value per share). Should be less than 2, unless return on equity is appreciably high.
- Inventory Turnover (Cost of Sales / Average Inventory). Should be better than the competition.
- Accounts Receivable Turnover (Sales / Average Accounts Receivable). Should be better than the competition.
- Avoid companies that manufacturer alcohol and tobacco.
- Avoid companies that promote abortion.
- Avoid companies that sell or promote pornography.
- Look for management that is shareholder friendly.
- Look for management with a sensible asset allocation policy.
- Buy stocks in companies with a CEO with passion and who exhibits a humble, learning attitude.
- Look for management with good relationship with employees and stakeholders.
- Invest if management is known for high levels of integrity.
Among all things, “But seek first the kingdom of God and his righteousness, and all these things will be added to you.” – Matthew 6:33