Last year, I wrote an article titled, "The 10 stock-picking questions I ask", and it was well received amongst regular readers here at The Motley Fool Australia.
Before I get into the nitty-gritty of my stock-picking list, please, allow me to digress…
In late 2014, when I was applying for an equity analyst position I was asked a question I'd never heard before.
The interviewer asked, "If you had to recommend a company but only had five days to research it, how would you spend your five days?"
I was stumped. "What are they getting at?" I asked myself.
Like a kangaroo caught in the headlights, I skipped around the question. Jumping around what I thought would've been a sensible answer.
Somewhere down the track, however, I ultimately concluded I'd spend around four of my five days on qualitative research. Then I would have just one for the quantitative stuff.
Now, I know what you're saying to yourself: "Four days! Why so long?"
Whilst I'll admit I was under pressure in the interview. It was an honest answer and I stand by it.
I'm a firm believer that undertaking qualitative research, such as understanding the company's service/product and industry are far more influential to stock-picking prowess than calculating the P/E ratio in year 2023 or setting a price target in 12 months' time.
It's akin to doing your high school certificate. One year out of school and 99% of the technical mumbo jumbo they forced you to learn goes out the window.
Personally, I'd say 90% of the companies that I refuse to invest in are discarded at the qualitative stage of my research.
The 10 stock-picking questions I ask
Whilst not exhaustive by any means, my checklist is a filter which I use to sort the wheat from the chaff.
Indeed, it's far from a guaranteed market-beating checklist.
In fact, I'm a firm believer that there is no filter, screener or stock-picking tool ever created which could guarantee market-beating returns.
Look around the poker table; if you can't see the sucker, you're it
However as legendary money manager, Peter Lynch, famously quipped, if you're right about buying a stock 60% of the time, you're good.
I'd like to think this stock-picking filter could help investors do that…
- What does the company do (think: products, business divisions, etc)?
This is the start of the qualitative part of your research. It's alright to be confused about a company's operations, at first.
However, if you find yourself scratching your head for too long, ask yourself if you can afford to invest in a company which you may never truly understand. To quote Lynch again…
"If you're prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won't get bored."
A company's website is a good place to start.
- Does it operate in a growing industry?
If not, what's its niche or advantage?
Tailwinds (e.g. a rising population, increased healthcare spending) can multiple a company's profits many times over. However if it's facing significant headwinds, you must ensure the opposite won't happen!
- What competitive advantage does it possess?
Is it durable (i.e., can we rely upon it over time)?
For long-term investors this characteristic is a necessity. It doesn't have to be a world recognised brand like those offered by Coca-Cola Amatil Ltd (ASX: CCL) but it must be durable.
But a competitive advantage isn't a 'get-out-of-jail-free-card' either. Despite being one of the world's lowest-cost producers, the iron ore produced by Rio Tinto Limited (ASX: RIO) has fallen in price for two years straight because of massive oversupply in the seaborne market. Some would say, it's facing significant headwinds.
- Does management hold shares?
Are their interests aligned (incentives, bonus etc.)?
Look at previous experience, technical knowledge and capital management.
When we buy shares. We're essentially saying, "Here you go Mr/Ms Manager, put my money to work for me."
Now, you wouldn't do that with a stranger down the street, so make sure they have your best interests at heart when you hand them your money! Personally, I like to see long-term earnings per share incentives.
The senior management team at payday lender, Money3 Corporation Limited (ASX: MNY), hold a heap of the company's stock and perhaps unsurprisingly it has performed very well for shareholders over the years.
- Does the company have a solid track record in terms of shareholder returns?
Total shareholder returns, which equals dividends plus capital gains, is a quick way to look back in time and gauge the success of the company in delivering market-beating returns.
If you've got access to a decent stock broking account, you'll likely be able to see all the historical figures you'd ever want (plus many you don't want!). Woolworths Limited (ASX: WOW) has a fantastic track record of growth in profits and dividends.
- Are the company's economics 'good'?
What is the debt, cash, equity position?
What are the margins to know (Return on Assets, Return on Equity, Operating Margin etc.)?
Can it reinvest in itself at an acceptable rate?
Is its FCF growing or diminishing?
I might be jumping the gun by putting this question in at number six but these figures are (hopefully) easily identifiable in a company's latest annual report. Telstra Corporation Ltd (ASX: TLS) is an example of a business which has excellent economics.
There is a caveat here. Don't rely on your brokerage account for up-to-date figures and if you don't know what they mean, Investopedia, YouTube and many other sites provide excellent resources, which are free. Use them.
- What are the 5 greatest (known) risks?
1.
2.
3.
4.
5.
Got any more? You should!
Risk and reward go hand-in-hand. There'll be a lot more than five risks, do your best to find them. Go beyond the company itself and look at the industry, geographical spread, regulatory risks, etc.
- Do we have a variant perception?
Some would argue this is the most important question of all.
Think hard about this because it'll enable you to determine why now might, or mightn't be the right time to buy. However do not reject someone who offers a differing point of view – it could save you a bucket load of money.
A variant perception must be justified with facts. Not something such as "a low share price" –remember the market is not your master.
- Can a discounted cash flow analysis be used with moderate reliability to determine intrinsic value?
Use a 5 or 10-year forecasting period with a minimum discount rate of 10%.
Depending on your valuation skills, this question might be the only one which differentiates you from those pesky Wall Street analysts.
A Discounted Cash Flow ("DCF") analysis takes the forecast cash producing ability of a company and brings it back to today's prices. Sounds simple.
It should be noted, however, that these models are only as reliable as the information which goes into them. That is: garbage-in, garbage-out.
That's why comprehensive qualitative research must be done before quantitative research, aka valuation.
I believe Coca-Cola Amatil shares now trade at a fair price, using my very conservative estimates of the value of its future free cash flows.
- Is there an adequate margin of safety under all manner of sensitivities?
Use the identifiable risks to run different forecasts
Use the risks you identified above, in conjunction with all the other information from the questions you've asked to run some 'what-if' scenarios.
I'd rather be generally right than specifically wrong with my analysis, so I take a conservative approach and use the worst and best case scenarios, giving me a range of values.
For example, in my DCF analysis of Coca-Cola Amatil I made adjustments for very low levels of growth in Indonesia because I believe the island nation will be tougher to dominate than New Zealand and Australia.
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I'm sure these 10 questions will help many readers improve their stock-picking ability.
However, whilst it's definitely not an exhaustive checklist, few companies would make it through the entire filter and still allow you to sleep easy at night.
Finally, it's also important to note that what works for me may not work for you and remember to read whatever you can because putting time aside to grow your investing knowledge base will be the best investment you ever make. I can guarantee that!
