I cannot guarantee this checklist will bring you investing success.
But here are the 10 stock-picking questions I ask
After a few years experiencing the good, the bad and the downright ugly of investing, I hope this checklist can help guide your investment strategy in a way which makes your journey at least a little more profitable.
I think it's also worth noting that my strategy has — and will continue to — change as time goes by. It emphasises the notion that investing is a learning exercise.
Indeed, the more investing I've done, the more books I've read and the more academic study I've completed — the more I've realised how much I don't know. Try to keep that in mind when developing your own stock-picking strategy.
10 stock-picking questions I ask
- What does the company do?
"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." — Peter Lynch
Browse a company's website. Then, find its annual report. Read it. If you don't understand the numbers that's fine. But if you cannot get your head around its products/services, how it makes money, or its strategy — don't buy its shares.
I find looking at a company's "Segment Report" (which should break down businesses into their divisions/segments) is a great place to start.
- Where's the competitive advantage?
After you've understood the business, you must take a look at the industry to determine if it has (or is likely to generate) a competitive advantage. A competitive advantage is the thing that makes one business better than another, consistently. Not by luck, but by process.
Porter's Five Forces model considers major factors (new entrants, suppliers, customers, buyers and substitutes) to determine industry rivalry. I use it to help me summarise the factors that shape a company's industry and any advantage it could have.
You may also seek answers to questions, such as: How many companies are in the industry? Is the company's service/product protected by a patent, regulation, trademark or other barrier? Can the company control sales prices?
Competitive advantage comes from two strategies: Cost leadership or product differentiation.
For example, Rio Tinto Limited (ASX: RIO) sells iron ore, a commoditised product (i.e. it doesn't matter who sells iron ore — it's all the same). Therefore, it must pursue a cost leadership strategy to hold a long-term advantage over its rivals.
- Does management own shares?
Successful investing goes hand-in-hand with uncertainty. As outsiders to a company, we'll never know everything. So there's no better way to have certainty that our investment will be looked after than by seeing if management (i.e. the insiders) have 'skin in the game'. If management are selling, be (very) critical. Many CEOs tell their faithful investors that they need to 'diversify' or 'buy a house'. Be critical.
Look in the annual report to answer important questions such as: How much is management paid? How many shares do they hold? Do they have more long term or short-term incentives?
The dodgy operators will make these questions more difficult to answer. However, incentives should always be geared to outcomes for individual shareholders. For example, if management's incentive is to 'achieve 20% revenue growth in the next year' to get a bonus, you can bet they'll do whatever it takes to reach that target regardless of whether it's good for every shareholder over the long term.
- Are the company's economics 'good'?
In my opinion, this differentiates the 'good' investments from the 'great' investments.
Ask yourself:
- Does the company have positive operating cash flow? Usually, this is the first sub-total on a company's Cash Flow Statement. If it's not positive, the company is burning cash.
- What is the debt and cash position?
- What are the margins to know (Return on Assets, Return on Equity, Operating Margin, etc)?
- Can it reinvest (capex) in itself at an exceptional rate? This can be difficult to ascertain if you are not familiar with financial statements or accounting. This blog post details some tricks you could use.
- What are the five greatest (known) risks?
I say 'five' risks, but in reality there are likely many more. Nonetheless, this question is skewed towards critiquing your thesis. Look at the company, its accounting policies (found in the 'notes to financial statements'), its suppliers, industry trends, regulations, geographic exposure and technology.
- Do we have a variant perception?
Just remember: If you are doing what everyone else is doing, you will get the same results. What makes your thesis different? Maybe you've identified one segment within the company that's been overlooked by other investors? Maybe the company is too complex, but you've worked in the industry for many years so you know it better than anyone.
- Is the valuation compelling?
Over the years, I've come to realise this question is not the most important on the list. Valuing a company provides a reality check on prices, but it is not the be all and end all for long-term investors.
Indeed, you shouldn't buy a company's shares simply because they have a low price-earnings ratio, or because 'a discounted cash flow analysis says they are cheap'.
A seasoned analyst could create five valuation models in 30 minutes, or spend a week creating one detailed model. Ultimately, the value from valuation comes from the data that goes into it, not the output.
- Do you have a margin of safety?
Adjusting for the uncertainties in your valuation is essential. Even if you are planning to buy a mature business like, say, Telstra Corporation Ltd (ASX: TLS), you should be willing to wait until you are offered a margin of safety. That is, you want the difference between what you think the shares are worth and what you can buy them for to be as wide as possible.
Remember to keep the risks in mind when evaluating a margin of safety (or margin for error, if you will). For example, if you say a high-risk share is worth $5 and it trades for $4.50, your margin of safety is not very good (slightly more than 10%). But if it was a low-risk company, offering a stable dividend, it may be a compelling investment.
- How does it fit in my portfolio?
You don't need to be a portfolio management mastermind to know that if you have 50% of your cash in one stock, 90% of your holdings come from the resources sector, or 100% of your wealth is invested in Australia (don't forget to include your house) then you're playing a very risky game.
The best investors know their holdings inside out and can cross-check their exposure to various trends (e.g. falling oil prices) or themes (e.g. China).
There is a large chorus of professional investors who believe the best returns come from savvy asset allocation (e.g. property versus shares) rather than the individual stock picks themselves.
However, just imagine if you bought Amazon shares (up 237%) in a US dollar (up 45%) share account just five years ago. Being smart with both your security selection and portfolio management yields the best results.
- Would I be happy holding this company for five years, if I couldn't track the price?
In five years (a reasonable timeframe for a long-term investor) a lot can change. Prices will rise or fall, and management teams might come and go. So if you are even a little uncomfortable with your investment now, chances are, you will feel less comfortable when prices fall.
