Do You Have an Investing Checklist?

I've been asked by several Motley Fool Live viewers to share my investing checklist, so I pulled together this article.

This is the 10-question investing checklist that I'm currently using to measure business quality, growth, resilience, and even antifragility in companies I'm considering for my portfolio. I say "currently" because I am constantly refining my checklist as I learn and grow as an investor.

Why use a checklist and how does it work?

As an analyst, I use an investing checklist for several reasons. These include:

• I'm process-oriented by nature. I enjoy designing, using, and refining frameworks.
• It enables me to research each business I cover thoroughly and equally by asking the same set of questions across my coverage universe. This way I don't forget anything, and I get the satisfaction of knowing I put in the work.
• I like the idea of 10 questions. To me, 10 checks seem like not too many, not too few, but just right. Also, 10 questions easily equate to a letter grading system, such that a 7 out of 10 is a C, and 8 out of 10 is a B, a 9 out of 10 is an A, and a 10 out of 10 is the rarified elite (the best of the best).
• Running each company through the checklist allows me to easily track that company's progress over time. Did one company increase its score from an 8 to a 9? Did another company decrease its score from an 8 to a 7?
• It forces me to slow down and helps me avoid making hasty buy-and-sell decisions. If I'm in the mood to be very selective, this checklist makes it very easy to say "no."

Each of the 10 questions can be answered with a "yes," "no," or "maybe." A yes equals one point, a no equals zero points, and a maybe equals 0.5 points, meaning that the highest possible score is a 10 out of 10. Each of the 10 primary questions contains multiple sub-questions and sub-frameworks that help me answer the main questions. I don't always answer each of the sub-questions on paper in detail. Rather, they serve as a guide to finding the right answer to the main question. This analysis structure provides a simple framework and conviction-rating system, but it also ends up being a very robust and rigorous investing tool.

Who influenced this list and how does it influence my actions?

I adopted several of the questions on this checklist from the investors I admire and study most, including: Motley Fool co-founders Tom and David Gardner; Brad Slingerlend and Brinton Johns from NZS Capital; Dan Davidowitz, Damon Ficklin, Tucker Walsh, and Rayna Lesser Hannaway from Polen Capital; Rishi Gosalia from SF Value Capital; Michael Shearn from The Compound Money Fund; and Sean Stannard-Stockton from Ensemble Capital. Ensemble Capital even has a beautiful diagram depicting its investing philosophy. Check it out here.

This checklist influences both my stock picking and my portfolio management (or position sizing), but it does not preclude me from buying shares of businesses that I want to own but that don't currently score high on this checklist. I buy larger positions in companies that score high on my checklist (i.e. that I have a high conviction in) and I buy smaller positions in companies that don't presently score high on the checklist (but that I deeply admire and have a gut feeling about based on my high hopes for their futures) or that score high on the checklist but are trading at what appear to be very high valuations.

10 main questions, but lots of sub-questions

So, with the explanations out of the way, here is my 10-question checklist for evaluating quality growth stocks:

1. Does the business have a strong balance sheet, preferably with net cash?

• Does the business have net cash or net debt? Large net cash positions can be a key source of optionality.
• Are the company's debt and net debt levels increasing or decreasing?
• How does the company use debt? Is it strategic (issuing long-term debt at today's record-low interest rates), is it out of necessity, or is management mortgaging the company's future to buy back stock and increase the dividend while underinvesting in growth and adaptability?
• What is the cyclical nature and capital intensity of the industry? Is the business both cyclical and capital intensive (something that is often a bad combination)?
• Does the company have a lot of operating leverage and financial debt leverage (a bad combination if sales start to fall)? Operating leverage works both ways: If sales fall, earnings fall faster, and the company's interest coverage ratios fall, making it more difficult to service its debt.
• What is the company's cost of debt (the interest rate it pays to borrow money)? What are its maturities on its debt (repayment schedules)? And can the company withstand rising interest rates?
• What percentage of the debt is fixed-rate versus a variable rate?
• What amount of debt is corporate debt versus bank debt?
• What are the size of pension obligations and operating leases?
• What is the company's credit rating?
• What are the company's financial health ratios including net debt to free cash flow, interest coverage, debt to equity, debt to total capital, net cash to total assets, net cash to market cap, and goodwill (intangibles) to total assets?
• If we ever have another economic shutdown as we experienced in the first and second quarters of 2020 in response to the global coronavirus pandemic, how long can the company's cash on its balance sheet cover the company's total annual expenses on the income statement (assuming the company generates zero revenue)? This is the ultimate stress test.

2. Can the business generate organic revenue growth powered by a large market opportunity and/or long-term tailwinds?

• What is the total addressable market (TAM) and is the market growing?
• What long-term secular themes are powering the company's growth?
• Does the business have a product or service that is relevant and in high demand?
• Is the business completely customer- and product-obsessed?
• Does the company create joy for its customers?
• Is the business committed to investing in innovation and long-term growth through research and development (R&D), capital expenditures, and recruiting and retaining top talent? What I'm ultimately trying to figure out is if the business is innovating and adapting to maintain growth and relevance in a rapidly changing digital world.
• Does the business have clear opportunities to reinvest capital at high rates of return?
• What is the company's go-to-market strategy?

3. Does the business have rising or stable margins, with particular emphasis on gross margins and net operating profit after tax (NOPAT) margins?

• What is driving the margin increase or decrease? Pricing power? Scale, high operating leverage, and incremental margins? A new product launch? A shift in the mix of the business from selling lower-margin to higher-margin products or services? Acquisitions or divestitures? Cost-cutting programs? A change in corporate tax rates or other regulations?
• Does the company have a fixed-cost or variable-cost business model?
• Is the product mission­-critical for customers but accounts for only a small percentage of customers' cost of doing business?
• Does the business have a culture of profitable growth or a culture of growth at any cost?

4. Can the business generate high (or increasing) returns on invested capital (ROIC) and growing earnings and free cash flow (FCF)? Strong profitability and free cash generation is another main source of optionality.

• Does the company have a unique business model or is there something else unique about the business that is hard to replicate?
• Are the barriers to entry high?
• Are the barriers to success high?
• Is the company a market share leader, and does it have limited competition? Is its market share growing?
• Does the business have the very best product and the very best customer service in the industry? Is the product or service integrated into the fabric of the customer's business? Is there a very close relationship with customers that creates constant feedback and innovation?
• Is the business fundamental to our way of life? In other words, if the business suddenly disappeared, would the world be set back five, 10, or even more years?
• Does the business have defensible competitive advantages?
• What are the sources of its competitive advantages? (culture, adaptability, brand and other intangibles, high switching costs, scale, network effects)?
• Is the company investing to protect its moat? (Most companies don't have moats and those that do often have declining legacy or shrinking moats, but the rare few have wide and sustainable moats).
• Is the company investing in building new moats over time?
• Do I understand the competitive environment, market-share trends, the rationality (or lack thereof) of pricing in the industry?
• Did I perform a DuPont Analysis?
• Is management compensation based on ROIC (or a similar return-based metric) or FCF?
• Does management base its capital allocation decisions on ROIC (or a similar return-based metric)?
• Do management's language and writings constantly refer to metrics such as profitable growth, ROIC, and FCF?

5. Is the business led by an exceptional CEO and quality leadership team?

• Is the CEO also the founder or co-founder?
• Does the CEO have high inside ownership of the company?
• Is the CEO focused on building long-term profitable growth over short-term earnings per share (EPS)?
• Is the CEO someone I'd want to work for?
• Is the CEO compassionate, capable, candid, and committed?
• Does the CEO have a soul in the game, in addition to skin in the game?
• Has the CEO created and nurtured a healthy and enduring corporate culture?
• Has the CEO created an ESG-centric culture that permeates every level of the business, including having an executive compensation plan that's partly based on ESG-related criteria (see Accenture)?
• Is the CEO a first-ballot entrant in the Management Hall of Fame (if such an award existed)?
• Does the CEO have a strong No. 2 in a role such as CFO or Chief Operations Officer?

6. Does the business have recurring revenue and/or pricing power?

• What is the source of the company's recurring revenue? Is that source long-term contracts? If so, how long are the contracts? Is that source subscription services? Is that source a consumable (use-once-and-dispose item)? Is it a daily habit or pleasure? Is it a mission-critical product or service?
• How often does the company increase prices and by how much?
• How enduring are pricing power and recurring revenue?

7. Does the company have a medium (or lower) risk profile?

• Does the business have too much debt?
• Does the business suffer from mismanagement or poor leadership?
• Does the business have deteriorating vital signs (rising debt and net debt, declining revenue, or ROIC that is falling for the wrong reasons)?
• Does the business have commodity exposure?
• Is the business cyclical and capital intensive or does it sell products with short lifecycles?
• Is there a business-model risk?
• Are there low barriers to entry?
• Is the business experiencing industry headwinds -- long-term trends working against the company?
• Is there a potential for disruption or obsolescence?
• Is the business overly exposed to customer or supplier concentration?
• Is the business overly reliant on global supply chains?
• Does the business have poor earnings quality with red flags?
• Does the business have poor customer service?
• Does the business have a toxic or unhealthy corporate culture?
• Is there a lack of data privacy at the business?
• Is there a lack of transparency from management?
• Is there a lack of succession planning, especially when the business is run by the aforementioned first-ballot hall of fame CEO?
• Is the business overly focused on short-term earnings and underinvesting in R&D and other important areas to maintain long-term adaptability?
• Is there a brand or reputational risk?
• Is the business operating in an industry with burdensome regulation?

8. Is the business executing well (is it experiencing strong business momentum)?

• Is it maintaining high organic revenue growth or is top-line growth even accelerating?
• Is it taking market share from competitors?
• Is it winning new contracts?
• Is it able to increase prices while maintaining high demand?
• Is it winning recognition for having the best product or service or being the best place to work?
• Is it recruiting and retaining top talent?
• Are its margins and returns on invested capital rising?
• Is it successful in integrating any acquisitions?

9. Is the company driven by a mission beyond maximizing profits for shareholders?

• What is the company's mission and is it trying to solve an important problem?
• Do the company's business decisions, products/services, and actions align with the mission?
• Does the company take a stakeholder-first approach to value creation by understanding that, in order for the shareholders to do well in the long term, the business must first treat its employees, customers, suppliers, community, and the planet well?
• Does the company create an equal amount of (or even more) value for its key stakeholders as it does for itself? In other words, does it try to pursue shared value creation and win-win outcomes?

10. Does the business have multi-bagger potential?

• Is the business committed to innovation and adaptability? Is the management committed to investing to future-proof the business?
• Does the company's product or service fundamentally change the way we work or live?
• Does the business reflect what I think the world will look like in the future?
• Does the company's product or service save the customer time or money?
• Does the business have embedded optionality either through large net cash on the balance sheet and strong FCF, a strong core business that redirects cash flows to fast-growing adjacent businesses or into new market opportunities (both from a product/service standpoint and geographic standpoint), or a business that was a first mover in an emerging frontier-market opportunity (such as virtual reality, robotics, autonomous driving, 5G, the Internet of Things, gene sequencing, or space travel)?

Two additional considerations

If the business scores high on this 10-point quality-growth checklist, only then do I think about valuation by asking two last questions:

1. Is the stock selling at a sane valuation?
2. What is the opportunity cost for my capital (i.e., is this new investment more attractive than buying more of what I already own)?

If the business scores highly and is selling at a reasonable valuation, then I initiate with a full position of about 3% or possibly higher of my overall portfolio. If there's a company that I have a gut feeling about but that doesn't currently score highly on this framework, or that scores highly but is trading at what seems to be an awfully high valuation, then I initiate with a small position of 1% or often smaller of my overall portfolio.

As a result, this checklist effectively guides both my stock picking and my portfolio management (or position sizing). I love frameworks like this that are simple and yet serve multiple functions.

Something to think about

There you have it, Fools. Hopefully, this framework helps you to think about and craft your own investing checklist. Even if you take only one main question or one sub-question from this list to use in your own stock analysis, I hope it makes you smarter, happier, and richer. If not, at the very least it can spark a good conversation about investing checklists and frameworks on Motley Fool Live. Catch me there and Fool on!