On several occasions Warren Buffett has used an analogy that, when I first heard it, completely changed the way I approached investing.
When asked about his methods for finding high-quality stocks, he describes a basketball coach walking down the street looking for potential players to recruit. Great basketball players have attributes such as dexterity, quickness, coordination, and high vertical jumps.
But there's one very obvious trait that many of the greatest basketball players share: They're tall.
So, Buffett said if tasked with recruiting basketball players, he'd simply start by looking for anyone over 7 feet.
While I'm not convinced the Oracle of Omaha would make a Hall of Fame basketball coach, his reasoning is sound. Not every 7-foot-tall player is going to make a great basketball player, but the percentage of 7-footers who are likely competent players is much higher than that of players who are 5 feet tall.
This same concept applies to investing. When picking stocks, it's helpful to have a quick method for distinguishing the 7-footers from the 5-footers.
Let's examine how to do that.
Image source: Getty Images.
The 7-footer test for stock picking
When I first started investing, I would come across compelling ideas frequently, but often after hours of research, I would realize the business had serious flaws.
After hearing Buffett's basketball coach analogy, I developed a series of initial criteria to help me quickly decide if an investment idea was worth pursuing further research.
Before diving into the details, I always make sure a business checks the following four boxes:
- Current ratio of at least 2
- Revenue growth of at least 20%
- Positive operating cash flow
- Net profit margins of 10% or higher
If a stock does not meet these criteria, I simply move on instead of spending valuable time researching. If a company does check all four boxes, I know its worth spending the time analyzing the business.
I recently invested in the programmatic advertising company PubMatic (PUBM -2.98%).
Before diving into the research, I put the company through my 7-footer test, which it passed with flying colors.
Let's take a look:
- Its balance sheet has over $400 million in current assets versus $200 million in current liabilities, equating to a current debt ratio of over 2.
- PubMatic has grown its revenue by an average of 32% annually over the last three years.
- The company has delivered positive cash flow from its operations for the last four years.
- With $56 million in profits and $237 million in revenue in the last 12 months, PubMatic's net profit margin is 23%, and has been consistently improving.
All four of these criteria are easy to verify, which is important. It means that within a few minutes, I knew the company was worth a deeper dive. And ultimately, after adequate research, I decided to buy some shares.
Your pre-screening should reflect your investing style
The trick to developing an effective set of pre-screening criteria is to first understand what you value in a quality business. Every investor is different, and knowing your own personal investment style is key to developing solid conviction.
If you're an investor who values growth, you might consider screening for price-to-earnings growth (PEG) ratio and revenue growth. If you have an affinity for software-as-a-service (SaaS) companies, you should probably be looking for a high dollar-based net retention rate (DBNRR).
Or maybe you're nearing retirement, in which case you might start by looking at Dividend Aristocrats.
In addition to the four criteria I use, here are some examples of attributes you could quickly screen for:
- Total assets greater than total liabilities
- More cash and cash equivalents than long-term debt
- Insider ownership of at least 10%
- Founder-led company
- Net Promoter Score of at least 50
- DBNRR of at least 110% (for SaaS businesses)
- Glassdoor CEO approval of at least 90%
- Glassdoor employee rating of at least four stars
- Gross margin of at least 50%
- Increasing gross margin
- Positive free cash flow
- PEG ratio under 2
- Price-to-book ratio of less than 3
- If the company pays a dividend, has it raised it consistently? Is it a Dividend Aristocrat?
Your time is valuable -- don't waste it
Stock picking isn't easy.
With over 5,000 publicly-traded companies, it can often feel like searching for a needle in a haystack. But developing your own 7-footer test will allow you to focus on the businesses that meet your definition of quality instead of spending valuable time studying companies you'll likely never invest in.
