"I'm a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it's easy to miss something important."
--Charlie Munger, 2007 Wesco Financial annual meeting
In their excellent book What's Behind the Numbers?, John Del Vecchio and fellow Fool Tom Jacobs cite a study performed by Blackstar Funds that tracked the performance of about 8,000 stocks that qualified for the Russell 3000 between 1983 and 2007.
The results are astounding. During that time, the Russell 3000 rose about 900%, yet 75% of the components had a collective total return of zero -- meaning 25% of the stocks generated all of the 900% gain!
Because only a small percentage of companies account for the vast majority of stock market gains, investors need to sift through many companies to find those few compounding machines. One of the best ways to perform effective research is to use an investing checklist on the criteria for your investments.
One way to structure the checklist -- which was recommended to me by Buck Hartzell, dean of investor education at The Motley Fool -- is to put the things we dislike most at the front of the list. This way we don't spend hours or even days wasting time on a business that ends up not meeting our investing criteria. So, for example, if high debt is a disqualifier for us, we can quickly eliminate any companies that don't meet this check.
Below are 10 categories of questions that I include in my investing checklist. The first four questions are my front line of defense, or the questions I always ask first to see if I want to proceed with further research. Doing so saves me time and allows me to focus on the best ideas -- those I believe have the least potential downside and above-average upside.
- Do I understand the business and the industry in which it operates? If I don't understand the business or the competitive landscape, I move on.
- Does the company have too much debt relative to its equity, total capital, and industry norms? Does it have a healthy interest-coverage ratio? If I am uncomfortable with a company's financial leverage, I move on.
- Is the company generating positive net income and free cash flow? I generally do not invest in companies that are losing money, but I make exceptions if the company is experiencing temporary losses, or if it is investing heavily now for future growth and I see a clear path to robust profitability in the future.
- Does the company have a history of sales and earnings growth? And do I understand where future growth will come from?
Notice that these first four categories all have a clear "yes" or "no" answer, allowing me to answer the questions quickly and without conducting deep analysis. If a company scores well on this four-question "disqualifier" test, then I move on to categories five through 10, which require significant reading and thinking.
- Are the financials strong, and do I understand the accounting and the notes to the financial statements?
- Does the company have a clear competitive advantage? Is the competitive advantage sustainable? These are the questions I spend the most time on, because businesses with sustainable moats outperform the market over long periods of time. For more on this, click here and here.
- Is management competent and candid about its mistakes? What is management's track record with capital allocation? What metrics and time frame does management base its pay on?
- Can the Internet kill this company?
- What are the risks? What is the short thesis?
- Is the stock selling at an attractive price? If so, why?
This checklist is only a starting point. As you take companies through an investing checklist (whether this one or another), you will most likely find that new questions pop up during the research process.
For example, you might discover a company makes a lot of acquisitions, which could encourage you to research its history with buyouts. (For example, what multiples does it typically pay? Does it issue shares or pay in cash? If it issues shares, does it do so when its stock is cheap or expensive? Does it stretch its balance sheet to seal a deal? Does it have a history of writedowns?)
Or you might come across a line item on a financial statement that you are not familiar with, which could encourage you to find out what that line item means. You might also want to add questions specific to certain industries, such as exploration and production, banking, and insurance.
Using a checklist has made me a better investor because it helps me to speed up the research process by focusing my attention on the best bets but also forces me to slow down before making an actual investment. I believe it can do the same for you.
By committing to adequately answering each of the 10 categories of questions before making an investment, I am confident that we can minimize the likelihood of making poor investments and increase the likelihood of making profitable stock purchases.
I am always looking for ways to enhance my process, so I would love to hear any questions you think I should add to my checklist. Until then, Fool on!