I focus on a few critical issues during my analysis. Below is the latest version of my ‘checklist’. The idea is to have as many positive answers as possible before making a new investment or deciding to keep the existing one. Simple 'Yes' / 'No' answers can be given only to questions about the company’s Management and Business, while Financial and Valuation questions are more quantitative.
I don’t think there is a magic number of ‘No’ answers that would disqualify a new investment or force you to sell the existing one. I guess the key is to have as few ‘No’ as possible (less than 10%) and compare investment opportunities between themselves. For example, if your best five investment ideas have 15% of ‘No’ answers – it is still better to own some of them than to sit in cash. But keep looking for better opportunities.
Different sectors and different type of investments have their own most important questions, so I have tried to separate questions into an ‘Ideal case’, ‘Turnaround’ and ‘Commodity’.
‘Ideal case’ is an excellent business with a significant earnings growth potential due to unique product, large and growing addressable market, high barriers to entry (hence sustainable returns), led by great managers (preferably founders with most of their net worth held in the business), with a great track record in capital allocation (e.g. buying back shares during the downturn) and if such business is purchased at a reasonable price. There is no magic formula to decide the reasonable price; a lot depends on alternative opportunities, general market conditions, and interest rates.
‘Turnaround’ is a situation where the business does not stand out on a few of the points above (e.g. does not have a unique product, is not operating in a fast-growing market, the management team is average etc.), however, the price is ‘very attractive’.
In this case, ‘Attractive price’ can be defined in terms of cash returns (dividends, buyback, free cash flow) or the company’s assets (price relative to replacement cost of equipment, working capital, net cash position). A stock that pays a 10% dividend yield with a moderate (3-5% growth potential) can be considered to be attractively priced in the environment when long-term rates are 1-2%. Similarly, a company valued at 50% of the replacement cost of its fixed assets that operates in a stable sector with continuous demand (e.g. power utilities) and which can generate adequate returns on its fixed assets (e.g. 10%) is also quite attractively priced.
‘Commodity’ opportunities relate to both companies – quality companies at a reasonable price as well turnaround situations, but both types are within the commodity sector. This makes earnings much more volatile and raises the importance of a strong balance sheet. Management has no impact on pricing; it can control some costs. Its decisions broadly lie within the capital allocation sphere (e.g. expand or reduce capacity, explore or acquire new resources, raise debt or buy back shares, etc.).
Bear in mind that industry gurus have developed their versions of checklists. You can learn about some of them in the books (for example, check Phil Fisher’s'Common Stocks and Uncommon Profits' or Peter Lynch’s'One Up on Wall Street' which I keep in my Library).
1. Will I be happy to own the stock for ten years or more. Will I still be happy to own it if markets are fully shut?
2. Will I be happy to own 100% of the company, not just a few shares?
3. Do I know how the company earns money, what makes its product special?
4. Have I analysed the industry enough?
5. Do I know main competitors, their valuation multiples?
6. Will I still like the company if its shares drop 20% next week?
7. Has management been buying shares, when and at what price?
8. How significant is management’s ownership in the company? What share of management’s net worth is invested in the business?
9. What is management’s incentives structure?
10. What are the KPIs, key strategic goals for management, how do they decide if the business is successful?
11. Has the management team been stable over many years (or have there been constant changes)?
12. Are employees happy at that company? Is the corporate culture good? Is it considered a top employer in the sector?
13. Has management largely avoided big mistakes in the past (or, to the contrary, there have been plenty of issues)?
14. Is the company’s product a leader in the market? Does it have a great product? Do people I know, or I use it?
15. do competitors offer any alternative products? How different are they? Does the company need to keep spending on advertising to promote and differentiate its products?
16. Do customers love the product? Is it a high-quality product?
17. Is the business growing or declining (in terms of units sold, market share, margins, dividends)?
18. Pricing power: has the company consistently raised prices for its products without losing market share?
19. Is the product demand generally resilient (or susceptible to macrocycles)?
20. Does the company have a strong R&D team, pipeline?
21. Will the company’s products be used 10-20 years from now?
22. Has the company’s gross margin expanded or remained stable over time? What is the source of gross margin – premium prices (higher quality product) or lower costs? How sustainable is this?
23. EBIT margin – has it expanded/remained stable or, on the contrary, declined over time? What is the structure of SG&A expenses? How much is spent on Marketing vs R&D vs general admin and HQ costs? How do these costs compare to peers (especially relative to sales)? Will EBIT margin remain positive if sales drop 10% (this depends on the share of fixed costs and the overall level of Gross and EBIT margin)?
24. Interest expenses relative to Operating Cashflow, EBIT – how significant are they? A lot depends on the industry but having interest expenses at 20%, or more of operating cash flow can significantly limit a company’s growth potential and create more significant risks of bankruptcy in the future?
25. Net income: what is the normalised level of earnings? The key is to exclude expenses related to growth (that bring more sales in the future) and one-off charges (e.g. penalties, extra tax incurred in prior periods, FX losses/gains, Goodwill amortisation, write-down of PPE, provisions etc.).
26. Operating Cashflow / Net income (sometimes called ‘Cash conversion’ ratio). Ideally, the ratio should be close to 100%, suggesting that all reported profits turn into cash. For growth companies, it is hardly achievable and should not be the goal. Avoid companies with a low ‘cash conversion’ low ratio (50% or less) and fail to grow.
27. Capex / EBITDA ratio. Ideally should be low or declining. If the business has to spend a high share of its operating earnings on re-investments, there is less capital for paying dividends or pursuing growth projects.
28. Low leverage. Great companies can grow without relying too much on leverage, limiting their downside risks. If a company generates high returns on capital, but its balance sheet is quite stretched due to heavy debt burden, its actual returns are much lower. Net debt / EBITDA should be less than 3x for most types of companies with very few exceptions (e.g. when a company has firm contracts for the next ten years). Ideally, a company would have less than 1x Net Debt / EBITDA. Need to consider interest expenses as a share of operating profits and cashflows, Debt / Assets level too (ideally, should be less than 10%).
29. Hidden leverage. This could relate to contingent liabilities, pending court hearings, possible fines, risks of non-payments by important clients. The high share of fixed costs (e.g. rent expenses) is also a form of hidden leverage as companies cannot cut them even if they face deterioration of their financial position during an economic recession.
30. Use of cash. How the company decides to allocate its capital. How many decisions are based on long-term strategic thinking instead of short-term gains (e.g. cutting CAPEX to boost buyback, which could temporarily increase the share price but limit future growth potential)? In particular, from the normalised operating cash flow, what portion is spent on maintenance/growth CAPEX, M&A, buyback, dividends, paying off debt, interest.
31. How much capital does the company need for its business – now and in the future? How much does it generate relative to this capital?
32. What is the expected Total Return (assuming you own 100% of the business and do not sell it for the rest of your life)? Total Return = Shareholder Yield + Growth. Shareholder yield is the sum of dividends and buyback.
33. What FCF (cash flow available to shareholders) the company generates now, in 3-5 years? How sustainable is this FCF? FCF/Market Capitalisation should ideally be 10-15% if the company is a slow grower. Such yield could be applied to future FCF (Year 10) for a fast-growing company (the value should be discounted to the present).
34. What multiple am I paying (ideally 10-15x for an average grower – 5-7% growth rate)? Am I applying this multiple to normalised earnings? How this multiple would look like taking into account the company’s growth in 3-5 years (e.g. if I pay 30x PE for current-year earnings, but the business is growing at a 30% rate, then I only pay 13.7x for Year 3 earnings and 8.1x for Year 5.
35. How does the multiple compare to multiples of other companies in the sector? Why the difference? What multiple did this company trade in the past 3-5 years?
36. Have the been strategic acquisitions in the sector? What have strategic investors historically paid for similar companies?
37. What could go wrong with the company, industry?
38. How can I lose money in this investment?
39. Which areas in my analysis do I know least about? What should I learn more, focus on the most in my research in the future?
40. What are the key risks for the company: product becoming obsolete, too much debt (bankruptcy), management misallocates capital, regulatory changes?
41. What I could have missed?
42. Why does this opportunity exist?
43. What do I see what the market does not see? What is my edge in this investment?
44. What signals/evidence do I need to gather to decide if my original thesis is intact or I made
a mistake and need to sell out?
45. Is my personal leverage low enough to be able to wait enough time for my investment to generate adequate returns (and not be forced to sell the position prematurely if, for example, I lose a job)?
For Turnaround opportunities, the additional focus should be on the management team and the plan going forward. Just a cheap stock with weak management and no clear plan to improve things may end up as a value trap (flat earnings, exact low multiple due to little progress, zero returns).
1. Do I trust this management team to deliver a turnaround?
2. What returns will the business generate in the current situation if the turnaround plan does not work out?
3. What are the downside risks assuming turnaround fails?
4. Is this business permanently declining or just very slow to grow? Are the problems with poor management (poor capital allocation) or poor product?
5. Is the industry highly competitive? Is there significant differentiation between products? Are there high barriers to entry?
6. Will the company require new capital?
7. What does the success of the turnaround plan depend upon?
8. How long will it take?
9. What would profits/cash flow look like after the turnaround? What could be improved levels of profits/cash flow in the future?
As I mentioned previously, commodity companies have little impact on pricing and can control just their costs, how they spend capital (on what). The role of management may thus be even more critical than in the case of a strong consumer franchise business (like Coca Cola). As for the price, even though companies are generally price takers, it is crucial to understand the long-term marginal cost of supply and mid-term supply/demand balance for valuation. The safest way to invest in Commodity companies is to avoid leveraged balance sheets. Due to the higher volatility of commodity prices, a weak financial position can quickly ruin the business.
1. Is management trustworthy?
2. What is management’s operational track record?
3. What is the company’s reserves life, how long can current production level be maintained?
4. What is the minimum capital investments needed?
5. What are replacement costs (costs needed to replace commodity produced to keep overall output stable)?
6. Are there risks of declining quality of reserves over time?
7. Regulatory risks – risks of licence being revoked, not extended?
8. What are the risks of higher taxes in the future?
9. Risks of social issues (e.g. strikes, protests)?
10. Company’s leverage, required funding? Apply 50% lower leverage ratios to Commodity companies compared to what you would consider reasonable for businesses in other sectors.
11. Industry cycle – is the market oversupplied or undersupplied? Is the commodity going to be in demand in 3-5-10 years? Who are the key suppliers, what are their returns at current prices, are they increasing capacity? Are the key players focused on the growth of production or cash returns for shareholders (what is the capital discipline in the sector)?
12. What is the long-term marginal cost of supply (costs to bring additional volumes to meet incremental demand)?
13. How easy it is to raise capital in this industry (the harder, the better)?