Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
In his seminal The Checklist Manifesto, Atul Gawande describes how doctors—widely considered among the most intelligent, competent professionals out there—often missed simple steps due to arrogance, impatience, or simply human nature. When a checklist was employed, lives were immediately saved (and fewer sponges were ultimately sewn up inside patients!).
Gawande describes a great checklist as being much shorter than you might imagine and suggests that a good checklist should comprise the fewest possible steps required to successfully complete a task. A comprehensive list that covers every minute detail can overwhelm a user (and is less likely to be used in the real world). In other words, the checklist should be as simple as possible but no simpler.
Now, there are dozens of great value-oriented stock-buying checklists out there, and many of them are excellent, but this checklist is in the vein of what Gawande suggests, and I think it may add some value to your own investing journey.
Next time you're thinking about adding a stock to your portfolio, ask yourself whether it meets the following seven criteria.
1. It's Undervalued
If "buy low, sell high" is starting to sound incredibly obvious to you, a part of you is programmed to think like a value-oriented investor, and the concept probably comes somewhat naturally to you at this phase of the game. However, it's still incredibly important to actually check whether said stock is really undervalued.
I wrote a short primer on stock valuation that may help point you in the right direction. The key message here is that you need to do your own diligence, and that includes determining how to figure out whether a stock is cheap or not. While you can get an idea from pretty much anywhere, the actual vetting means trying multiple methods of valuation in order to reach a conclusion that a stock is undervalued. A prudent investor only buys a stock if a number of methods (e.g., discounted cash flow, EV/EBITDA, and relative valuation) draw the same "cheap" verdict.
2. It Has a Margin of Safety
Once you've identified a stock as being on sale, you need to circle back and ask yourself a simple question: How confident am I that this stock is on sale, and that the price I think it should be selling for (intrinsic value) is the right price? This is incredibly important, since being approximately right is generally always better than being precisely wrong, and you're very likely to be precisely wrong if it's an industry you don't understand very well.
If a company falls within your circle of competence and you're already familiar with it, you might demand a 20% margin of safety (after all, no matter how well you understand a company, you could always be wrong about one of your assumptions).
On the other hand, if a company is on sale in an industry you're less familiar with, perhaps a 40% (maybe even higher) discount to intrinsic value would be needed. Circle back to step one, including your margin of safety, and ask if the stock is still cheaper than your margin of safety. If it is, and if you don't have any other better opportunities, the stock is a buy.
3. It Has a Possible Catalyst
If you're a long-term "buy and hold" investor intent on picking out a handful of great businesses to buy then forgetting about them for decades, you can safely ignore the need for a catalyst. For everyone else, however, this important checklist item can amplify your returns and give you the potential to take profits much more quickly.
I describe the catalyst-identifying process in some detail here, but the nuts and bolts are this: Is there a reason why this particular stock might jump in price in the short-to-medium term? If there is, and the stock happens to be a beneficiary of such a jump, you might make 30, 40, or 50% in a few months instead of in a few years.
The key here is not to bank on this happening. If you have to keep the stock forever, perhaps it's a great long-term hold that you might not mind having in your portfolio. If you end up having to sell at a loss since the catalyst didn't happen, at least the downside can be minimized by having a reasonably good business in the first place.
4. It Has an Asymmetrical Upside
A direct follow-up to the catalyst concept is that you want to have protection in case the catalyst doesn't come to fruition, ultimately minimizing the downside to very little potential damage. You might have heard the phrase "asymmetrical upside" with regard to stocks or other investment opportunities, and that is exactly what you're looking for.
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If you guess that the likely worst-case scenario for a stock is to get cut down by 25%, but it's much more likely to grow by 40% this year, you're thinking along the right lines (and this stock is a screaming buy, as long as it fits in with the rest of your portfolio).
It's even permissible to have one or two stocks that might go to zero, provided that's not the case for a significant portion of your portfolio, and you should feel confident that, over time, your portfolio is still likely to perform reasonably well.
To quote Monish Pabrai, "heads I win, tails I don't lose much." Get yourself excited about this prospect by imagining a coin flip where you get $75 if it lands on heads, but you only lose $25 if it's tails. Now ask yourself: How many times would I take that wager?
5. It Has a Moat
While identifying a short or medium-term catalyst is a necessary step for most investors, those interested in long-term investing can get away with skipping it; the inverse is true with a moat. The longer you intend to hold, the more important competitive advantage is for a company.
In a perfect world, you're able to identify a great bargain with a desirable margin of safety, and you have both a catalyst and a moat; that way, you could sell if a great opportunity presented itself via the catalyst, or hold for a long time, minimizing your downside by relying on the moat the stock has in order to protect you from a bad scenario.
Identifying an area in which the business will continue to dominate for a decade or more isn't always an easy process, and the more you know about an industry or business, the more likely you are to be able to identify moats. Think about moats the same way you think about margins of safety: The less you understand about the business, the more margin of safety you'd demand, and the less of a moat you'd want to ascribe to a business. By buying businesses with moats, you protect yourself against long-term loss of capital.
6. It Has Solid Management
Buffett describes a perfect business as one that any idiot can run, since (as the story goes) eventually, one probably will. Savage, Warren! But he makes a great point: Every step in our checklist so far has identified characteristics of the stock or the underlying business itself, and these are often enough to ensure that a stock goes up in price over time.
However, taking a look at how management behaves can add one additional layer of protection. A good manager should be both shareholder-oriented and fit within your ethical requirements. If you agree with most of the decisions management makes, and you like the general direction the company seems to be going, that's fantastic, but your management also needs to be aligned with the company's best interests.
Take a few minutes to understand whether the CEO and their team own a sizeable portion of the company, indicating that they're probably very interested in how the business's shareholders do over time (since they're shareholders too).
Do they buy back stocks if the stock is on sale? Do they increase dividends over time? Neither of these questions is a deal-breaker in and of itself, but they are great data points that can help you determine what to do next.
7. It Doesn't Have Too Much Debt
The last item on this checklist is debt. A business can seem otherwise healthy, and you might be starting to get excited about making a purchase, but there's one more item to consider: How much does the business owe?
A quick ratio tells you whether a company can meet its short-term obligations and by how much. Understanding how much of an issue the company might have with debt over time and taking a guess at whether it's likely to run out of cash and lose the ability to meet its obligations gives you a much fuller picture of whether the stock is a good investment or not.
There's no magic buy or sell decision that the quick ratio or the amount of debt indicates, and the amount of leverage you should find acceptable as an investor should probably change across sectors and industries. After all, a sawmill that has borrowed $10 million to buy $10 million of equipment, which will still be worth something in two or three years is in a better position debt-wise than a streaming media company that has acquired the rights to this year's world championships of badminton (no offense, badminton value investors out there! you guys rock).
The bottom line here is to be careful and to consider the amount of debt a company has and ask yourself whether that might affect one of the other checklist items.
Circles and Cycles
One thing you might notice about this checklist is that every item you "check off" or answer seems to lead you back to a previous checklist item. This is by design, and a good investment decision means checking and revalidating assumptions numerous times through several different types of filters and screens.
Remember that you don't have to swing at every pitch (or even every 10th or 100th pitch!), and preventing yourself from buying something that might be riskier than first appearances indicate is every bit as valuable as identifying your next buy.
Spend just as much time disqualifying potential buys as you do identifying potential prospects, and cycle through this checklist with every stock purchase as many times as you need to. Your results can only be improved by a more careful screening process.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith