George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario
I always wondered why airline pilots have checklists and go through them carefully before takeoff. When I started investing many years ago, I realized why. When risk is high, it is always good to have a checklist. Using a checklist acts as a circuit breaker, according to Zurich-based investor Guy Spier, and prevents investors from making a number of bad decisions.
Here is a check list I use prior to investing to help me overcome the weaknesses inherent in human nature, such as following the crowd and making impulsive decisions.
First, I want to understand the business and strategic positioning of the company before anything else. Is the industry or sector attractive? How well is the company positioned strategically in the industry? What is the competitive situation in the industry and how does the company fit within the industry? Are there barriers to entry? Who are the key players in the industry and how does the company compare with the dominant players? What is the company's market share? Do I understand the company's business and its business model? What is the company's business risk?
Second, I need to understand the company's profitability and if there are any trends unfolding on the positive or, more importantly, on the negative side. Is the company's operating margin high and stable? Is the company's operating margin rising or falling, and why? Does high-revenue growth eventually show up on the income statement in the form of profit? Is high profitability passed along to shareholders in the form of dividends and dividend increases? Companies with high-operating and gross margins and returns on invested capital, all of which are well above the industry average, are preferred as these are companies with a moat and a strong down-side protection.
Third, the company's balance-sheet strength and financial position are of paramount importance to the company's long-term survival. Is the company conservatively financed? Is the company's total debt to capital in line with the industry norm? Is interest coverage at least about 5x? Does the company have enough cash flow to pay off long-term debt – long-term debt to cash flow should not exceed 3x. What does the maturity schedule of long-term debt look like? Does the company have enough cash flow to pay off debt as it matures?
Fourth, as the agent of a company's efficient operations is management, understanding management quality is important. Both quantitative and qualitative analysis of management is required. Calculating various financial ratios and comparing them with the company's peers is a good starting point. In particular, I would like to know the following. Does management understand the company's business and the industry dynamics? Does management have the right education, background and experience to manage the company? Do they tend to revise financials over time and book many non-recurring charges? What is actual performance compared with projections? What is management's record in asset allocation? Are they a good operator? Does management hold a lot of excess cash? Do they make unrelated acquisitions? How excessive is their compensation package? Are there good internal training programs and well-thought-of and clear succession-planning initiatives?
Fifth, are there short-term catalysts that may affect the company and its value? Has something transpired that caused the stock price to decline? Is this a bad quarter and a one-time event, or it is something of a more permanent nature? Are there any coincidental events that will probably not be repeated in the future? Are there any activist investors sniffing around the company?
Sixth, I will examine the company's valuation. One can buy the best company in the world, but if the individual pays too much this will limit profit or will eliminate any profit opportunities for years. Does the stock seem to be undervalued? Looking at P/E or P/B is a good starting point. P/E and P/B should be less than or equal to 13x and 1.2x, respectively.
But, at the end of the day, one has to take a careful and disciplined approach to determine the company's intrinsic value, which is over and above focusing only on low P/E or P/B stocks.
Seventh, one needs to be aware of value traps. Few things stoke fear in value investors' hearts than realizing they've invested in a value trap. A value trap is a stock that looks like a bargain, based on key valuation metrics such as P/E or P/B, but falls further in price and fails to recover within a value investor's investment horizon and, at worst, goes bust, either because of a fundamental shift in the company's business or because of changes to the environment in which the company operates. The changes are not business cycle related, but instead they are secular, structural and mostly permanent. Unlike common belief, the value-trap reference applies to more than the case of a company in a dying industry. Bad companies (i.e., companies whose organizational structure is convoluted and whose strategy is complex, even when dealing with small problems), bad management and bad strategies could also result in value traps under certain circumstances. In general, companies with a Piotroski F-score which is less than or equal to 2 and an Altman Z-score of less than 1.8 should be avoided.
Finally, the above checklist should be followed with patience and discipline. And always know when to buy a stock and when to sell.
While nothing is guaranteed, having a disciplined investment approach and a "when to invest" checklist will go a long way in helping an investor achieve their long-term goals.