My Investing Checklist
In this weeks post, I thought I would summarize the checklist I use before buying a stock. When it comes to value investing, it sounds simple to just buy cheap stocks. But this gets to be more complicated because you first have to make sure the stock is actually undervalued. Second, you watch out for land mines indicative of a value trap.
Since I have started investing, I have continually refined my approach to buying selling stocks. For a while I have used a quantitative value strategy, where I buy a basket of statistically undervalued stocks. The quantitative nature means you just buy 20 or so cheap stocks without doing much analysis. This strategy tends to work well over a long period of time, but I feel like I’ve lost money from things could have been easily avoided.
This short checklist is the latest iteration of my process to determine if a company is undervalued, and to be familiar enough with the business to avoid some mistakes I have made in the past.
#1 Verify the Stock Price is Depressed
I often use stock screeners to find ideas, but the downside of this technique is that it often provides results that are only optically cheap. The first step in my process is to simply make sure the share price has significantly fallen since a recent peak. To me, value stocks are stocks that have sold off because they are out of favor. However, often times cyclical companies with a low P/E ratio have share prices near all time highs. This suggests to me that the cyclical stock is not out of favor, but just has abnormally high earnings that will probably revert back to an average level.
#2 Understand Why the Company has Sold Off
Once I have confirmed that the stock has had its share price tumble, I want to understand why. Like I mentioned, I want to find out of favor stocks. People become pessimistic over a company due to things like the industry is in a rut, earnings were disappointing, the company is not ESG, there is some sort of scandal or lawsuit, etc. These factors are indeed negative, but often times the market overreacts from the bad news, creating a situation where the company trades below a reasonable valuation.
After figuring out the reasonable explanation for why the company is out of favor, then I want to have an idea of how the issues could be resolved. Sometimes this is a matter of me being more patient than other market participants, or that I’m taking a contrarian position, or sometimes I just feel like the odds are in my favor. Either way, I want a plain-English explanation of why people don’t like the stock and why I think they are wrong.
#3 Perform a Basic Valuation
Moving onto the next item in my checklist, at this point I do a back of the envelope valuation of the company. I like the valuation framework laid out in Bruce Greenwald’s book. For this post I’ll just give a high level overview instead of getting into the details of the valuation methods. In the book, Greenwald presents three different ways to value a company:
Asset Based Valuation: If the company is not consistently profitable and its return on capital is below its cost of capital, estimate the replacement or liquidation value of the companies assets
Earnings Power Valuation: If the company is generally profitable, but has no competitive advantages then value it based on a reasonable estimate of earnings without the effect of earnings growth
Growth Return Valuation: If the company is expected to consistently grow sales and earnings, and it has a competitive advantage, then incorporate a reasonable growth rate to the earnings power valuation
When I look at a new stock, I try to determine which valuation method is the most appropriate. My valuation calculations are meant to be quick, just to verify that the company is actually trading below fair value. An important aspect to this is to make sure I document the valuation so I can look at it in the future and check my assumptions.
#4 Read the Annual Report
The last step in my checklist is to read the company’s annual report. The purpose of this is to get a clearer understanding of what exactly the business does. I am more able to stomach volatility in the stock if I understand how the company makes money and what factors can affect its profits.
In the past, when I bought stocks that were quantitatively cheap, I spent less time doing due diligence. There have been several times where I bought a stock without knowing key information that cost me money which would have easily been identified if I read the annual report. For smaller position sizes, just reading the annual report may be good enough. In the case for longer term holds, I would read more annual reports, earnings calls, and try to learn more about the industry.
Conclusion
After going through the checklist, I will be in a good position to either pass on the stock, or continue to refine my analysis and purchase some shares. The aim for this checklist is for it to be relatively quick to iterate through. I want to reject a bad stock idea as quickly as possible so I don’t spent too much time on it. Additionally, I believe this process can help avoid some of the mistakes I’ve made by “buying the screen” when using a quantitative value approach.