My Simple Investment Checklist
by elmads
Introduction
Every investor and trader has their own strategy. I’m a value investor, though its philosophies generally are the same for investors who follow this method of investing, the investment approach is still different for every single value investor. There are some who mixes value investing with price action, or with momentum, or with macroeconomic conditions of a country more than the microeconomics of the business, to name a few.
This doesn’t mean that if a value investor deviates from the what some claims the “generally accepted” value investing method, that they’re automatically wrong. Investing is not about what specific philosophy or style of investing you follow, it is whether that method works well with you.
Find that investment and/or trading method that will be in sync with your time, effort, understanding and personality.
Value investing is dynamic, it changes with time, but the general philosophy has always been the same since Benjamin Graham coined this investment approach.
This blog of mine is to share how I approach my investment analysis in the simplest way possible.
First of all, disclaimer: I am not a financial professional nor a finance, economics, accounting and business management degree holder. I am just a person who found what he loves to do on the side and only has an informal education from the said fields including its disciplines.
This blog is only for educational sharing purposes and is not in any form of financial advice or recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.
With that aside, let’s now go ahead with my simple investment checklist.
1.) Increasing Revenue/Operating Income & Net Income
This is a no brainer, a growing company should not just be profitable but also expanding. If not, then the company could either be in the mature phase where they’ve reached their maximum growth (stagnated or their market have saturated already), or declining phase where they’re losing their dominance and market share.
I don’t put emphasis that much on the percentage year-on-year growth of a company, because this is relative to the industry where it operates. For instance, a tech company usually has a revenue growth of more than 10% or sometimes 20% yearly, whereas a utility company only has roughly mid-single digit growth.
What’s important for me is that I understand how the company works and how it generates its revenue.
2.) Maintained or Increasing Margins (Gross Margins, Profit Margins & Net Income Margins)
Having good to increasing margins may indicate a durable competitive advantage for the business. This just means that the rate of profitability increases year-on-year faster than the increase of its costs of goods sold/revenue, operating expenses, interest payments and taxes.
Gross Margins (Gross Income / Revenue) – A business whose gross margins are maintained or increasing may indicate that they are able to control the price of their products and services.
As stated from Mary Buffett’s & David Clark’s book titled Warren Buffett and The interpretation of financial statements. “What creates a high gross profit margin is the company’s durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of good sold. Without a competitive advantage, companies have to compete by lowering the price of the product or service they are selling. That drop, of course, lowers their profit margins and therefore their profitability.”
Operating Margins (Operating Income / Revenue) – Companies who have increasing or maintained operating margins show their ability to produce higher operating income net of their operating expenses (SG&A, R&D, depreciation and amortization, and other expenses).
Net Income Margins (Net Income/ Revenue) – Is the percentage amount left once costs of goods/services sold, operating expenses, interest payments and taxes have been taken into account. As like with the other financial margins, having a stable to increasing net income margin reflects a strong economics of the business.
Comparing the margins of the business within its industry peers are one of the ways for us to see and analyse which one has a better profitability and advantage from others.
3.) Low or Manageable Debt Levels
Debt is neutral, it’s not good nor bad, but it does depend on how it is being handled. I’ve discussed corporate debts and how investors could understand which companies have a safe debt ratio via a debt fundamental analysis.
4.) Has Good Liquidity Levels
All future events are unpredictable, and this is also applicable with an economy. To mitigate such financial uncertainty, individuals need to always have financial protection and mitigation strategies to put in place. Hence, the personal finance core strategies (Cash flow, savings & debt management, emergency fund, rainy day fund and insurance.), while in corporate levels it’s through strengthening their balance sheet.
5.) Generating Consistent Positive Free Cash Flow (better if increasing)
Free Cash Flow is the real amount of money that the business receives once real cash expenses and capital expenditures are deducted. This is what Warren Buffet also calls as the “Owner’s Earnings”. The shareholders are also the owners of the business.
The management of a company has 5 ways where they can allocate the Free Cash Flow that the business has generated.
- Pay off the company’s debt
- Reinvest it back to the business
- Acquire companies or merge with another company
- Do a share buy back
- Pay dividends to the shareholders of the company
Companies who has a durable competitive advantage would most of the time have positive and increasing free cash flow to further expand their business (reinvesting it back to the business and acquire other companies), and/or distribute those cash flows to their shareholders via share buybacks and dividends.
That being said, capital allocation is paramount in any business, as there is always an opportunity cost for every action take by the management.
- Free Cash Flow – Cash Flow is King
- What are Dividends?
- Share Buyback & Dividends
- Beware of Share Dilution
6.) Stable, High and/or Increasing ROE & ROIC
Return on Equity is an important metric in fundamental analysis because it shows a company’s financial performance and their efficiency in using their equity to generate income. Yet, this is only one side of the financial story, as this doesn’t show the full narrative of what happened in a company within a certain fiscal year and past years. This is why digging deeper, reading the company’s annual reports (past & present), looking into what the management has had said, their plans for the future and the risks they face are important. This gives the financial data colour and life for investors, which will significantly help us to arrive into our own personal investment decision based on what we have read, and analysed.
Investing is making an informed decisions based on the available data we can acquire directly from the source (financial reports). We do this in order to lessen the risk of permanent capital loss and also open our eyes to the opportunities that we never knew existed before.
Return on Invested Capital, though is almost as important as Return on Equity, still is considered by some as the star metric to finding companies that can grow over a long period of time. Businesses who posses long-term historical ROIC are called as the “Compounders of Value”.
Management that can give high Return on Invested Capital for their business says a lot of things. Mainly the durable competitive advantage of the company (most especially if it has been delivering high ROICs for years), and a good management.
A business and its management possessing the Midas touch, as every capital (either through their earnings or debt financing) that they have invested back to their business, turns into large sums of money in the future. No wonder this is the considered 5th and prevailing strategy in the ever evolving equity investing landscape.
NOTE: STEPS 1-6 can all be found and read online via a public company’s financial statements and reports (Annual, Interim and Quarterly). This is accessible via their corporate public website where everyone in this world can access.
- How to Understand & Research a Public Company from Scratch
- Understanding a Public Company from Scratch – MD&A & Financials
The 7th and Final step can only be done by learning and understanding financial modelling methods, such as the Discounted Cash Flow Model (DCF) and Dividend Discount Model to name a few.
7.) Should be below my Fair Value Calculation
When purchasing a share of business, what we are actually paying today are the potential cash flows of the business in the future. It is by analysing and computing the present value of a business’ future cash flows, where we discount it based on the probable risks it has today and could have in the future. This is called the Discounted Cash Flow (DCF) Modelling.
The last step in my checklist is doing the DCF model. There is no right or wrong DCF modelling. This is the reason why professor Aswath Damodaran emphasizes that DCF is hard to comprehend for some individuals because it’s not just a “1+1= 2” game, where there is a concrete answer for every model done for a certain business.
It is an approach based on conviction and faith, our trust on our own data analysis, research, understanding of the business and in our own abilities.
DCF modelling are numbers with stories, signifying our own understanding of the business and how we perceive and project what could happen to it in the future. For instance, if we see Tesla as an automotive business, then the numbers should support an automotive business cash flows, but if we perceive Tesla as a technological software business then that would reflect a different kind of cash flows, or we could use the mix of both an automotive and software business company.
The question here is, how confident are we with the story and the financial numbers that we have made? It’s easy to make a DCF model, but are we willing to put our hard-earned money on the line for it? There is no right or wrong answer, there is only faith, conviction and our informed decision.
What would you do when, your own made story for your analysed business does not materialize in the short-term? Are you willing to wait for that story and numbers to happen after a few year? and if yes, for how long? and what would make your future story and numbers of the business be invalidated? what are the cues that could tell you that your projected story and numbers don’t jive with what you though could happen in the future?
As we dabble with the uncertain future, we must always have a cushion to dampen the unknown errors in our own assumptions. Enter the mental model of “The Margin of Safety”. “The Investment Mental Models I Follow & Practice – Part 1” & “Part 2”
Let’s just say we’ve studied company ELM (a medium capitalized e-commerce public company in France, this is only a made up company), done our own reading and research. After which, we made a DCF model to compute how much should we purchase the shares of the said business. With our own story + numbers assumptions, we arrived into an intrinsic value for the business worth $2 Billion of market capitalization.
We understand that there are a lot of uncertainties in the future, which could derail our own projections for the business. This is where placing a margin of safety is important. Our chosen percentage of margin of safety we’ll be using on top of our computed intrinsic value is based on our confidence and conviction with the thesis that we’ve made.
Assuming that we’re confident and comfortable with our stories and numbers plugged in our DCF model for company ELM. And with this, we personally gave a 20% margin of safety based on our own conviction on our analysis.
Therefore:
Intrinsic Value = $2 Billion Market Cap
Margin of Safety = 20%
Buy price = $1.6 Billion Market Cap
This means that we’ll be purchasing the shares of the business once the stock price hits our Margin of safety level, which in our example is at $1.6 Billion Market Cap.
To Sum It Up
At the end of the day, understanding the business model, its management, competitive advantage, debt-liquidity levels and valuation are what have always been important for me.
- Increasing Revenue/Operating Income & Net Income
- Maintained or Increasing Margins (Gross Margins, Profit Margins & Net Income Margins)
- Low or Manageable Debt Levels
- Has Good Liquidity Levels
- Generating Consistent Positive Free Cash Flow (better if increasing)
- Stable, High and/or Increasing ROE & ROIC
- Should be below my Fair Value Calculation
Don’t get me wrong, this simple checklist of mine doesn’t give me 100% percent success rate, but it does personally make me comfortable with my investment choices. The peace of mind and a goodnight sleep regardless of the changes in the market condition, either for the best or for the worst. A simple goal of:
- Best case: I’ll make a lot of money – My investment choices will give me returns more than what I’ve expected
- Average case: I’ll still make money – Beats inflation and >=10%-15% YOY
- Worst case: I’ll have 0% returns, or I’ll lose money by paper but not as much.
What I have is time, and with a long investment time horizon, there are a lot of things that can be learned, and can further improve my investment returns.
To know more how to understand a company from scratch see the blog links down below 👇
- How to Understand & Research a Public Company from Scratch
- Understanding a Public Company from Scratch – MD&A & Financials
Knowledge is my Sword and Patience is my Shield,
elmads
This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.
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