How to invest

Following on from the discussion of my first investing checklist, it’s time to reveal my new investment checklist.

Rather than a checklist of yes/no answers, the new checklist focuses on sets of core to do tasks with the real checklist being only a handful of questions in the “Final Evaluation” section.

I’ve also made it visual so that it makes it quicker and easier to follow. Rather than having a checklist of 100 items thrown at you, having a flow chart will make it easier to manage and keep track of what stage of the investing process you are on.

Investment Checklist Flowchart

Old School Value Investment Checklist Process

Core Investment Checklist

Here is the text version.

Do the Pre Work

Preliminary Background Reading

• Read previous thesis on Blogs / Investing Sites / Forums / Alerts
• Read news headlines

Valuation

Financial Statement Analysis

• Go through line by line
  • Income statement + competitive advantage analysis
  • Balance sheet + competitive advantage analysis
  • Cash Flow statement + competitive advantage analysis
  • Quality of Earnings (Inventory, tax, EPS)
• Competitor comparison
• Verify 15 value investing metrics and ratios
• Discounted Cash Flow/ Graham’s Value/ Earnings Power Value/ Multiples/ Sum of Parts

Dirty Work

• 2 annual reports
• 3 quarterly reports
  • specific attention to footnotes at the end of the report
  • managers discussion – consistency, candidness
• 2 letter to shareholders
  • compare words, numbers to annual report numbers
• Latest proxy
  • CEO compensation (% of sales)
  • Greed factor (bonuses, reimbursements, planes, boats, family donations)
  • Insider ownership
• Search CEO history, track record, personality

Emotional Check

• Write down how you are feeling
• Beware of
  • wanting to just buy and study later
  • hindsight bias
  • overconfidence
  • obligation to buy due to amount of research
  • reluctance to accept differing opinions
  • social proof bias
• If required, take a break and clear your mind. Get away from the excitement and  noise.

Final Evaluation (the only checklist you need at this point)

• What can go wrong?
• What are the risks? How likely are the risks?
• How can you lose money?
• How would you categorise this investment?
• How attractive is this idea compared to the other holdings? (There can only be ONE best idea. Not 2 or 3.)
• What is the expected holding time frame?
• What should be the portfolio sizing?
• What price will you sell?

A checklist saves lives.

Before a planes takes off, the pilot must always go through a checklist to ensure that everything is rigorously checked.

And you certainly don’t want a nightmare crash in your portfolio.

I’ve had my checklist for about 2 years now and I felt it was time to go through it and improve upon it.

For long time readers and intrinsic value calculator users, you would have seen my initial checklist.

It went a little something like this.

Initial OSV Investing Checklist

There were two sections to the checklist. Qualitative and Quantitative.

1. Quantitative

2. Qualitative

By the end of these questions, I will have an idea of what number to give to categories in the spider graph such as below.

Problems with the Above Investing Checklist

1. Limited set of numbers and metrics

On the qualitative side, there isn’t much to explain. The criteria and cutoff points look pretty good. That’s only if you’re looking for the same type of company for every investment.

E.g. The cases couldn’t identify that a company with low margins with high inventory turnover could be even more effective than a high margin, low turnover company.

2. Too Narrow/Focused

By having setting specific standards, it was easy to forget other aspects like looking up CEO compensation, shares outstanding history etc.

3. Wording

The wording of the case also made it difficult because it just requires a yes or no. It made it far to easy to just answer based on my own guesses without performing the due research.

4. Not Universal

I found that the checklist was pretty lame against a company like KO or JNJ. I ended up skipping the entire checklist.

Checklist Improvement

So the question is, how do I improve on this?

Here is the new updated and improved investment checklist that covers a core set of to do tasks with a final evaluation checklist.

Previously I went through 4 combinations from the list of Benjamin Graham’s 10 criteria for stock selection.

Due to the many responses and requests for other combinations, I’ll be going through different conditions. I’ll also try to find the best performing condition to add to the value screens section.

Do take time to read the comments of the first article as it provides excellent additional information about the article as well as the screen itself.

And If you missed the original article, follow the links to get up to date.

• Graham stock selection screen article
• Forum link to the discussion of Graham’s stock selection criteria.
• Test of Graham’s stock selection criteria on industrial shares traded on the JSE (pdf)

Here are a couple of comments that I feel should be read.

Reader “Eldinril“, mentioned

..this is referred to as Graham’s Last Will and Testament. It was written by a man named James Rae, who became friends with Graham in the last few years of his life…

I recall reading once that Rae and/or his son attempted to run money using the ten-point checklist, but achieved lackluster results. I find it particularly intriguing to compare this checklist to the list of criteria included in the later editions of “The Intelligent Investor”. It is important to understand that this particular checklist was the result of conversations between Graham and Rae. Some of the details were the result of compromises between the two of them.

Reader “R” also brought up an interesting point.

..after coming up with these 10 points, Graham said that you could achieve the same result by selecting stocks with only the following 3 out of 10 points: Dividend yield at least 2/3rd AAA bond, Earning yield at least twice the AAA yield, debt to equity less than 1. Which means 1 3 and 6 above. Other points are redundant. See how the performance of a portfolio of those companies look like. I think there was an article on a recent AAII publication.

List of 10 Stock Selection Criteria by Benjamin Graham

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

3. Dividend yield of at least 2/3 the AAA bond yield

4. Stock price below 2/3 of tangible book value per share

5. Stock price below 2/3 of Net Current Asset Value (NCAV)

6. Total debt less than book value

7. Current ratio great than 2

8. Total debt less than 2 times Net Current Asset Value (NCAV)

9. Earnings growth of prior 10 years at least at a 7% annual compound rate

10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.

Test Combination of Criteria

The following combination of screen conditions have been applied

• (1),(2),(3)
• (1),(2),(3),(6)
• (1),(2),(3),(6),(7)
• (1),(2),(3),(6),(7),(8)
• (1),(2),(3),(6),(7),(8),(9)

The test conditions remain the same as the original and although I’ve received historical bond yield information, I have no idea how to incorporate it into my screen so I’ll have to stick with a static 4.5%.

I intentionally left out conditions (4) and (5) because these two produce zero results. It is best left as a standalone NCAV screen that I have available already.

As I was performing the screen, I noticed that the results of  (1),(2),(3),(6),(7),(8) was poorer compared to just (1),(2),(3),(6),(7), which means that condition (8) is a hindrance on performance.

I also noticed the same thing with condition (3):Dividend yield of at least 2/3 the AAA bond yield. The screen performed better without the dividend yield requirement.

This is a surprise because everyone has been saying that (3) is a main condition.

Or is it because of the drop after each dividend payment?

Old School Value’s Version of Graham’s Guru Screen

Here is what I have found to be the best stock selection criteria.

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

6. Total debt less than book value

7. Current ratio great than 2

Surprisingly very simple.

Stocks from the Best Performing Graham Checklist

I’ve added the above stocks to a virtual portfolio for you to track over time. Click to see the Graham Checklist Screen.

Disclosure

No positions.

A great way to find ideas is to use the selection checklist of gurus. There is one by Benjamin Graham that not too many people know about. A couple of readers have been kind enough to provide the selection criteria and papers testing the process which I will go into detail here.

Graham’s Stock Selection Criteria

• Forum link to the discussion of Graham’s stock selection criteria.
• Test of Graham’s stock selection criteria on industrial shares traded on the JSE (pdf)

There are 10 criteria in total.

The first 5 criteria measure ‘reward’ and is sensitive to price and earnings changes. The focus in this group of five criteria is on stock price, earnings and dividends.

The second group of 5 offers a measure of ‘risk’ and does not change rapidly with changes in price and earnings. Criteria number 6,7 and 8 represent the financial soundness of companies.

Selection, by using the criteria, is based on the concept of maximising the ‘reward’ to ‘risk’ ratio of stock selected.

One thing I want to point out is that the reward-risk philosophy is backward. Personally, after chasing reward to risk much often and taking the damage, I have found it much better to chase after low risk to reward ratios. It may sound like the same thing, but determining low risk followed by reward is much different to finding reward and then performing the risk analysis.

List of 10 Stock Selection Criteria by Benjamin Graham

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

3. Dividend yield of at least 2/3 the AAA bond yield

4. Stock price below 2/3 of tangible book value per share

5. Stock price below 2/3 of Net Current Asset Value (NCAV)

6. Total debt less than book value

7. Current ratio great than 2

8. Total debt less than 2 times Net Current Asset Value (NCAV)

9. Earnings growth of prior 10 years at least at a 7% annual compound rate

10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.

Test Combination of Criteria

Not a single stock will be able to pass this filter today. When the screen reaches no. 3, only around 30 stocks make it. When you hit the fourth condition, the list becomes 0.

So to make this exercise worthwhile, I would have to run the criteria in combination with each other but not all at the same time.

The table below is from the paper with the test performed from 1977 to 1995, a span of 18 years.

Keep in mind that back in the days of Graham, most companies were industrial and the stock universe was much smaller then as well.

In order to clean up the results, I left out financial stocks, OTC stocks and ADR’s.

I do not have access to historical AAA bond yield data so I applied a static 4.5% as the AAA bond yield for all screens for all periods.

Still, it results in plenty of pickings. The additional condition that I applied was (7) Current ratio great than 2.

I also tested one that included (8) Total debt less than 2 times Net Current Asset Value (NCAV). The number of results were reduced but the screen did not perform any better so I left it out.

Graham Stock Selection Criteria Results

With the limited amount of data that I have access to, 20 years of back testing is out of the question. 20 year tests also do not serve much purpose. Such tests, I find to be distorted due to it being unrealistic. You might as well do the test for 100 years and conclude it kills the market.

I chose the period from 2004 end of August 2010 to test the results.

Why 2004?

I didn’t want to apply the test in 2001-2003 because of the dot com bust. By 2004, the recession was over, markets have stabilized and “ordinary” people would have gotten back into the market. Not quite Nobel prize worthy, but realistic.

The conditions I applied to all screens are as follows:

• ignore financial companies, OTC and ADR’s
• AAA bond yield was kept at 4.5%
• max 20 stocks held
• 1 year holding period

I would say a 6 year period is long enough to say that this strategy would beat the indexes over the long run. With $100, the screen depicted by the orange line would have netted $193.

Individual year performance will vary and fluctuate and you won’t beat the market every year, but Graham’s simple selections looks to be solid for the passive investor as well as being a good source of ideas for the enterprising.

10 Stocks that Graham Would Choose

Applying the (1),(3),(6) & (7) conditions, here is a list of stocks that even Graham would be interested in if he were alive.

Disclosure

None

Thanks to a reader, I realized I’ve been making a mistake on how I read the SEC insider transaction Form 4.

How to Read SEC Form 4

The example above is the latest form 4 for Dilliards (DDS).

Overall, the form is very easy to understand. You have the filing person, the date of transaction, the type of security, codes for the type of transaction, the price paid for the security and comments down the bottom.

In the image above, I placed a star next to the transaction code.

My mistake was that I thought “A” stood for “Acquired”, which I also thought to be direct open market purchases. Oops.

Better a slice of humble pie now than later.

So for those unsure of what each transaction code stands for, the official code list from the SEC is below.

Transaction Code Definitions

General Transaction Codes

• P – Open market or private purchase of securities
• S – Open market or private sale of securities
• V – Transaction voluntarily reported earlier than required

Rule 16b-3 Transaction Codes

• A – Grant, award, or other acquisition
• D – Sale (or disposition) back to the issuer of the securities
• F – Payment of exercise price or tax liability by delivering or withholding securities
• I – Discretionary transaction, which is an order to the broker to execute the transaction at the best possible price
• M – Exercise of conversion of derivative security

Derivative Securities Codes

• C – Conversion of derivative security (usually options)
• E – Expiration of short derivative position (usually options)
• H – Expiration (or cancellation) of long derivative position with value received (usually options)
• O – Exercise of out-of-the-money derivative securities (usually options)
• X – Exercise of in-the-money or at-the-money derivatives securities (usually options)

Other Sections 16b Exempt Transactions and Small Acquisition Codes

• G – Bona fide gift
• L – Small Acquisition
• W – Acquisition or disposition by will or laws of descent and distribution
• Z – Deposit into or withdrawal from voting trust

Other Transaction Codes

• J – Other acquisition or disposition (transaction described in footnotes)
• K – Transaction in equity swap or similar instrument
• U – Disposition due to a tender of shares in a change of control transaction

Stock Screen Strategy and Backtest Series

• NCAV NNWC Screen Strategy Backtest
• CROIC and ROIC Screen Strategy
• Negative Enterprise Value Screen Strategy
• Free Cash Flow Screen and Backtest
• Piotroski Screen and Backtest

Altman Z Score Overview

The Z-score formula may be used to predict the probability that a firm will go into bankruptcy within two years.

Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. - Wikipedia

Much like the Piotroski score, the Altman Z score too was formulated by a professor by the name of Edward Altman of NYU from the 1960’s. At that point in time, most of the public trading companies were in manufacturing. No MSFT or GOOG at that time.

The Z score consists of 5 variables:

• X1 = Working Capital/Total Assets
• X2 = Retained Earnings/Total Assets
• X3 = EBITDA/Total Assets
• X4 = Market Value of Equity/Total Liabilities
• X5 = Net Sales/Total Assets

Original Altman Z Score for Public Companies

The original model to calculate the Z score for public manufacturing companies is as follows.

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

When Z is 3.0 or more, the firm is most likely safe based on the financial data. However, be careful to double check as fraud, economic downturns and other factors could cause unexpected reversals.

When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.

When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years. This is the lower portion of the grey area and a dramatic turnaround of the company is needed.

When Z is below 1.8, the company is highly likely to be bankrupt. If a company is generating lower than 1.8, serious studies must be performed to ensure the company can survive.

Revised Altman Z Score

Chroma Investing wrote about a revised Altman Z score as the original might be under reporting bankruptcies among non-manufacturing firms.

in subsequent studies, it was found that the original Altman Z score might be under reporting bankruptcies among non-manufacturing firms. Given that used correctly, it has a 80%-90% accuracy of predicting bankruptcy in the next year, Altman Z is a great tool, but it must be used correctly.

Z = 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4

You will note that there is no X5 included in this version of the Altman Z score.It seems that including the X5 increased the likelihood of missing a potential bankrupt company for non manufacturing firms.

The revised Altman Z score cannot be used for Manufacturing companies, which requires the original Altman Z score. Nor can it be used for privately held, or publicly traded financial  companies.

Also, be aware that companies with one time charge offs may show up negatively.

Finally the Z score cannot be accurately used for companies with less than $1 million in assets and reportedly more accuracy may be obtained by using companies with more than $100 million in assets.

The Altman Z score is probably not all that accurate in the small camp universe I usually tread. It has more narrowly defined uses than I originally realized.

Along with the revised Altman Z formula, the weightings were also adjusted.

When Z is 2.6 or more, the firm is most likely safe based on the financial data. However, be careful to double check as fraud, economic downturns and other factors could cause unexpected reversals.

When Z is 1.1 to 2.6, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.

When Z is below 1.1, the company is highly likely to be bankrupt. If a company is generating lower than 1.8, serious studies must be performed to ensure the company can survive.

You can download the free Altman Z spreadsheet as well as check out the Altman Z screener. The premium stock valuation calculator will also include 10 years of Altman Z calcuations for both the original and revised formula.

Altman Z Screen Performance

If the Altman Z is to predict companies that are likely to go bankrupt within the next year or so, selecting a group of companies where the Altman Z score is above 3 should gather a list of fundamentally strong companies.

The screen assumes that it is rebalanced every 6 months. The results are all pre-tax so the overall results would be less.

From the looks of the results, the Altman Z score does a fantastic job of outperforming the market. 2008 results weren’t great but considering that no asset class or diversification saved any portfolio, I find the 2008 results to be acceptable.

Stock Ideas based on Altman Z Scores Above 5

Looking at the list of stocks in the list, a couple have been bought out, most, if not all, companies are fundamentally sound and the stock performances haven’t been too shabby either.

I’ve heard people mention that the Altman Z score can be used to find potential shorts, but from this short list, it may also be useful for finding buyout candidates.

The Altman Z score is something I’ll definitely refer to more often in my future analysis. When used correctly, it could save you from big headaches.

Grab your free Altman Z spreadsheet and check out the Altman Z screener. The premium stock valuation calculator will also include 10 years of Altman Z calcuations for both the original and revised formula.

Disclosure

None