The Use of Stock Checklists
I recently came across an interesting article in The New Yorker magazine called The Checklist written by a multi-talented surgeon who is also the author of an interesting book I am reading called “Complications: A Surgeon’s Notes on an Imperfect Science”.
The article is quite long but it boils down to that in spite of strong evidence to the contrary, highly trained people think it’s below them to use check-lists as they know what to do and working through a check-list is an insult to them.
But this time he found few takers. There were various reasons. Some physicians were offended by the suggestion that they needed check-lists. Others had legitimate doubts about Pronovost’s evidence.
Within the first three months of the project, the infection rate in Michigan’s I.C.U.s decreased by sixty-six per cent.The typical I.C.U.—including the ones at Sinai-Grace Hospital—cut its quarterly infection rate to zero.Michigan’s infection rates fell so low that its average I.C.U. outperformed ninety per cent of I.C.U.s nationwide.In the Keystone Initiative’s first eighteen months, the hospitals saved an estimated hundred and seventy-five million dollars in costs and more than fifteen hundred lives. The successes have been sustained for almost four years, all because of a stupid little check-list.
All this from a checklist with steps as simple as “wash hands with soap”.
An aeroplane is a complex entity, so is medical procedures and I want to argue so is investing.
When evaluating a company there are so many factors that are beyond your control. You however, through empirical research, know what increases the probability of you making profitable investment decisions.
What is thus important is that you focus on what you can control in your research and analysis.
My 40 Point Checklist
As part of my evaluation process I work through the following check-list:
- Can I in one sentence say exactly what the company does? (Thanks Cristina)
- Is operating cash flow higher than earnings per share?
- Is Free Cash Flow/Share higher than dividends paid?
- Debt to equity below 35%?
- Debt less than book value?
- Long Term debt less than 2 times working capital?
- Is the debt to EBITDA ratio less than 5? (Thanks Guy)
- What are the debt covenants?
- When is the debt due?
- Are Pre-tax margins higher than 15%?
- Is the Free Cash Flow Margin higher than 10%?
- Is the current asset ratio greater than 1.5?
- Is the quick ratio greater than 1?
- Is there growth in Earnings Per Share?
- Is management shareholding > 10%?
- Is the Altman Z score > 3?
- Does the company have a Piotroski F-Score of more than 7?
- Is there substantial dilution?
- What is the Flow ratio (Good < 1.25, Bad > 3)
- What are management’s incentives?
- Are management’s salaries too high?
- What is the bargaining power of suppliers?
- Is there heavy insider buying?
- Is there heavy insider selling?
- Any net share buybacks?
- Is it a low risk business?
- Is there high uncertainty?
- Is it in my circle of competence?
- Is it a good business?
- Do I like the management? (Operators, capital allocators, integrity)
- Is the stock screaming cheap?
- How capital intensive is the business?
- Does management have the ability to naturally re-invest in the business at a high return?
- Is the company highly profitable?
- Has it got a high return on capital?
- Has the business got an enormous moat?
- Is there room for future growth?
- Does the business have strong cash flow?
- What has management done with the cash?
- Where has the Free Cash Flow been invested?
- Share buybacks
- Reinvested in the business
I also have an analysis spreadsheet for companies I have come across through the Magic Formula Screen from Joel Greenblatt.
For these companies I use these additional check-list items:
- Are there any Magic formula value outliers?
- Is the company in a bubble industry over the last 5 years?
- Does the cash belong to the company?
- Is EBIT / Assets > 20%
I have put this checklist together over a period of more than 20 years and often make changes as I gain new information and insights.
I also do not have a formula that if a company fails X amount of points on the check-list I do not consider it.
The checklist however gives me an indication of what problem areas the company has and where I have to do further analysis.
Feel free to use the above stock checklist points in your analysis process and let me know if you have any additional points I can add in the comments below.
About the Author
Tim du Toit is editor and founder of Eurosharelab. On his website he reveals what more than 20 years of equity investment have taught him – sometimes at considerable cost. To discover how you can avoid costly mistakes and enjoy greater profits, sign up for his free newsletter “Investing that makes sense” at Eurosharelab.