Stock Buying Checklist: Essential Part of Evaluating Stocks (Example Checklist)

The stock buying checklist is one of the essential tools to any investor, in my opinion, and to most, an underutilized tool.

Using a checklist is a fantastic way to learn from your mistakes, plus it can help you standardize your investment process by building on your experience and what you observe throughout your career.

Building a stock buying checklist is an ongoing project; you won’t ever make it, and one-and-done. It will evolve as you evolve as an investor.

My introduction to the world of stock buying checklists was through Mohnish Pabrai and his fantastic book “The Dhando Investor.” Pabrai is the leader of Pabrai Investment Funds and arguably one of the best value investors in the world. He has a fantastic record and is one of the best investors from the Buffett-Munger school of investing.

Pabrai gave a presentation to Columbia University a few years ago. In the presentation, he outlined some of his thoughts on using a checklist to help with his investing decisions. I highly recommend you check it out; it was life-changing for me.

Building a checklist doesn’t require tons of work or hours of study. An essential ingredient is to recognize mistakes from the past and the errors of others and build from those. You can take your journey, build from that, learn from the gurus we all admire, and take snippets from their mistakes and add them to our list.

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Currently, Pabrai has around 95 to 100 questions on his stock buying checklist, and it takes him approximately 20 minutes to work through them. Not all questions require lots of deep thought and spreadsheets full of financial data, but a thorough look gives you an excellent framework to dig deeper.

After reading Pabrai’s fantastic book, I came upon Buffett and Munger’s presentation on their four filters.

We will base our framework on these Four Filters. Buffett first presented the four filters in the 1977 Letter to Shareholders.

  1. A business that we can easily understand
  2. Favorable long-term prospects
  3. Operated by honest and capable people
  4. Available at a reasonable price

The following are ideas that I have adapted from the gurus mentioned above, as well as other books I have read on the subject, and finally, my experience investing. Please do not take this as a must-do list, this is my attempt to pass along some information I have learned along the way, and I hope it can help you as a framework for your ideas. None of the below remains set, and if you want to change, eliminate, or ignore individual sections, that is your choice.

Here are the four pillars [click to skip ahead]:

Business Pillar

The first pillar will examine questions based on understanding the business and what they do to make money.

1. Is the business understandable?

First, make sure this is a business that you want to spend some time learning about. If not, then move on to another. Make sure the industry offers a combination of something you know or follows your interests.

For example, after working at Wells Fargo, I developed an interest in financials based on my experience at the bank and talking with others in the food chain. I also have experience in the beverage and restaurant worlds. As we learn more about the business, you will spend time reading annual and industry reports, and if you have no love for the industry, move on.

2. Can you describe what the business does in your own words?

To understand the business, you must read through the business section of the 10-k. Here you will discover each of the business segments, distribution channels, marketing, what they manufacture, management discussion of strategies and risks, and so much more.

After reading through this section, please take a moment and, in your own words, write down what the company does and how they operate.

Next, visit the company’s website and learn what products and services they offer, with the goal of better understanding the business.

picture of a graph illustrating a check list

Writing in your own words helps solidify your thoughts and gives you a deeper understanding of the business.

If I have not mentioned this before, keeping an investment journal is crucial to this type of activity, both for keeping your ideas and to have the ability to look back.

3. How does the company make money?

It sounds simple, but understanding how a company generates earnings is crucial, and many investors fall into the trap of not indeed assuming this simple question.

Think about a bank, most people think that banks make money from the fees they charge us, but that is, in almost all cases, a minor part of their earnings. Banks make most of their income from lending and the spread between the interest rates they receive and the rates they charge consumers.

Think about how the company segments its business and how each segment drives earnings. Typically one or two will be the big hitters, and the rest are add-ons. For example, where does Disney generate most of its earnings? Is it the theme parks, or is it the merchandise, or is it the movies?

Those are the types of questions to ask yourself as you investigate each company.

4. How has the company evolved?

Historical perspectives can give you a deeper understanding of the business. We can see how the company’s competitive advantage has grown or maintained over the years. Check the company’s website for a timeline or historical overview to see how the company has evolved.

Another option is to scan over ten years of 10-ks for a historical perspective.

5. Who is the customer of this business?

We must understand the core business customer. The core customer often will boil down to a few customers, giving us important information to comprehend because losing those consumers would be extremely risky.

Typically, the business will outline its main customers in the business section of the 10-k.

We should focus on the company’s core customer or determine if the company tries all things to all people, which can lead to a lack of focus and losing market share and earnings.

Companies need to note if the customer base remains consolidated or not.

6. What is the retention rate of the customer?

How sticky is the company’s product or service? Apple (AAPL) and the iPhone offer a great example. Apple has done a fantastic job creating a product their customers love, and once in the ecosystem, it remains difficult to leave.

For me, Google (GOOG) offers another great example with its website tools, such as Sheets, Pages, and Drive. I can’t imagine life without those tools for my writing, investing, and keeping track of everything.

Right now, you can argue that Netflix rules the streaming world, but incredible competition exists from Hulu, Disney+, Amazon Prime, etc. Churn remains one of the main focuses for Netflix and entices customers to stay with the service. It’s a critical item for Netflix’s business and is vital for their continued success.

7. What pain does the business solve for the customer?

What does the company exist to do if the business doesn’t solve a problem or fill a need? We must understand the customer’s pain point and what the company does to fix the problem.

8. Does the company have a durable competitive advantage or a moat?

We need to understand if the business has long-term protection from competition. Munger and Buffett come back to this point numerous times in their interviews, speeches, and writings.

A durable competitive advantage remains one of the biggies in value investing. If you have difficulty discovering whether the company has a moat, you will have trouble finding out whether or not the company has long-term opportunities.

When we do find a company with a moat, it is critical to determine the strength and staying power of the moat.

Two great questions to ask when deciding if the company has a moat:

  • How easily can someone replace or copy this moat?
  • How quickly might this happen?

A company you could argue has a vast moat is Visa; its control over the payment processing space and Mastercard remains complete. American Express does have its niche, as does Discover, but Visa, in particular, remains powerful and has a moat.

We can find many examples, and using metrics to measure a moat remains one of the best ways to measure and assess the company’s financial strength. Still, the most obvious way is to ask yourself, how can we live without this product, and who out there will replace them?

Think of Google; they have won the internet search war for now, so much so that it has become a verb to “google” something.

For more information, check out Michael Mauboussin’s work on moats.

9. Can the company raise prices without losing its customers?

The best indicator of a company’s moat is the ability to raise its prices without losing many customers. For example, look at:

  • Apple and the iPhone
  • Netflix and their streaming service
  • Amazon and Amazon Prime
  • Costco and their annual membership

Those are just a few examples of companies with pricing power. No matter what they charge, we will pay it to have the service or product.

Some examples of common characteristics of pricing power:

  • High customer retention rates
  • The quality of the product is more important than the price
  • Customers have a high cash value.
  • Low price sensitivity

10. Does the business operate in a good or bad industry?

Finding the right industry can impact what kind of returns you can earn. As you evaluate your industry, ask how easily you can make money in the industry.

To evaluate the industry, look at the return on invested capital for the industry and the company. If it is easy to make money, then most companies will have excellent ROIC; if the range varies more, with a few doing well and the rest struggling, then the industry might not work.

For a more in-depth understanding, try comparing the best companies to the dregs of the industry, and you will identify the good from the bad.

11. What is the competitive landscape, and how competitive is it?

Analyzing the competition is crucial to determine how successful your company will be in the long run. A few questions to ask:

  • Does the business have limited competitors?
  • Does the industry change much?
  • How fiercely do the competitors compete?
  • Which company is the industry standard?
  • If competitors have failed, why?

Management Pillar

In my opinion, assessing management is a harder skill to analyze because it involves more “soft” skills than deciphering numbers.

1. What type of manager is the leader?

The type of manager goes to what kind of incentive will the leader have. If you find a company with a leader with a long history of success, the chances of success will continue. On the other hand, if you find a new management team, you will encounter many unknowns with far greater risks.

There are three types of managers:

  • Owner operator
  • Long-tenured manager
  • Hired Hand

The owner-operator has the most skin in the game and more on the line. Typically they founded the business; an example would be Jeff Bezos of Amazon or Warren Buffett of Berkshire Hathaway.

Long-tenured managers have operated in the industry for more than ten years, typically promoted from within, and have a real sense of the business and what it takes to succeed.

Hired Hands is a manager from a related industry, and they jump from job to job without real tenure in the industry or business. Most of these managers make short-term decisions because of their short-term focus. Hired hands also typically cut revenues, not build revenue and earnings.

2. Has the manager demonstrated a high level of honesty and integrity?

The best way to assess these qualities is to read both the letters to shareholders or annual reports and the management section of the 10-k. You can tell a lot from the words these managers wrote; also, you can see if they have a plan and follow through with it.

Another takeaway from these sources is the ability to manage through tough times or if things don’t go as planned. Do they make excuses, or do they take ownership of the mistakes?

Another way to analyze the integrity is to listen to quarterly earnings calls. You can tell a lot about a person by how patiently they answer the questions from these analysts and how well they treat their fellow team members.

3. Is management candid with shareholders?

Use Warren Buffett as a yardstick for this question. No more candid manager is open with his shareholders about his decisions and performance. If you read through his letters to shareholders, you can see his honesty as he discusses his failure to lead Berkshire’s insurance arm during the early 1980s.

Anytime we encounter a problem, you aren’t necessarily looking for excuses; you are looking for the manager to be honest with you and explain in plain language what happened and how they will fix it. And then watching the follow-through of that plan will tell you a lot about a manager.

4. How are senior management compensated, and how did they gain their ownership?

We should examine the proxy statement to understand the compensation and ownership interest of the senior management. You can gain great insight into the motivation for high-level management decisions based on their compensation. We want to find managers with a long-term view, and if they have a long-term compensation package, their focus will have a long-term perspective.

Ideally, we would love to find a CEO with a small salary and significant stock ownership compensation. These managers tend to have a long-term view, which we want.

Watch out for managers with stock options or companies with huge CEO payouts. They will have a short-term outlook and look out for themselves, not the company or the shareholders, because the incentives will encourage boosting earnings instead of building a great company.

5. Look for insider buying or selling

If a senior manager buys or sells company stock, that can tell you much about what is happening with the company. Sometimes, the manager may liquidate shares to pay for a child’s education.

But suppose the manager continues buying their company’s shares. In that case, the buying might indicate they think the company offers a good opportunity or there is a catalyst for its value to increase.

Insider buying or selling can tell you much about what the people closest to the company think about it and its prospects.

Try not to jump to conclusions because one manager selling his shares might not mean much, but if the whole management team is selling or buying, that is far more indicative of something much better or worse.

6. Does management have a plan, and do they communicate that plan?

Reading through the annual reports and discussions from the 10-k can help you determine if management has a plan to grow the business and how well they execute their projects.

Follow-through is essential to determine the integrity of management and to see if they are the right team to lead the company.

7. Do the CEO or CFO offer guidance regarding earnings?

Earnings drive Wall Street, and it is the main focus of analysts. They tend to fixate on earnings, and the company may feel the need to hit those earnings projections, to the detriment of the company. Because the company’s price relates to the analyst’s view on the company’s performance, which they measure by earnings, they may focus on earnings.

And if that CEO or CFO has stock options tied up in earnings performance and the price of the stock increasing, that leads to more focus on earnings.

8. Are the CEO and CFO disciplined in making capital allocations?

What management does with the cash that they create can go a long way towards more value for the shareholders. Increasing or paying a dividend, reinvesting in the business, or buying back shares are a few possible decisions.

Finding a great CEO to operate the business will typically not allocate capital well because the two functions are very different.

The best capital allocators are typically not day-to-day operators but remain removed from those operations. Warren Buffett would fit into this mold, as he is removed from daily operations.

9. Does management think independently and remain un-swayed by what others in the industry are doing?

One of the toughest challenges a CEO faces is to see its competitors having great success and all the earnings they are creating and not copying those methods. Sometimes companies may create earnings that are not sustainable.

Shareholders will often push to maximize short-term earnings, but the best managers will have a long-term view and focus on building for success over the long-term, which might not show results for a year before exploding.

Another way to tell if a manager thinks independently is if they compare themselves to a benchmark instead of competitors. It is often difficult to copy someone’s success, and if management tries to replicate that success, it might indicate that management doesn’t have a plan for themselves.

10. Does the business grow organically? Or through mergers and acquisitions?

We can answer this question by viewing the cash flow statement found in the 10-K.

The Investing section of the cash flow statement has a subsection titled “Acquisitions.” Calculate the percentage of cash flow from operations spent on acquisitions for the last 5 to 10 years.

We can classify a business by several growth styles depending on the acquisition percentage. On one end would be those businesses that grow organically. On the other end would be serial acquirers. And others would fall in the middle.

The serial acquirers risk paying too much for those businesses and adding more debt to the balance sheet.

The advantage of companies that grow organically is they don’t have to waste energy working to integrate other businesses with theirs and focus on their own. Plus, they spend less money on acquisitions and take on less debt.

11. What are the future growth prospects of the business?

We can assess future growth by reading through the management discussion and analysis of the 10-K. Management will discuss its plans for the future and how they intend to go about executing that plan.

Be careful not to base your future success on past performance; remember that we do not profit from yesterday’s success.

12. Is management focused on growing quickly or at a steady pace?

Growing companies are exciting, but if they are outpacing their business, this could lead to failure down the road.

Focus on whether the company has a disciplined or undisciplined growth strategy. A high growth rate does not guarantee profitability. I am looking at you, Tesla.

If the company is growing disciplined, it can control the growth and create more value for the shareholders.

Financial Pillar

This section will focus on the financial health of the business and will spend some time reading through the financials of the 10-K and 10-Q.

The first part is to go through the financial statements.

1. Go through the financials line by line

  • Income statement – line by line
  • Balance sheet – line by line
  • Cash flow statement – line by line

Read through at least two annual reports to compare numbers using an excel spreadsheet or your favorite financial website for comparisons. Look for trends, either on the upswing or downturn.

Make a competitor comparison of the numbers to give you an idea of the strength of the business.

2. What are the business operating metrics that we need to focus on?

Every industry has metrics that are more useful for that particular business; for example, price to book is excellent for financials such as banks.

The best way to identify whether the company has improving or deteriorating fundamentals for the business is by using metrics. Operating metrics can help us determine the true health of a business. To identify the metrics that would be best:

  • Find the best industry metrics
  • Research the source of the metrics, i.e., 10-K and 10-Q
  • Observe the metrics over time by utilizing simple spreadsheets
  • If there are changes, determine if they are permanent or temporary
  • Compare the metrics to the competition and identify the reasons for any differences

3. Identify key risks the business faces

We can identify key risks in the 10-K under the risk sections and the management discussion section.

Risks are associated with the business and others related to the stock price. Please focus on the risks associated with the company, as they are more critical. There is a lot of boilerplate language in these sections, and it is essential to read through them and you will learn what to ignore and what to focus on.

A great practice is to list the risks particular to your company and assess each of them and the impact they can have on your company’s value. Another great idea is to take it a step further, look at the competitor’s risks, and see if they line up.

4. Assess the strength or weakness of the balance sheet

A strong or weak balance sheet can mean the difference between surviving an economic downturn, like the Coronavirus pandemic, or struggling and declaring bankruptcy.

A healthy balance sheet allows a company to take advantage of any opportunity regardless of economic conditions.

Our primary goal is to determine if the cash flow is sufficient to meet its debt obligations and if there is a margin of safety to cover those debt payments in the case of cash flows declining.

We can use ratios to help us determine the company’s ability to pay its debt. We can use coverage ratios:

  • Earnings before interest, taxes, and depreciation (EBITDA) to interest expense
  • Earnings before interest and taxes (EBIT) to interest expense
  • Cash flow from operations to interest expense

Other useful ratios are:

  • Current assets to current liabilities
  • Debt to equity
  • Debt to total assets

Another option is to check the credit rating of the company at one of the credit rating agencies such as Moody’s or Standard & Poor’s.

We can also analyze the cash portion of the balance sheet with ratios:

Accounts receivable = net sales / total accounts receivable, and then divide the number by 365 to find how quickly the company turns its receivables into cash

Inventory = cost of goods sold / inventory, then divide by 365 to find how many days it takes to turn over the inventory.

5. What is the return on invested capital for the business?

Return on invested capital on a business is the profit created by the company relative to the money reinvested in the company. It tells us how well a company is using its assets. The more profit a company can make from its assets compared to the capital required, the better the business.

Each industry will have different levels of ROIC, some much higher than others. For example, the tech industry will be much higher than banks because there is less capital expended to create profits.

A couple of rules regarding ROIC:

  • We consider anything below 5 a low-quality business
  • We view any ratio above 10 as a high-quality business

Of the ratios we calculate, ROIC remains one of the more important ones to determine because the profit a company can make from its assets and the reinvestments it makes in the business are crucial for the long-term profitability of the company.

Buffett never explicitly says he calculates the ratio; however, he repeatedly talks about finding a business with a high return on capital as one of the most critical requirements.

If you are unfamiliar with this ratio, please check this out to learn more.

6. Does the business generate earnings from steady income or one-off transactions?

Evaluating companies generating earnings from a steady flow of business is easier to value than companies hitting home runs every once in a while.

Think of companies like Amazon with Amazon Prime, whose steady income makes them easier to value because of the greater predictability of those earnings. Also, there is less pressure and reliance on always having to create new products.

Companies like Apple that update their iPhones every few years create consistent earnings with the one product which generates most of their income.

You can learn more about this aspect of the business in the management discussion section in the 10-K.

7. Is the Return on Equity Attractive?

Again, measuring the return on the equity the company creates is essential, another Buffett favorite. You can learn more about this here.

8. Is the company conservatively financed?

Using our debt ratios from the balance sheet analysis, we can determine how much debt the company carries. The balance sheet analysis can also show how the company is functioning regarding creating value for the shareholders.

If the company uses debt to fund dividend payments or share buybacks, that is a red flag because eventually, the tide will wash out to sea, and they will be there with their pants down.

You can also determine from the notes section of the 10-K what kind of debt they are carrying and when it matures, which can tell us how much the debt might impact our cash flow in the future and the ability to reinvest in the business.

9. Does the company have a track record of growing earnings above the market average?

We are looking for companies who will grow their earnings over a long period. There will be starts and stops, but generally, you want to see long-term growth.

Any company growing revenue should expand its earnings in tandem if they keep the costs under control. Naturally, some costs will rise with an increase in business, but eventually, earnings must outpace the costs.

Another trick we can use – observe how they weather the storm. For example, how they had performed during poor market conditions. A good method is to check their business performance and earnings through the financial crisis of 2007-2009, which will tell you a lot about the strength of the business.

Valuation Pillar

1. Verify value investing metrics or ratios

Here is a list of ratios I run; you can either calculate them yourself or find a trusted financial website and use their data.

2. Calculate intrinsic value using different methods.

Using multiple ways to calculate the intrinsic value to find a margin of safety is crucial to finding an excellent investment that will reward us for years.

A word of caution – don’t get bogged down in trying to find the exact number because all valuation methods use a degree of guessing in the form of different discount rates you utilize. Remember what Buffett tells us: it is better to be approximately right than precisely wrong.

  • Discounted cash flow – my favorite model, using free cash flows; remember to use the most current discount rates from the 10-year or 30-year bonds, which will help you remain consistent. As with any practice, the more you execute this model, the better you will become.
  • If you value a bank or any other financial, we recommend using a dividend discount model to evaluate those companies. Banks and financials offer a challenge in analyzing their cash flows. Again, focus on the discount rates.

We have access to many other formulas, such as the Graham formula, which is an easy way to value a company. Remember, the Graham formula tends towards the upper end of valuations. In other words, the formula yields a higher price than others, so I tend to view it with skepticism and use the formula to find an upper range of possibilities.

When using any of the above valuation models or metrics, remember we are looking for a value we think is reasonable. Do not use the valuation number as your only checklist item to decide whether to buy a stock or not.

Valuation is both art and science, and the more you practice, the better you will become at deciphering the numbers. Practice, practice, and more practice.

Ok, that wraps up our valuation pillar. Short, but very important.

Additional resources

Here I would like to add some additional resources for you to reference in regards to adding to your stock buying checklist.

The Investment Checklist is the most in-depth guide to help create a stock buying checklist.

A Buffett-style checklist for reference.

Investment Checklist from ValueWalk – lots of great ideas taken from all the gurus we love to follow.

Final Thoughts

Creating a stock buying checklist is essential to our success in investing. Buying stocks is extremely difficult, and utilizing a checklist to monitor our successes and mistakes can help us keep track.

Setting up the stock buying checklist is not difficult; we can make it as simple as understanding the business and some valuation metrics. Using these checklists allows us to adapt them to your needs and experience.

My checklist has evolved over the years as I have discovered more exciting ideas. As you experience different market cycles and the ups and downs of buying or selling stocks, you will make mistakes; the trick is to learn from them, so we don’t make them twice.

Please take all the items I have added to my checklist and use whatever fits your investment style. The list is by no means exhaustive, and you will find others to add or remove as you explore more companies.

Try to think of yourself as Sherlock Holmes as we investigate different companies. Our goal remains to find a stable, profitable, growing business, and we must look for the clues that give us better insight into our ideas or investments.

As always, thank you for taking the time to read this article. I hope you find something of value for your investing journey.

Until next time,

Take care and stay safe,

Dave

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