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 through your career.
The stock buying checklist is one of the essential tools to any investors, in my opinion, and to most an underutilized tool.
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.
Life Changing Checklist from a Great 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 any mistakes from the past, and 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 to our list.
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 of the questions require lots of deep thought and spreadsheets full of financial data, but a thorough look does give you an excellent framework to dig deeper.
After reading Pabrai’s fantastic book, I came upon Buffett and Mungers’ presentation on their four filters. Much has been written about these filters, as well as Andrew and I have recorded a podcast episode about them so I won’t beat a dead horse in regards to rehashing all of those ideas.
But what I did was take their framework as a starting point for my checklist and then worked from there. Buffett and Munger are two of my gurus, as well as Pabrai for inspiration, and the following will be a list that I have come up for my use, and I am happy to share it with you as a guide to create your own.
Here are Buffett’s and Munger’s Four Filters that we will base our framework. The filters were first presented in the 1977 Letter to Shareholders.
- A business that we can easily understand
- Favorable long-term prospects
- Operated by honest and capable people
- 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 that it can help you as a framework for your ideas. None of this is set in stone, and if you want to change, eliminate, or just ignore individual sections, that is your choice.
And finally, I am not presenting these ideas because I think I am some sort of gifted investor. After all, I assure you I do not. Instead, I hope that you can learn from my mistakes and avoid them in the future.
Ok, enough preamble, let’s get to the stock buying checklist. I will number these items as we go along, and later, I will create a worksheet with them all in one place for your use.
The first pillar will examine questions based on understanding the business and what it is they do to make money.
Is the business understandable?
First, make sure this is a business that you want to spend some time learning about it. If not, then move on to another. Make sure it is in an industry you either have experience with or is in an industry that you are interested in learning more about.
For example, after working at Wells Fargo, I developed an interest in financials based on my experience at the bank and talking with others higher in the food chain. I also have experience in the beverage world and the restaurant world, so those would be strengths for me. Others would have more success than tech than myself, so I tend to not look for those kinds of companies.
As we go through learning more about the business, you will be spending time reading annual reports, industry reports, and if there is no love for the industry, then move on.
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, managements discussion of strategies and risks they face, and so much more.
After reading through this section, take a moment and, in your own words, write down what it is the company does and how they operate.
Next, take a moment to visit the company’s website and learn what products and services they offer, the goal here is to be able to recite to a friend what it is that the business does and sells.
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.
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 the majority of their income from lending and the spread between interest rates they receive and the rates they charge consumers.
Think about the segments that the businesses are broken up into, and how each of those segments drives earnings for the company. Typically one or two will be the big hitters, and the rest are add-ons. For example, where does Disney generate most of their 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.
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 either grown or been 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.
Who is the customer of this business?
It is essential to understand who the core customer of the business is. Many times, the core customer will boil down to a few customers, and it is crucial to understand that aspect because that is a tremendous risk if they lose that customer.
Typically the business will outline who their main customers are in the business section of the 10-k.
Another aspect of this question is to focus on whether the company is focusing on its core customer or if it is trying to be all things to all people, which can lead to a lack of focus and losing market share and earnings. Think about restaurants that try to be all things and stray away from their core business; most get on the struggle bus once they try to cross that bridge. Imagine the Olive Garden trying to serve tacos!
There is a risk that needs to be notated if the customer base is concentrated as opposed to more diversified.
What is the retention rate of the customer?
How sticky is the product that the company produces? A great example of this is Apple (AAPL) and its iPhone. Apple has done a fantastic job creating a product that their customers love, and once in the ecosystem, it is incredibly difficult to leave.
Another example would be Google (GOOG), and their website tools such as Sheets, Pages, and Drive for me. I can’t imagine life without those tools for my writing, investing, keeping track of everything. I have tried dabbling with Microsoft products, but for me, they are not as mobile-friendly and not as functional for my life.
Another example is Netflix (NFLX) and its streaming services. Right now, you can argue that Netflix rules the streaming world, but there is incredible competition from the likes of Hulu, Disney +, Amazon Prime, and so on. One of the main focuses of Netflix is on their churn and enticing customers to stay with the service. That is a critical item for Netflix’s business, and it is vital to be aware of it.
What pain does the business solve for the customer?
If the business doesn’t solve a problem or fill a need, then what is the company existing to do? It is crucial to understand the customer’s pain point and what the company does to fix that problem.
Does the company have a durable competitive advantage or a moat?
It is crucial to understand if the business has long-term protection from competition. Both Munger and Buffett come back to this point numerous times in their interviews, speeches, and writings.
Having a durable competitive advantage is one of the biggies in the value investing world. If you have difficultly discovering whether the company has a moat or not, then 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 that you could argue has a vast moat is Visa, its control over the payment processing space along with Mastercard is nearly complete. American Express does have their niche, as does Discover, but Visa, in particular, is powerful and has a moat.
There are many more companies out there, and many of the best ways to measure a moat are using different metrics to asses the financial strength of the company. Still, the most obvious way is to ask yourself, how can we live without this product and who out there is going to 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.
I could beat that to death, but we have other questions to get to.
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 that have 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
- Quality of the product is more important than price
- Customers have a high cash value.
- And low price sensitivity
Does the business operate in a good or bad industry?
Finding the right industry is vital because it has a bearing on what kind of returns you can earn from the right sector. As you evaluate your industry, ask how easy is it to make money in this industry? If it is easy, then that is the right choice.
To evaluate the industry, look at the return on invested capital for the industry and the company you are investigating. If it is easy to make money, then most companies will have excellent ROIC; if the range is more variable with a few doing well and the rest struggling, then that is not the right industry for you.
For a more in-depth understanding, try comparing the best company’s to the dregs of the industry, and you will identify the reasons why the industry is a good one.
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?
That wraps up the business section of the checklist. Next up, a look at assessing management.
Assessing management is, in my opinion, one of the harder skills to analyze because there are more “soft” skills involved than deciphering numbers.
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 that has a leader with a long history of success, the chances are that it will continue. On the other hand, if you find a new management team, then there will be a lot of unknowns, and it could be far riskier.
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 are the founder of the business; an example would be Jeff Bezos of Amazon or Warren Buffett of Berkshire Hathaway.
Long-tenured have been in the industry for more than ten years, and are typically promoted from within and have a real sense of the business and what it takes to be successful in the industry. A risk is they may be promoted out of a position they were perfect in, to the CEO, which is not their strong suit.
Hired Hands is a manager from a related industry, and they jump from job to job, without any real tenure in the industry or business. Most of these managers make short-term decisions because they are not in it for the long-haul. They are also typically revenue cutters, not builders of revenue and earnings.
Has the manager demonstrated a high level of honesty and integrity?
The best way to asses these qualities are 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 written by these managers; also, you can see if they have a plan and if they follow through with that plan.
Another take away 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 earnings calls that are recorded quarterly. 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.
Is management candid with shareholders?
Use Warren Buffett as a yardstick for this question. There is no more candid manager, and he is open with his shareholders about his decisions and performance. If you read through his letters to shareholders, you can see the honesty he displays as he discusses his failure in leading the insurance arm of Berkshire during the early 1980s.
Anytime there is 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 are going to fix the problem. And then watching the follow-through of that plan will tell you a lot about a manager.
How are senior management compensated, and how did they gain their ownership?
It is essential to 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 how they might be compensated. We are looking for managers with a long-term view, and if they have a long-term compensation package, then the chances are they will have a long-term perspective.
Ideally, we would love to find a CEO with a small salary and significant stock ownership compensation. These types of managers tend to have a long-term view, which is perfect for us.
Be wary of managers with stock options or companies with huge payouts for CEOs. Their view will be short-term and looking out for themselves, not the company or the shareholders, because the incentives will encourage boosting earnings, as opposed to building a great company.
Look for insider buying or selling
If a senior manager is buying or selling a company’s stock, that can tell you a lot about what is going on with the company. In some cases, the manager may be liquidating shares to pay for a child’s education.
But if they are buying their company’s shares, that could be a great sign that they think the company is undervalued or there is about to be a catalyst for the value of the company to increase.
Insider buying or selling can tell you a lot about what the people closest to the company think about the company and what the prospects for the business are.
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.
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.
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 price of the company is tied to the analyst’s view on the companies performance, and that is measure by earnings, there may be a 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.
Are the CEO and CFO disciplined in making capital allocation?
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 of the possible decisions.
Finding a CEO that is great at operating the business, they 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 rather are removed from those operations. Warren Buffett would fit into this mold, as he is removed from daily operations.
Does management think independently and remain unswayed 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 those earnings might be gained byways 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 as opposed to competitors. It is often difficult to copy someone’s success, and if management is trying to replicate that success, it might indicate that management doesn’t have a plan for themselves.
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.
In the Investing section of the cash flow statement, there is a subsection titled Acquisitions. Calculate the percentage of cash flow from operations spent on acquisitions for the last 5 to 10 years.
Depending on the percentage spent on acquisitions, a business can be classified along with several growth styles. 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 run the risk of 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.
What are the future growth prospects of the business?
The future growth can be assessed by reading through the management discussion and analysis of the 10-k. Management will discuss its plans for the future and how they plan 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.
Is management focused on growing quickly, or at a steady pace?
Companies that are growing quickly 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 growth strategy or an undisciplined growth strategy. A high growth rate does not guarantee profitability. I am looking at you, Tesla.
If the company is growing in a disciplined way, it can control the growth and create more value for the shareholders.
Ok, that is going to wrap up our discussion on management, now we will switch over to the numbers section.
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.
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.
What are the operating metrics of the business 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 with the use of 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
Identify key risks the business faces
The key risks are identified in the 10-k under the risk sections, as well as the management discussion section.
There are risks associated with the business, and others related to the price of the stock. 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 make a list of the risks particular to your company and asses each of them and the impact they can have on the value of your company. Another great idea is to take it a step further and look at the competitor’s risks and see if they line up.
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 one we are experiencing during the Coronavirus pandemic or struggling and declaring bankruptcy.
A healthy balance sheet allows a company to take advantage of any opportunity regardless of the 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 & Poors.
We can also analyze the cash portion of the balance sheet with ratios:
Accounts receivable = net sales / total accounts receivable and then divide that number by 365 to find how quickly the company turns its receivables into cash
Inventory = cost of goods sold / inventory and then divide that number by 365 to find how many days it takes to turn over the inventory.
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 is going to have different levels of ROIC, some much higher than others. For example, tech is going to be much higher than banks because there is less capital expended to create profits than for the bank.
A couple of rules regarding ROIC:
- Anything below a five is considered a low-quality business
- Any ratio above ten is viewed as a high-quality business
Of the ratios that we calculate, this is 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 is crucial for the long-term profitability of the company.
Buffett never says explicitly he calculates this ratio; however, he does repeatedly talk about finding a business that has 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.
Does the business generate earnings from steady income or one-off transactions?
Evaluating companies that generate earnings from a steady flow of business are easier to value than companies that hit home runs every once in a while.
Think of companies like Amazon with Amazon Prime, that steady income makes them easier to value because there is 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 in the 10-k.
Is the Return on Equity Attractive?
Again, measuring the return on the equity company creates is essential, another Buffett favorite. You can learn more about this here.
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 tell us how the company is functioning in regards to creating value for the shareholders.
If the company is using 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 that might impact our cash flow in the future, and the ability to reinvest in the business.
Does the company have a track record of growing earnings most years above the market average?
We are looking for a company that will be growing its earnings over a long period. There will naturally be starts and stops, but generally, you want to see long-term growth.
A company that is growing revenue should be expanding the earnings in tandem if they keep their costs under control. Naturally, some costs will rise with an increase in business, but eventually, they have to outpace the costs.
Another trick is to see how they weather the storm, for example, how they had performed when market conditions were poor. A good example is to check their business performance and earnings through the financial crisis of 2007-2009. That will tell you a lot about the strength of the business. We are going through a period now that will test many companies and, in the future, will be a good litmus test
That wraps up the financial analysis section, now on to the valuation pillar.
For this pillar, you can make it as hard or easy as you would like, depending on your comfort level with formulas and ratios. I will share what I want to use, but this is by no means exhaustive.
Verify value investing metrics or ratios
Here is a list of ratios that I run; you can either calculate them yourself or find a trusted financial website and use their data.
- Free Cash flow growth over five to ten years, use a median instead of an average.
- CROIC or cash ROIC, which is a concept I learned from F Wall Street, again use five or ten years.
- FCF to sales – excellent ratio to determine profit versus free cash
- Earnings Yield – from Joel Greenblatt’s Magic Formula
- Price to FCF
- Owner Earnings, way better than regular earnings, favorite of Buffett.
- ROA, and ROE margins
- Debt to Equity
- Piotroski F-score
- Price to earnings
- Price to book
- Price to sales
Calculate intrinsic value using different methods.
Using multiple ways to calculate the intrinsic value to find a margin of safety is crucial to find an excellent investment that will reward us for years.
A word of caution, don’t get bogged down in trying to be exact 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, compared to precisely wrong.
- Discounted cash flow – my favorite model, is to use owner earnings, remember to use the most recent discount rates from either the 10-year bond or 30-year bonds, this will help you avoid a number that won’t be relevant to today. As with any practice, the more you execute this model, the better you will become.
- If you are valuing a bank or any other financial, it is recommended to use a dividend discount model as your method of evaluating those companies. It is much more difficult to asses the cash flows of those businesses. Again focus on the discount rates.
There are many other types of formulas, such as the Graham formula which is an easy way to value a company, it tends to be on the upper end of valuations. In other words, it yields a higher price than others, so I tend to view it with skepticism and use it to find an upper range of possibilities.
When using any of the above valuation models or metrics, remember that we are looking for a value we think is reasonable. Do not use that 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 it, the better you will become and deciphering the numbers. Practice, practice, and more practice.
Ok, that wraps up our valuation pillar. Short, but very important.
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 – by far the most in-depth guide to help you 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.
Peruse through all of the above resources for more ideas to add to your stock buying checklist, I know I have.
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, it can be as simple as understanding the business and some valuation metrics, the beauty of these checklists is the ability to adapt it 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 will be learning from those mistakes, so we don’t make them twice.
Please take all the items that 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 is to find a stable, profitable, growing business, and we must look for the clues that tell us whether our ideas are correct or if they are misleading us.
As always, thank you for taking the time to read this article. I hope you find something of value for your investing journey.
I would love to hear what items you use for your stock buying checklist; please share them with me if you feel comfortable.
If you have any questions or I can be of any further assistance, please don’t hesitate to reach out.
Until next time,
Take care and stay safe,