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, outlining some of his thoughts on using a checklist to help with his investing decisions. It was life-changing for me.
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.
- 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 it can help you as a framework for your ideas.
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.
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.
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 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?
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-k’s 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.
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.
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.
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.
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.
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.
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.
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.
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.
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. How does management react to this pressure?
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.
The best capital allocators are typically not day-to-day operators but remain removed from those operations. Warren Buffett would fit into this mold.
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.
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.
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.
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?
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.
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.
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 a pandemic or financial crisis, or struggling and declaring bankruptcy.
A healthy balance sheet allows a company to take advantage of any opportunity regardless of economic conditions.
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.
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.
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.
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.
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
We have some many metrics we have covered on our blog; 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.
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 of things.
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
