I believe investing is an information game.
The more you know, the better the odds of picking a winner.
Perhaps that's why some believe Warren Buffett – often considered the world's greatest investor – was rumoured to read around 1,000 pages of information per day, when he was just starting his investing career.
His partner in crime, Charlie Munger, was/is the same. Continuous learning, is what makes us better investors.
That's why I read as much as I can.
However, dividing fact from fiction is vital. So read the important stuff, from the people you respect.
I've made it my goal to read at least one thing, from an investor I respect, daily. Although I usually do a lot more than that!
Develop your own formula
There are no hard and fast rules to stock picking. The 'experts' aren't always right.
As most long-term investors will tell you, the qualitative information is much more important than the quantitative stuff (i.e. valuations, forecasts, etc).
I believe it's our own interpretation of it, which determines how successful we'll be.
More often than not, forecasts turn out to be wrong anyway. Which is another reason I prefer to be generally right than specifically wrong.
But it might not work for you.
So if you're planning to invest for the long term, develop your own formula but make sure, you don't repeat yesterday's mistakes. Reading what has, and what hasn't worked for others will make the process a lot quicker.
I've recently developed a 12 question checklist (OK, there might be a few more than 12) which I ask myself, before buying any stock.
I've taken bits and pieces from successful investors and tweaked it to my own liking.
12 questions to ask yourself before making an investment
1. What does the company do (think: products, business divisions, etc)?
This is the qualitative part. Do your own research. It's alright to be confused at first. But, if you find yourself scratching your head for too long, ask yourself if you can afford to invest in a company which you may never truly understand. Fund manager Peter Lynch famously said…
"If you're prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won't get bored."
A company's website is a good place to start.
2. Does it operate in a growing industry?
If not, what's its niche or advantage?
3. What competitive advantage does it possess?
Is it durable (That is, can we rely upon it)?
For long-term investors, this characteristic is almost a necessity. It doesn't have to be a world recognised brand like those offered by Coca-Cola Amatil Ltd (ASX: CCL) but it must be durable.
4. Does management hold shares?
Are their interests aligned (incentives, bonus etc.)?
Look at previous experience, technical knowledge and capital management.
When we decide to buy shares, we're essentially saying: "Here you go Mr Manager, put my money to work for me." You wouldn't do that with a stranger down the street so make sure they have your best interests at heart.
I like long-term earnings per share incentives, not the use of EBITDA, revenue or anything else, which I believe encourages empire building.
5. Does the company have a solid 5 or 10-year track record in terms of shareholder returns?
Total shareholder returns (dividends plus capital gains) ("tsr") is a quick way to look back in time. If you've got access to a decent stock broking account, you'll likely be able to see all the historical figures you'd ever want.
6. Are the company's economics 'good'?
What is the debt, cash, equity position?
What are the margins to know (Return on Assets, Return on Equity, Operating Margin, etc)?
Can it reinvest (capex) in itself at an acceptable rate?
Is free cashflow growing or diminishing?
I might be jumping the gun by putting this question at number six but these figures are (hopefully) easily identifiable in a company's latest annual report. Don't rely on your brokerage account for up-to-date figures and if you don't know what they mean, Investopedia, YouTube and many other sites provide excellent resources, which are free.
7. What are the 5 greatest (known) risks?
1.
2.
3.
4.
5.
Got any more?
Risk and reward go hand-in-hand. There'll be a lot more than five risks, find them. Go beyond the company itself and look at the industry, geographical spread, regulatory risks, etc.
8. Do we have a variant perception?
Some would argue this is the most important question of all. Think hard about this because it'll enable you to determine why now might, or mightn't be the right time to buy.
Digging a little deeper…
9. Look backwards (say five years). Is the stock priced 40% higher or lower than its highest average annual (most appropriate) valuation ratio?
Compare to peers for clues.
This is one from the father of value investing, Ben Graham. I think this question works wonders for some investors' temperaments – a thing which is important for long-term investing success. It puts the company's price history into perspective. For example, looking at the historical price to book ratio of Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) might give you an idea of the 'value' in their shares, at current market prices.
10. Does the earnings to price (E/P) yield at least twice the AAA bond rate?
Flipping the common 'PE ratio' on its head reveals some interesting things. Remember, the stock market is inherently riskier than bonds, cash accounts and term deposits. Make sure you're getting a premium for the extra risk.
11. Can a discounted cash flow be used with moderate reliability to determine intrinsic value?
Use a 5 or 10-year forecasting period with a minimum discount rate of 10%.
Depending on your valuation skills, this question might be the only one which differentiates you from those Wall Street analysts. A Discounted Cash Flow ("DCF") takes the forecast cash producing ability of a company and brings it back to today's prices. It should be noted that these models are only as reliable as the information which goes into them. That is: garbage-in, garbage-out.
12. Is there an adequate margin of safety under all manner of sensitivities?
Use the identifiable risks to run different forecasts.
Using the risks you identified above, in conjunction with all the other information from the questions you've asked, run some 'what-if' scenarios. Once again I'd rather be generally right than specifically wrong, so I take a conservative approach and input different risks into my forecasts, from worst case to best case, giving me a range of values.
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I'm sure these 12 questions could help many investors become better at what they do. However, whilst it's definitely not an exhaustive checklist, few companies would make it through the entire filter. It's also important to note, what works for me may not work for you.
Remember to read whatever you can because your growing knowledge base will make you a better stock picker, over time. Who knows, it might be the best investment you ever make!
