In The Checklist Manifesto, surgeon Dr Atul Gawande says “under conditions of complexity, not only are checklists a help, they are required for success.”
The best checklists, Gawande says, “are efficient, to the point, and easy to use even in the most difficult situations. They do not try to spell out everything – a checklist cannot fly a plane. Instead, they provide reminders of only the most critical and important steps – the ones that even the highly skilled professional using them could miss. Good checklists are, above all, practical.”
Here's our 12 point checklist for value investors:
1. Can I explain to a 10-year-old what this business does and how it makes money? You'll make fewer mistakes if you stay within your circle of competence.
2. Is the company still selling what it did 10 or 20 years ago? Industries characterised by rapid technological change are harder to value and face a greater risk of obsolescence.
3. Is this a high-quality business? Look for companies earning high returns on capital and those with a sustainable competitive advantage. The main ones are: Economies of scale; High customer switching costs; Patents; Government/regulatory permits; Brand recognition; and Network effects.
4. Is management acting in the interest of shareholders? Look for high insider ownership, and executive compensation based on performance and earnings per share growth. Beware of companies that regularly issue shares to raise capital or with overly promotional managements.
5. Is the company's future dependent on factors outside its control? Examples include commodity prices, interest rates and regulatory changes.
6. Does the company have a conservative balance sheet? Companies with net debt-to-equity ratios above 50% or interest coverage ratios below 5.0 are more likely to get into trouble in times of crisis. The less debt the better.
7. Do profits turn into cash available to shareholders? If free cash flow consistently trails net profit, it may suggest a capital intensive or low-quality business.
8. Am I confident that earnings will be materially higher 5 or 10 years from now? Ideally, you want to own businesses whose intrinsic value marches upwards over the years and whose earnings are protected against inflation and competition.
9. Why are others selling this stock? Can you articulate the bear case better than they can and explain why they're wrong?
10. Am I being adequately compensated for the risk? All equities carry risks. For all but the safest stocks, you should seek a total return of 10% or more, including dividends and growth in the intrinsic value of the business.
11. Am I over exposing myself to a single sector or set of risks if I add this stock to my portfolio? Those investments with the least downside should be your biggest positions and speculative investments should only ever make up a small part of your portfolio.
12. What's the worst-case scenario? What errors in judgement could you be making and what uncertainties could hurt this investment? Always seek a margin of safety in your assumptions.
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