THE INVESTING CHECKLIST

Investors such as Warren Buffett, Charlie Munger and Mohnish Pabrai have discussed using an investment checklist when evaluating a company, just as veteran airline pilots continuously use a checklist to avoid catastrophic risk arising from human error so may we use a checklist to avoid potential errors in our appraisal of a company. You can generate your own checklist by looking at your past investment failures and those of other investors you admire to see where things went wrong. Was there some important information left unchecked which led to a flaw in the investment thesis?. You can also generate ideas for a checklist by reading and taking notes from the many great investment books available, these are a goldmine of useful information.

Below I will list and describe a working checklist to give you some ideas on what to include and why. I suggest for those who don’t yet have a checklist that you begin to employ one and those that do should refine it as they accumulate more investment and business knowledge.
Does the company possess a moat?. You may have come across the phrases durable competitive advantage and barriers to entry before and these essentially constitute the moat of a company. A company without a moat has no protection from competitors eroding its market share, however one with a moat has some form of ongoing protection, which enables it to outperform its peers and earn a superior return whilst protecting and potentially increasing its market share. A company’s moat may take on a variety of forms such as a network effect, economies of scale, high switching costs, intangibles and lowest cost production. Companies with a network effect include Microsoft (MSFT), Ebay (EBAY), Visa(V) and Mastercard (MA). These companies are attractive to new and existing customers because of the network they have established, they are the preferred choice by the majority and therefore possess greater value and the ability to strengthen their position, those who do not use the product or service of these companies are thus often left at a disadvantage.

Companies with economies of scale often possess cost advantages derived through increased outputs at lower costs, increased scale and size of operations and superior bargaining power, examples include United Parcel Service (UPS) and Kraft Foods Group Inc (KRFT) High switching costs lock in customers to a product or service, these costs may take the form of fees and charges to transfer to a competitor or they may be time and effort based costs, examples include Paychex Inc(PAYX) and Automatic Data Processing(ADP). Intangibles may include copyrights, trademarks and patents, brand names and government approvals. Companies with strong intangibles include Coca-Cola(KO), McDonalds(MCD) and Procter & Gamble(PG). Lowest cost production allows a company to undercut it’s competition and increase market share, a good example of this would be Walmart (WMT). Buffett looks for ‘unbreachable moats’ and favors companies that earn consistently high returns on capital from intangible assets, particularly strong brand names. It is much harder for a competitor to replicate an intangible asset and in some case virtually impossible. This is why Buffett likes Coca-cola, Wrigleys, Durracell, Heinz etc, when you think of the product you instantly associate it with a particular brand, thus the company owns what Buffett calls ‘a share of your mind’.

What is the level of institutional and insider ownership in the company? Peter Lynch liked to find companies with both a low institutional and high insider ownership. Low institutional ownership implies the company may be an undiscovered story and thus selling at a fair or discount price with plenty of room to grow and high potential upside when it is discovered by the wider investment community. High insider ownership aligns management and common stockholders with a common goal to see the company succeed and to share in that success through their fractional ownership in the business.

What is the analyst coverage of the stock? Just like the institutional ownership, the lower the analyst coverage the better. If you can discover a wonderful company before the Wall Street herd gets wind of it you can often get in at great price and then ride the growth which comes from the company’s expansion and its subsequent discovery by other investors and institutions. A useful technique is to scour lists of over -the-counter stocks and markets that are out of favor to find quality companies flying under the radar of Wall Street.

Is the company buying back shares or is it issuing them to fund growth? Charlie Munger calls companies that aggressively buy back their own shares cannibalize stocks. By doing so these companies reduce the number of shares outstanding and increase the earnings per share and equity stake for their existing shareholders, and unlike dividends, share buybacks are not taxable which is of added benefit.. Companies, which have to constantly issue more shares in order to finance growth, dilute the equity stake for existing shareholders, it is much better if a company can fund growth organically through retained earnings. Some examples of cannibal stocks are Chubb Corp(CB), Becton Dickinson(BDX) and Lowes Companies Inc(LOW). A word of caution regarding buybacks though, it is only beneficial to the investor if the company is buying back it’s stock when the market price is below it’s intrinsic value. If the company is paying a premium to buy back it’s stock this is poor allocation of capital. If the company is financing these over-priced buybacks with debt or is merely seeking to artificially inflate EPS figures is of concern to the investor. Buffett looks at Net Income rather than EPS to avoid the aforementioned distortion.
What level and type of debt does the company possess?. Ideally we are looking for companies that have little to no debt although if used correctly financing can speed up the expansion and growth of a company. A key question to be asked is: Can the company comfortably manage the debt load? It’s also worth checking historical data to compare the company’s current debt position to it’s past average and to measure the company’s debt levels in relation to the industry average. The worst kind of debt tends to bank debt and that which is due on calls. Debts, which are due on demand, tend to be called in at the worst possible time for the company, just as the economy contracts and markets decline. Funded debt such as corporate bonds is much more favorable for the common stock holder since it cannot be called in as long as the interest is paid, the company may also have the right to temporarily postpone coupon payments if any financial problems arise.

Is the company’s primary product or service at threat from a lower cost operator?. Even the Oracle of Omaha, Warren Buffett, has been a victim to the threat of lower cost competition. His investment in Dexter Shoe Company turned out to be a failure because the low cost of labor in emerging markets allowed cheaper competitors to undercut the business and erode market share. Companies with a niche or moat may have protection from this competition and should be investigated further.

What share of its market does the company occupy?. Peter Lynch looked for small companies within a slow growth industry that had the room and freedom to expand unhampered by strong competition. In a high growth market competition is fierce as new competitors are constantly emerging to mount a challenge for market share. Companies with a large market share may benefit from economy of scale and some form of moat that protects their position; if they can combine this with a consistently high return on capital then huge profits can be generated.

What is the company’s liquidity position? A company’s liquidity position is a measure of its ability to meet its short term debt obligations such as accounts payable and short terms borrowings. Various ratios such as the current, quick and cash ratios can be examined and the cash conversion cycle is also worth considered. Generally speaking, the higher the ratio the better but this is not always true. Wide moat stocks that generate large sums of Free Cash Flow and don’t require large reinvestment can operate with a much tighter liquidity position, take a look at KO for example. Its quick ratio for the last 10 yrs. has been below 1 and its current ratio has been around 1.
What is the Cash position of the company? As a general rule the more cash a company has on its balance sheet the better. A company with plenty of cash is better prepared to weather any financial storms than its weaker competitors. If, however, the company has a huge sum of money sat on its balance sheet doing nothing it could be putting that capital to work to generate a greater return on capital.

Are Insiders buying shares?. There can be a large number of reasons why insiders sell shares. They may wish to diversify their portfolio by buying other stocks, they may wish to pay down a debt or pay for their children’s college tuition or perhaps they want to use the money to purchase a new car or house. There is only one reason why they would choose to buy shares, because they believe that the company is going places and they wish to take part in that success. If you find a company with high insider buying it’s worth investigating further to see what you can find out.

What is the state of executive compensation within the company?. The motives of management may be biased by excessive executive compensation so itís worth checking to see if it is line with that of their competitors. Excessive executive compensation may lead management to do things which benefit themselves but which are detrimental to shareholders.
Does the company have the capacity and room to expand operations in existing and new markets? It’s all well and good finding a quality company but if it is nearing a point of market saturation there is clearly a limit to growth. You are highly unlikely to find a ‘multi-bagger’ in this sort of instance so it’s worth checking annual reports etc. to see how much room management thinks the company has to keep growing. What are their plans for expansion and do you think they can achieve it?

What is the state of pension liabilities within the company? Large amounts of unfunded pension liabilities can be a major problem for companies since they may well be legally obliged to honor them. This could potentially have serious consequences for the company and its owners if the problem is allowed to get out of hand. Take a look at the company’s balance sheet to see the levels of pension liabilities it holds and compare them against its equity base and annual Free Cash Flow, if push came to shove could the company afford to honor the liabilities. Typically young small firms have not been established long enough to develop large pension obligations but it’s worth check with mature large companies.
Is the companies workforce part of a labor union?. Companies whose labor force is part of a union may be forced to commit to labor contracts and wage increases which become unsustainable in the future. Furthermore higher labor costs will drive up the cost of goods sold and push down the company’s margins. Any emergence of competitors employing cheap labor will further compound the problem. Increasingly, companies that are been forced to pay higher labor costs are moving toward atomization and the mechanization of labor, this is currently quite pronounced in the services industry and the imposition of minimum wage laws only encourage it.

What is the company’s client base?. By reading the annual reports of a company you can get a picture of what it’s client base is like. Is the company dependent on a few major customers for the large proportion of its revenue, does it have any short or long rolling contracts which lock in revenue streams and what is it’s customer retention rate?. Companies that are dependent upon a few clients for their revenue are a far riskier proposition since a cancellation of contracts could result in a significant drop in sales and earnings; Geospace Technologies Corp (GEOS) is an example of this. It is also worth considering the type of client the company has, in some cases it may have dealings with government entities in politically unstable countries that heightens the level of catastrophic risk. TransGlobe Energy Corpís (TGA) operations in Egypt are a current example of this, as are CTC media Inc (CTCM) in Russia.

What does the competition look like?. Sometimes if you look at a company’s competitors you end up discovering a better investment candidate, be it a comparable but cheaper alternative or a rival who earns a much higher return on capital. You can check a company’s vital statistics against the competition in order to see where it sits in it’s market, whether it is outperforming it’s peers and if it is selling at a discount to the industry average. You can get a good breakdown of industries and their constituent companies here.

What is the cash/accrual earnings position within the company?. Not all earnings are created equal, accrual earnings are income earned by a company but not yet received in payment. If a company sells a product or service in one fiscal period but does not receive cash payment until a future period then it will be recorded as accrued income. There is nothing inherently wrong with this method of accounting and it’s generally accepted and widely used. A potential problem arises when there is an excessive build up in accrued income. A downturn in the economy could have a serious impact upon the company’s clients and their ability to pay their bills. The Sloan Ratio can be used to identify companies that have low accrual earnings in relation to their cash flow.

Are there any accounting fraud red flags?. Investors should be wary of signs of potential accounting fraud within a company and there are a number of things we can look out for; An auditor being dismissed and replaced and an accounting period being missed, this may provide a window of opportunity to fix the figures. An unusual and substantial increase in a company’s performance in the last quarter of the fiscal year, this may suggest that management is cooking the books to fulfill analyst’s expectations. Growing revenues without corresponding growing cash flows, it’s much harder to manipulate cash flow than sales. Frequent or unusual related-party and third party transactions, this may indicate that debt is being hidden off the balance sheet. A significant and unexplained rise in the level of fixed assets may suggest the use operating expense capitalization rather than the recognition of those expenses. An unusual rise in the number of day’s sales in receivables coupled with growing inventories, this may indicate that management is attempting to hide obsolete inventory by falsely recording future sales. There are many other indicators of potential accounting fraud and it may be worth creating a separate checklist purely for the detection of potential accounting fraud.

Can the company successfully pass the cost of inflation on to the consumer? Companies such as Philip Morris International Inc (PM), Coca-Cola (KO) and Procter & Gamble (PG) can pass the cost of inflation on to the customer by raising prices. Their dominant position, brand loyalty and economic moats give them pricing power which weaker competitors simply do not possess.
Does the company operate in a highly regulated environment? Companies that operate in a highly regulated market may suffer due to the costs incurred from adherence to the law. Environmental regulations may increase the cost of goods sold thus impacting the top and bottom line for the company. On the other hand companies may benefit from government regulation by being granted exclusive rights to operate within a given market, this may lead to a monopoly of sorts existing. Common examples of this can be seen in the utilities and healthcare/biotech industries.

Are the company’s prospects intimately tied to cyclical fluctuations such as commodities and interest rates. Companies which are cyclical in nature tend to follow the ebb and flow of the wider economy and can be affected by commodities prices, interest rates and various other macroeconomic factors. It is important for these companies to have healthy balance sheets and management that can allocate capital effectively in order to adapt to the prevailing cyclical conditions. When there is economic contraction it may be prudent for management to halt expansion plans and instead reward shareholders through dividends and share buybacks.

Is the company’s product or service liable to become obsolete in the future? Some products and services may suffer creative destruction as technology advances ever forward rendering them obsolete and consigned to the trash heap of history. Others may continue to be desired or in demand irrespective of advancements in technology and science. The emergence of mobile technology, the internet and social media have had no effect on peoples’ consumption of Coca-Cola(KO) or Wrigley’s chewing gum but internet live streaming and pay per view purchases of films has made companies like Blockbuster obsolete. This is precisely why Warren Buffett has invested in Coca-Cola but not Microsoft (MNST), he thinks both are wonderful companies but cannot make reasonable predictions about Microsoft’s future earnings power due to the high obsolescence rate in the technology industry.

Does the company pay dividends and if so for how long has it paid them and has it increased, decreased or suspended them in the past?. If a company pays dividends it’s worth checking a few things. How long has the company paid them for?, if a company has paid them for a considerable period of time we can be confident that it will continue to do so but if it has suspended them in the past we cannot be so sure. It may, however, be prudent for management to decrease or suspend dividend payments in order to avert financial problems for the company. Some companies have a track record of consistently increasing dividends for many years, these include businesses such as Johnson & Johnson (JNJ), Chubb Corp (CB) and 3M Co (MMM). It’s also worth checking to see what the payout ratio is. This tells us how much of a company’s earnings are being paid out as dividends. Companies with very high payout ratios may not be able to sustain them into the future and those with low payout ratios have plenty of room to grow dividend payments over time.
Is the company engaged in mergers and acquisitions and if so, are they of benefit or detriment to the companies prospects?. Its worth investigating the types of companies that are being acquired, are they within the same industry or an unrelated field?. Peter Lynch describes companies that try to expand outside of their circle of competence as deworsifying. Frequently these acquisitions do not work out and the company suffers a drag on it’s top and bottom lines, later having to spin off the acquisitions into stand alone companies and incurring losses in the process. Companies may, however, successfully expand through wise acquisitions purchased at reasonable prices. Bolt on acquisitions tend to be less capital intensive than ones that must be vertically integrated but competitive advantages may arise through successful vertical integration. Examples of companies which have successfully achieved growth through acquisitions include Berkshire Hathaway Inc. (BRK.B) and National Oilwell Varco Inc (NOV).