I think you’ll agree with me when I say:
It can be difficult to invest for the long-term with the amount of “market noise” out there.
Everyday as you watch the financial media, you have many analyst sharing their opinions about the market…
Bull markets! Bear markets! Trade War! China Slowdown! Blah, Blah, Blah…
Where do you even begin? How can you filter out the “noise” and focus on things that really matter?
With a checklist, you can ignore the “noise” and focus on identifying high-quality investments that will help compound your portfolio.
So here I’ve compiled a list of key questions that you should ask yourselves before investing in a stock:
1. How does the business make money?
Let’s start with the most basic question. In the world of finance, companies are typically categorised by its size.
We have large, mid, small and even micro cap stocks listed in the exchange. Large cap companies tend have a diverse range of income from multiple business segments. While small cap companies are more concentrated and only focus on 1 or 2 revenue streams.
This is why it is important for us to understand how the business makes money and what are its main source of revenue.
Understanding its revenue model is important. The revenue model often determines the consistency of cash-flow that the business generates. For example, a main source of revenue for a civil engineering company are the in-flow of construction projects awarded by clients.
The more projects awarded, the more money this company makes. However, as economic activity shrinks, fewer projects may be awarded, hence, fewer profits for the company.
In contrast, a utility company that supplies electricity for the whole country or city makes money by charging customers a monthly bill. In comparison, this revenue model is much more consistent and is less likely to be impacted by economic cycles.
Other examples of revenue models are:
2. Who are the core customers of the business?
Once you’ve understood how the business makes money. You now have to know who their customers are.
Companies with a wide customer base are less prone to customer concentration risk. This means that should they lose a customer, it is unlikely to deal a great impact on its revenue.
Conversely, a company that makes money from 2 or 3 major clients are more prone to this risk. Losing a customer would mean a 30-50% lost in revenue.
Another definition of customer concentration is when the majority of a company’s customers come from a certain industry. For example, in the oil market crisis of 2014/2015, shipyard operators had a tough year as oil companies cut down on offshore exploration and production activities amid a slump in global crude oil prices.
These operators derived the bulk of their income from energy-related projects and it was estimated that between 70% and 80% of the shipbuilding and ship repair revenue came from oil and gas projects.
In such an instance, these operators are at risk of suffering from slower orders or slower collections should the oil industry face a prolonged slump.
3. Who are its competitors?
The degree of competition or how fiercely competitors compete determines the long-term success of the business. In an industry where competition is plenty, there are no market leaders, therefore, profits and margins are marginal.
In contrast, an industry with few dominant companies are the notoriously known for leveraging on their size advantage. These companies will do whatever it takes to keep competitors away. Going against them would require vast amount of resources and a good strategy without any guarantees of success.
A recent example is the entrance of TPG Telecom into the Singapore market, since announcing its entry into Singapore, the incumbents (existing telcos) have aggressively undercut subscription plans to retain customers and protect market share. The incumbents were willing to incur less profits in the short-term to create high barriers to entry for TPG Telecom.
Invariably, competition impacts market-share and profits. Hence the less competitive the industry, the more profits a company makes.
4. Does the business have a competitive advantage or an economic moat?
High-quality companies generates sustainable excess-profits. These companies have an edge over its competition, this is also known as competitive advantage.
Just imagine, if you had all the money in the world, would you be able to build a company that could overtake Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its vast amount of trademarks, patents and brand name products? Or even Alphabet Inc.’s Google with its legions of tech engineers and AIs?
If your answer is no, that’s because these companies have a durable competitive advantage – they do things their competitors can’t reproduce.
When a market or product yields high profits, naturally it will attract competitors. Competition will eventually eat up market share as it saturates the supply of products or services in the market.
In other words, competition makes it difficult for most firms to generate long-term excess profits since any advantage is always at risk of imitation. Sustainable competitive advantages deters competitors and protects the business’s market share.
5. Does existing management have experience and skills related to the business?
Track record matters. You want to look for senior managers who have a proven record in their respective companies or industry. As Warren Buffett would say “staying in your circle of competence”.
Take Microsoft’s Satya Nadella for example, prior to becoming Microsoft’s CEO in 2014, he worked in several of its divisions such as R&D, Cloud and Business Solutions for 22 years and held many senior level positions within the company.
In the years since becoming CEO, Nadella has exceed expectations, as reflected on Microsoft’s stock having tripled, with a 27% annual growth rate. In December 2018, Comparably name him the best CEO of a large company in the United States, citing Nadella’s employee reviews.
This simply proves that if a CEO has a track record of doing well in related companies or within the industry, he/she has the necessary competence to grow the company.
6. What are the future growth prospects for the business?
Future growth would have to come from increase in revenue and a business that addresses a large and growing market will eventually grow as well.
An attractive business is one that grows for multiple years ahead, thus keeping an eye on growth industries will help you find prospective gems.
Growth is more sustainable if it is supported by innovations or secular industry trends. To help you identify secular growth, think about the industry’s job-growth potential. Ask yourself if the industry is one where future workers will work.
A business may grow organically or inorganically. Organic growth simply refers to the company’s ability to increase output and sales naturally. On the other hand, inorganic growth happens when a company acquires another company to access to new markets through and is considered a faster way for a company to grow.
In a recent example, Disney has formally completed its takeover of 21st Century Fox in a deal worth $71 billion. The company has said that the deal is designed to help the company increase its international footprint and expand its direct-to-consumer offerings.
To forecast growth, I use a process called the Revenue Growth Framework.
Revenue Growth Framework: Graph below
Organically, there are 3 ways for a company to increase its revenue:
- Sell more of its core products to existing markets (increase market share). To do this, a company can employ various strategies such as increasing production capacity, improve distribution network or invest more in marketing.
- Sell more of its core products to new markets. This strategy is about reaching new customer segments or expanding internationally.
- Create and sell new products to existing markets. This strategy is about developing supplement products as “add-ons” to existing products. The main motivation to do this is to increase Revenue per customer.
On the other hand, inorganic growth can be classified into 3 types of strategies:
- Related diversification also known as horizontal refers to entering a new market with a new product that is related to a company’s existing product offering. Disney’s acquisition of 21st Century Fox is an example.
- Unrelated diversification refers to entering a new market with a new product that is completely unrelated to a company’s existing offering. Think SPH’s acquisition of M1.
- Vertical diversification refers moving backward or forward in the value chain by taking control over activities that used to be outsourced to third parties like suppliers or distributors.
Typically, young and small companies grow organically as its products and services may still have plenty of room to reach its maximum potential.
Moreover, young and small companies often do not have the financial resources to acquire other companies to boost growth. A small company that acquires another funded by debt is a major red flag.
Inorganic growth is often pursued by large companies. These companies have enough financial resources to make acquisitions after years of consistent profits.
Inorganic growth is sometimes preferred as it is considered a faster way for a company to grow compared to organic growth. That said, businesses that grow inorganically are often more risky as acquisitions might not turn out to be accretive.
7. Is management’s investment focus on building long-term shareholder value, or has it engaged in a growth-for-growth’s-sake strategy?
Investment decisions that provide both short and long term benefits are ideal, but good managers should be willing to sacrifice short-term results to create long-term shareholder value. Poor managers, on the other hand, have a myopic focus on short-term results and have less concern for long-term consequences.
Valeant Pharmaceuticals, a drug manufacturing company, made headlines after allegations of improper accounting.
Prior to the scandal, Valeant was a Wall-Street darling and Michael Pearson, its CEO, became a star. In a short time span, the company went on a spending spree and rapidly acquired other pharmaceutical companies to produce lots of growth.
After acquiring them, Valeant would then push to cut-down on R&D to reduce operating expenses. This move helped boost Valent’s EPS year after year and Wall Street loved it.
For years, Valeant made money not by providing economic value to customers but by financial engineering and by gaming the system.
The best-performing businesses over the long term, as measured by shareholder returns, are managed by CEOs who have a purpose greater than solely generating profits. Jeff Bezos is a prime example and a truly admirable CEO, under his leadership, Amazon puts the customer at the center of everything they do.
In a talk at the Economic Club of Washington, Bezos said:
“The No. 1 thing that has made us successful by far is obsessive compulsive focus on the customer as opposed to obsession over the competitor.”
“I talk so often to other CEOs and founders and entrepreneurs, and I can tell even though they’re talking about customers, they’re really focused on competitors” he added.
As one of the most valuable companies in the world right now, Amazon has reached near mythic status for its superior service and customer service strategy.
8. How much debt does the company owe relative to its operating income?
High levels of debt significantly impact cash flows as interest payments fluctuates. A company that borrows too much will spend the bulk of its earnings to repay debt and forgoing to opportunity to reinvest back into the business.
There are several advantages to businesses with low levels of debt. First, the business has less risk of entering bankruptcy, allowing you, as an investor, to sleep better at night.
Second, a strong balance sheet allows the business to be opportunistic. Businesses that have strong balance sheets are often able to gain competitive ground, because they are able to invest in their business in ways that their leveraged competitors cannot.
Personally, I refer low-debt to debt that can be paid back in less than three years out of existing operating income.
9. Can the stock be purchase at a reasonable valuation? How would you value it?
To prove the importance of valuation, a study was conducted on the performances of 2 sets of portfolios; Value (low P/E & P/B stocks) and Glamour (high P/E & P/B stocks).
In a 33 year period (1980-2013), historical performance of the 2 portfolios shows that the Value portfolio generated an average yearly return of 14.1% while the Glamour portfolio averaged 8.3% annually.
The difference meant that the Value portfolio outperformed Glamour portfolio by 5.8% annually.
Hypothetically, $10k invested in each portfolio would mean that the Value portfolio generated generated about $777k while Glamour generated only $138k over the 33 years – that’s a difference of $638k!
In other words, the Value portfolio generated 5 times more profits than Glamour. This proves that when investing in stocks, PRICE DO MATTER. The price you pay can make a difference between a potential 10 bagger or a 2 bagger.
There are 2 conventional approaches to valuation. The first, measures the value of a business to the present value of expected future cash-flows. The second, estimates the value of a stock by looking at the pricing of ‘comparable’ assets relative to a common variable such as earnings, cash-flows, book value or sales.
Choosing the right valuation method for the appropriate business is as critical as everything else. So please take time to understand the business and value it accordingly.
10. Is there enough margin of safety to offset errors in your valuation?
A good company is not always a good investment. A good investment is a good company bought at the right price. Margin of safety is the difference between the intrinsic value of the business and its share price.
For example, you identified APPL’s intrinsic value to be $240 per share while its share price is $160. This would mean that buying APPL shares at $160 will give you a margin of safety of 33%.
Warren Buffett compares margin of safety to driving across a bridge:
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”
In the same statement, Buffett also said “You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.”
Seth Klarman, well-known value investor and author of the book “Margin of safety” wrote:
“Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”
In this short paragraph, Klarman was emphasizing the importance of having a wide margin of safety given that investors are capable of making mistakes and are prone to errors when evaluating a business or calculating its intrinsic value.
The benefits of having an investing checklist are manifold and they range from reducing the stress, to improving quality of investment ideas, to becoming more informed about the companies that you are investing in.
If you are not having a checklist, or if you are looking for ways to leverage the benefits of utilising an investment checklist, ask these 10 questions before buying your next stock to take your investing to the next level.
If you want to learn more, join my mailing list and I will share with you my investing journey and how I turn from a loss-making investor to a profitable one.
Now what I’d love to hear from you is this…
What are some of the things you look out for before investing in a stock?
Leave a comment below and let me know what you think.