Monday, June 29, 2015

Checklist for buying stocks - IMPORTANT!

Just finished reading "Education of a Value Investor" by Guy Spier. A short and informative narrative by a value investor about his own journey. I found it really useful and would like to incorporate a few key lessons from what I have read. We all know the importance of checklists, pilots and surgeons use them, so should investors. Charlie Munger had said it years ago that all prudent investors should have one and Guy got the idea from Charlie.

Guy went one step further by saying that the checklist should be used as a final step to just make sure that we don't get screwed by our brains telling us all sorts of stuff. You see, our brains have this ability to rationalize everything and convince ourselves to do all the things that we desire and not to do the things that we do not want to do. Like when we are due for our weekly jog this afternoon, the brain will start telling us, "It's too hot, there's haze coming, or oh just take a break this week, you worked too hard... etc". So similarly, when we are all excited to buy a stock, the brain will overlook all the impt warning signs and say, "Yeah, it's a great buy, don't worry about the balance sheet, or the parent company will buy it out if it falls, or the competitors are too weak to matter... etc". Don't fall for all that Jedi mind tricks that we play to ourselves. Use a checklist. Here's mine in no particular order. It's still a work in progress but I guess it's important to start somewhere.

1. Look at the balance sheet and Net Debt to EBITDA or cashflow, does it look prudent enough? Usually Net Debt to EBITDA should not be more than 4x.


2. Does it have sustainable ROE over the last few years? Should be a double digit number or at least high single digit if it has a lot of cash on its balance sheet.

3. What is the track record of its management. How much did they pay themselves? Did they screw minority shareholders?

4. What is the nature of the business, is it a cut-throat dog-eat-dog business? What is their moat? How many players in the industry? What is the combined share of the largest players?

5. How many times have the company raised capital?

6. Who are the other shareholders? Are there a lot of insiders?

7. Free cashflow (FCF) track record: does it have a consistent and even better, rising FCF over time?

8. Finally valuations, valuations, valuations. Is it below PE of 20x and EV/EBITDA of 14x. How about it's free cashflow yield. Can it return 3x over 10 years?

As mentioned, this is a starting list and although it could work for me, your checklist should be different. It's more as a reference to be shared here and over time we should keep revising our checklists. 

In the book, the author also mentioned that we are all slaves to our unique brain wirings and it is very difficult to overcome some of these innate idiosyncrasies. So we need to change our physical and social environment to help us. For him, he moved from New York to Zurich to get away from what he called the "Wall Street Vortex" that sucked him into lots of unhealthy behaviours like following too closely to short-term newsflow and comparing egos with the who's who in Big Apple. Also, for our social environment, it is well-known that people who are overweight have more friends who are overweight as well. Sadly, it's the environment that would change us, not the other way round. 

We need to tip everything to our favour which means we need to change our physical environment to ensure that it is compatible with our wirings. This would be making our home and work environment really conducive. I think for me one simple and yet important aspect is really just to reduce clutter. Keep our workplace simple and effective, stop buying unnecessary stuff and work with minimal tools and gadgets. Reducing clutter is the real boost to efficiency.

We also need to improve our social environment. Stop wasting time with people who don't value add. We have to keep the best friends that have given us the best advice over time, friends who are willing to share, non-pretentious, people whom we are 100% comfortable hanging out with. This could be the single most important change we make at the current stage of our lives. It takes years to build good and strong relationships and the window is closing for those of us reaching the midway in life. Once we surround ourselves with the best people we cannot help but improve! 

To conclude, I would like to share this old adage that comes to mind, "Make new friends but keep the old, one is silver but the other is gold." Make sure we have a lot more of these friends with the highest caliber!


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