Do you think it is a waste of time to work through an investment checklist? If you do this article will change your mind.
A while ago I came across an interesting article in The New Yorker magazine called The Checklist written by Atul Gawande the multi-talented surgeon who is also the author of a great book called Complications: A Surgeon’s Notes on an imperfect Science.
A checklist is an insult
The article boils down to that in spite of strong evidence to the contrary, highly trained people think it’s below them to use checklists as they think they already know what to do.
They feel working through a checklist is an insult.
From the article:
“But this time he found few takers.
There were various reasons. Some physicians were offended by the suggestion that they needed check-lists. Others had legitimate doubts about Pronovost’s evidence.”
This was in spite of these findings:
“Within the first three months of the project (the introduction of a checklist), the infection rate in Michigan’s I.C.U.s decreased by sixty-six per cent.
The typical I.C.U.—including the ones at Sinai-Grace Hospital—cut its quarterly infection rate to zero.
Michigan’s infection rates fell so low that its average I.C.U. outperformed ninety per cent of I.C.U.s nationwide.
In the Keystone Initiative’s first eighteen months, the hospitals saved an estimated hundred and seventy-five million dollars in costs and more than fifteen hundred lives.
The successes have been sustained for almost four years, all because of a stupid little check-list”
All this from a check-list with steps as simple as “wash hands with soap”
Why even a simple checklist can help your returns
Checklists work best in a complex environment where the performing of certain steps is critical.
It is taken as a given that highly trained pilots work through checklist for virtually every eventuality. An plane is a complex entity, so are medical procedures and I am sure you will agree so is investing.
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Why use a checklist when investing?
When evaluating a company there are so many factors that are beyond your control.
You however know what increases the probability of you making good investment decisions.
What is important is that you focus on what you can control in your research and analysis. And that is where an investment checklist helps you.
A checklist is especially helpful when you use a stock screener because it decreases the time you need to find out if an idea on the screener it worth analysing further.
Your investment checklist
This is the checklist I use to quickly find out if an idea on the stock screener is worth looking at further, I use the same checklist on the companies I recommend in the Quant Value newsletter.
- Can I in one sentence say exactly what the company does?
- Is operating cash flow higher than earnings per share?
- Is Free Cash Flow/Share higher than dividends paid?
- Debt to equity below 35%?
- Debt less than book value?
- Long Term debt less than 2 times working capital?
- Is the debt to EBITDA ratio less than 5? (Thanks Guy)
- What are the debt covenants?
- When is the debt due?
- Are Pre-tax margins higher than 15%?
- Is the Free Cash Flow Margin higher than 10%?
- Is the current asset ratio greater than 1.5?
- Is the quick ratio greater than 1?
- Is there growth in Earnings per Share?
- Is management shareholding > 10%?
- Is the Altman Z score > 3?
- Does the company have a Piotroski F-Score of more than 7?
- Is there substantial dilution?
- What is the Flow ratio (Good < 1.25, Bad > 3)
- What are management’s incentives?
- Are management’s salaries too high?
- What is the bargaining power of suppliers?
- Is there heavy insider buying?
- Is there heavy insider selling?
- Any net share buybacks?
- Is it a low risk business?
- Is there high uncertainty?
- Is it in my circle of competence?
- Is it a good business?
- Do I like the management? (Operators, capital allocators, integrity)
- Is the stock screaming cheap?
- How capital intensive is the business?
- Does management have the ability to naturally re-invest in the business at a high return?
- Is the company highly profitable?
- Has it got a high return on capital?
- Has the business got an enormous moat?
- Is there room for future growth?
- Does the business have strong cash flow?
- What has management done with the cash?
- Where has the Free Cash Flow been invested?
- Are there any odd (outlier) financial data over the past five years?
- Is the company in an industry that experienced a bubble over the last 5 years?
- Does the cash belong to the company (important if you use enterprise value)?
- Is EBIT / Assets > 20%
25 years in the making
I have put this checklist together over a period of more than 30 years and often make changes as I read about something interesting or learn something from experience.
I do not have a formula that if a company fails X amount of points on the checklist I do not consider it.
But a checklist like this gives you a good idea of what problems a company has and where you have to do further analysis.
Feel free to use the above items in your investment process and let me know if you have other good checklist items to add.
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