2♦ — You need a Stock Buying Checklist

You need a Stock Buying Checklist, but you need to make it for yourself.

Stock Buying Checklist

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

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You need a Stock Buying Checklist, but you need to make it for yourself.

Today I’m going to try to persuade you that you need a stock buying checklist. And for my next trick, I’m going to convince you that you need to build it yourself.

That’s the bad news over with quickly: this post won’t be “The Most Perfect Buying Checklist EVER” or “101 Things You MUST Do Before Buying A Stock”.

Yes, we’ll talk about things that various kinds of people have on their checklists.

But this isn’t a one size fits all deal. It needs to be your checklist.

Because you have to stick to it.

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Don’t think that a checklist is beneath you. You might have been investing for 30 years, and you might know everything.

But you still need a checklist. You need a stock buying checklist for the same reason that you need so many other types of planning tool.

You need a checklist for the same reason that an airline pilot and a brain surgeon need a checklist. So that you don’t forget anything.

In investment, your biggest enemy is your self. You need to take emotion, psychology and over-confidence out of the decision-making process.

Even highly trained experts use checklists, particularly in complex environments when the stakes are high. Does that sound like the stock market, or not?

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So why don’t I just cut to the chase and handover a checklist? Because you need to build it yourself.

If you’re going to stick to it, you need to believe in it. It needs to work for you.

Different kinds of investors will have different things on their checklist. A value investor will have different things from a growth investor.

A momentum investor will have different boxes to tick from a dividend investor. Swing traders and day traders will not agree on the details for an entry.

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It’s ok to start small. You might decide that you only buy UK stocks with a PE below 16, and a market cap between £50M and £500M.

That’s probably going to be quite a large group of stocks, but it’s a lot smaller than the global universe of stocks.

(It’s worth pointing out here that at this stage, your embryonic buying checklist is basically a simple mechanical stock screen, of the type available on many websites – see here for examples; as the list develops it will move away from this and become more personal to you.)

As you move through your investing career, make a note of what works for you, and for other people. Add to your list. Get comfortable with it.

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So let’s start to look at some checklists. Perhaps the most famous is Ben Graham’s. Graham is the father of value investing and the early mentor of Warren Buffet.

Initially he looked for stocks trading below their breakup or liquidation value, but he later moved towards higher quality value stocks (Buffet also moved away from the ‘cigar butt’ stocks).

In part this was because as his ideas became more widely adopted by his students (Graham was a Finance Professor at Columbia), the opportunities dried up. People caught on to the idea that very cheap stocks would out-perform.

This is true of most techniques that work in the markets – as they become fashionable, they stop working so well. With luck, they will in time become unfashionable – and more successful – once more.

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Graham’s final piece of work was a checklist known as his “Last Will”, designed to find stocks that are cheap – and therefore have potentially high return – but also safe.

Cheap:

  1. Earnings Yield twice that of investment grade bonds
  2. Dividend yield 2/3 that of investment grade bonds
  3. PE below 40% of the stock’s highest PE in the last 5 years
  4. Price below 2/3 of tangible book value (per share)
  5. Price below 2/3 of Net Current Asset Value (per share)
See also:  A♣ --- Asset Allocation Matters

Safe:

  1. Total debt less than book value
  2. Total debt less than 2 times Net Current Asset Value
  3. Current ratio above 2
  4. Compound earnings growth 7% or more over last 10 years
  5. Two or fewer falls in earnings over last 10 years

This is a tough checklist, and almost no stocks will meet all 10 criteria these days.

So it become a matter of how much you want to compromise. Is 8 out of 10 good enough? Or just 7?

Or would you rather relax some of the rules so that more companies can score 10? You could look for PE only 30% below the 5-year peak. Or you could make any one of the other nine rules easier to pass.

It’s up to you.

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From Graham on to Buffett. I’m not aware that Buffett has ever published a checklist, and I’m far from certain that he even uses one.

Nevertheless, he writes a lot about investment, particularly in the Berkshire Hathaway Annual Letters (click here for our summaries of these letters), and plenty of commentators have tried to synthesise a checklist on Warren’s behalf.

Buffett makes large investments in listed companies, and also buys them outright. But even in the second case, he usually leaves the existing management in charge. So as you will see, the quality of management is important to him.

Buffett’s golden rule is that the intrinsic value of a stock is significantly greater than what it is currently selling for. He doesn’t explain what size of discount he’s looking for, or how he calculates intrinsic value.

Buffett sometimes mentions discounted future earnings as a valuation measure, but his partner Charlie Munger says that he’s never seen Warren calculate a DCF.

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With those caveats, here’s a typical “Buffett-style” checklist, with additional numerical measures added where appropriate.

The business:

  1. Is it easy to understand (ideally in one sentence) what the business does, and how the money is made?
    • Warren has famously said that he won’t invest in companies that he doesn’t understand (for example tech stocks)
  2. Is there a large moat (barrier to entry from competition) around the business?
    • Buffet often prefers proven market leaders like Coke and Gillette, Kraft and Heinz
  3. Does the business have a reasonably long and consistent history of profitable operations?
    • Buffett generally uses 25% pa return on net tangible assets as a target, but will go as low as 12% pa
    • plus above average earnings growth (for the economy / market / industry sector)
  4. Does the business and industry have favourable future prospects?
    • this can be used to filter out ‘one-trick ponies’ with poor long-term prospects, as well as maturing companies that are about to become ex-growth
  5. Will the company be able to raise prices at or above the rate of inflation?
    • a related question is the power the company holds over its suppliers
  6. Can the company’s competitive position be maintained without major injections of capital?
  7. Is the company conservatively financed?
    • the key here is low debt – perhaps something like debt to equity less than 50%
    • this also speaks to the quality of management, as assessed in the next section
  8. Is the company being temporarily punished for a specific short-term risk or impact (which means the share price is too low)?
  9. Is the stock priced below its intrinsic value?
    • the big one, which is not so easy to answer – PE is not the perfect measure, but there must be some consideration of price

The management:

  1. Has the management demonstrated a high degree of:
    • integrity?
    • intelligence?
    • energy?
  2. Is management candid with shareholders (open disclosure of problems)?
  3. Has management resisted the temptation to grow quickly by acquisition?
  4. Is management pay reasonable and are any incentives linked to suitable targets (ie. not stock price)?
  5. Are there any question marks around accounting practices?

I offer no guarantees that following these fourteen rules will make you as rich as Buffett.

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There are plenty of other fundamental approaches to stock selection, as reflected in the various “Guru stock screens”.

See also:  7♠ - Don't Buy Too Much Insurance

Space does not permit a discussion of these today, but they will be covered over time in subsequent articles.

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Next let’s look at a dividend investor’s check-list. There are actually not so many of these around, perhaps because it seems like such a simple approach.

For dividend stocks:

  • we need a decent dividend (for the UK, say 120% of the FTSE-All Share yield, or an absolute value like 3%)
  • we need good dividend cover, which means good earnings
    • we also need positive cash flows, to show the dividend isn’t being funded by nefarious means
  • we want the business to grow, so that the dividend grows
    • we’ll look for evidence of long-term dividend growth in the past,
    • and the prospect of growth in the future, at least at the rate of inflation
  • we’ll get better results if we buy our stocks when they are cheap, so we also look for value

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I’ve leaned heavily here on the work of Compound Income, which we reviewed back in May.

I am also stretching the concept of a checklist to include a scoring system. In a sense the Graham list is a scoring system, but each item scores either one or zero.

Mechanical scoring systems tend to appeal to some types of investor (those who make spreadsheet models of everything in life) and to put off some others. Another example we’ve seen before are the StockRanks (momentum, value, quality) used by Stockopedia.

The Compound Income scores use six metrics:

  1. value
    • EVER, calculated by comparing the EBIT/EV multiple to the the expected return (the current Y1 yield plus the forecast Y1 dividend growth) – this is a kind of ‘dividend growth at a reasonable price’ equivalent of PEG
  2. cover (dividend security)
    • earnings cover
    • free cash flow cover
  3. financial security
    • the Piotroski F Score
    • interest cover of at least 3x
  4. operational quality
    • five-year average operating margin
    • five-year average return on capital employed (ROCE)
  5. dividend growth
    • a history of dividend growth in the past
    • a forecast of dividend growth in the future
  6. estimate revisions (of earnings, not dividends)
    • in the past month, and over the past three months – effectively an earnings momentum indicator

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Those with shorter time horizons – momentum traders, swing traders and day traders – will be looking at different things before they take a position.

This is not a Technical Analysis post, but let’s take a brief look at some of the numbers that might be included. Assume that we are looking to take a long position (buy the stock):

  1. Trend lines / moving averages – the periods of the moving averages will vary with the intended holding period, but the short MA should be higher than the long MA (upward trend)
  2. Support and resistance / channels / Bollinger bands – the stock should be moving up from the bottom of a channel, with plenty of scope to rise in price
  3. Relative strength – the stock should be rising faster than the market / index  (which should itself ideally be rising), and also the sector / industry, and should be near its year high
  4. Oscillating indicators like RSI, MACD, Williams %R etc.

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We’ve now looked at a number of checklist approaches to opening a position, and they don’t have that much in common.

Why should they? They all serve different masters, with different objectives behind their buying.

What they do all represent is a search for a set of conditions that have produced favourable results in the past. As the saying goes, past performance is no guide to the future, but it’s all we’ve got.

Things change in the markets, but usually quite slowly – slowly enough for you to tweak your model.

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So start working on your stock buying checklist – because you need one, and you need to make it yourself.

Until next time.

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Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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1 Response

  1. Hi Mike, an excellent list. Far too few investors use checklists in my opinion. Personally I wouldn’t dream of investing without one.

    John

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2♦ — You need a Stock Buying Checklist

by Mike Rawson time to read: 7 min
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