Methodology: Part 1. The Checklist

January 4, 2011 § 2 Comments

This is my series on how I decide to buy what I buy.
Part 2, Part 3

I gave myself a couple of investing challenges this past week. Not so much New Years resolutions, as more a guideline of good habits (and breaking bad ones) that I want to implement into my financial life. One of the bad habits to break was to stop playing around with leveraged commodity ETF’s, my favourites being HOU.to (which follows crude oil prices) and HKU.to (which follows copper.) They are definitely not value plays and therefore I shouldn’t be playing around with them. But having the type of disposition I have (being pretty calm when people go nuts about something) means that I do pretty well with tracking crude oil hysteria and price jumps.

But it’s not a science and I shouldn’t get into the habit of playing with it too much. And they fall way out of my investing worldview bubble, so I should just cut them out. You know…sometime. (Note: Yeah, so writing this out has made me rethink the whole short-term commodity trading and I realized I’m playing with fire. Sold all my positions in HOU.to (had none in HKU.to.) Made some money, but it’s guilt money! Lesson learned: do not stray from your worldview.)

But a good habit I’m implementing is to actually formalize my checklist and have the businesses I invest in pass my criteria. The checklist is designed to look for devaluation in price, gauge financial health, ballpark intrinsic value and have all the info at my fingertips so I can make a decision.

Now, there are plenty of awesome spreadsheets out there that can do all of this for you. The best one I’ve ever encountered is put together by Jae Jun at oldschoolvalue.com. He’s been tinkering with that sucker for a while now, and it is so worth the price he charges for it. If you want to save some time, go there and get it.

Now, there are two negative things that happens when you buy a ready made checklist. The first is that you are following what the author deems to be important (Jae sidesteps that problem by putting every freaking thing you could ever want in it!) The second, and more serious consequence is that you never learn how to do this stuff yourself. So that’s why I decided to clack out my own spreadsheet of the metrics that I use to gauge intrinsic value.

So lets talk about the process!

For me, investing is about one simple concept: each stock represents a business (this in itself can be a revelatory idea for some people) and that business is worth something. The money they generate, the monetary value that they can produce by means of their product, service and combined intelligence is worth something in a dollar sense (aside: magic happens when the value created is monetary and a social value to the world. But that’s another blogpost). I as an investor am trying to figure out what that money is worth, what it will be worth in the future, and how much of it in the future the business will generate.

Then when you have that all important figure, you go and see if the market is selling the stock at a greatly reduced price to what you deem the intrinsic value of the business to be. Basically, you are trying to buy a dollar for 50c. (Props to Joe Ponzio).

So I am trying to do 2 things:
1. See if the market is potentially undervaluing a business.
2. Find a fair value for that business and compare my price to the market.

Part 1 is below. Part 2 will be in post 2.

So what I do is give a company tests to pass trying to determine if the market is under-valuing them and to gauge financial health. If they pass the tests then I try to figure out a good price (pretending that I wanted to buy the whole company for myself.)

These tests they need to pass. And warning: we’re gonna get technical now, so if you are a new investor–a mere youngling in the world, you’re gonna have to look these puppies up on Investopedia.

Checklist:

ROE  >15% for the past ten years. I look at the average. This shows me what sort of return they are generating. It shows that they can at at the very worst manipulate their EPS every year, or, hey, at the best are actually adding value! But this number is not to be trusted. So that’s why he’s first. (Think of it this way: if you sold a TV with a year guarantee that if they hated the TV after a year they could return it for a refund, you as the TV salesman could report that sold TV as earnings this year. But if they return it and you have to pay them back, well, you can still call it earnings for your EPS, but just have the money flowing out in another section of your balance sheet. Sneaky eh!? So be careful with this one.)

P/E <10 A good indicator that the market is undervaluing the business. Again, be careful as different industries tend to trade at different P/E ballparks. But as far as I am concerned, once you start moving north of 10, 12, 14 you are getting into non-value zone.

FCF growth >10% for the past 10 years. You can’t argue with cash. Sure you can manipulate earnings, but not the movement of cash.

Assets > 1 and a half liabilities. Nice to know the outhouse isn’t overflowing.

Debt to equity ratio under 1. Debt can kill a business just as fast as it can kill a grad student.

FCF to debt > 10%. Good to see that they can manage the debt they do have.

CROIC growth >13% over the past 10 yrs. You can read more about CROIC here and here. If a business can generate a cash return on their invested capital, well, you’re gonna want to play for that team!

If a business passes these tests, man they are worth a closer look to see what sort of price you’d like to pay for em.

I’ll show you how I try to find that intrinsic value in post 2.

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