The Investment Checklist Read online

  Contents

  Preface

  Acknowledgments

  Chapter 1: How to Generate Investment Ideas

  How Investment Opportunities Are Created

  How to Filter Your Investment Ideas

  Using a Spreadsheet to Track Potential and Existing Holdings

  Chapter 2: Understanding the Business—The Basics

  1. Do I want to spend a lot of time learning about this business?

  2. How would you evaluate this business if you were to become its CEO?

  3. Can you describe how the business operates, in your own words?

  4. How does the business make money?

  5. How has the business evolved over time?

  6. In what foreign markets does the business operate, and what are the risks of operating in these countries?

  Chapter 3: Understanding the Business—from the Customer Perspective

  7. Who is the core customer of the business?

  8. Is the customer base concentrated or diversified?

  9. Is it easy or difficult to convince customers to buy the products or services?

  10. What is the customer retention rate for the business?

  11. What are the signs a business is customer oriented?

  12. What pain does the business alleviate for the customer?

  13. To what degree is the customer dependent on the products or services from the business?

  14. If the business disappeared tomorrow, what impact would this have on the customer base?

  Chapter 4: Evaluating the Strengths and Weaknesses of a Business and Industry

  15. Does the business have a sustainable competitive advantage and what is its source?

  16. Does the business possess the ability to raise prices without losing customers?

  17. Does the business operate in a good or bad industry?

  18. How has the industry evolved over time?

  19. What is the competitive landscape, and how intense is the competition?

  20. What type of relationship does the business have with its suppliers?

  Chapter 5: Measuring the Operating and Financial Health of the Business

  21. What are the fundamentals of the business?

  22. What are the operating metrics of the business that you need to monitor?

  23. What are the key risks the business faces?

  24. How does inflation affect the business?

  25. Is the business’s balance sheet strong or weak?

  26. What is the return on invested capital for the business?

  Chapter 6: Evaluating the Distribution of Earnings (Cash Flows)

  27. Are the accounting standards that management uses conservative or liberal?

  28. Does the business generate revenues that are recurring or from one-off transactions?

  29. To what degree is the business cyclical, countercyclical, or recession-resistant?

  30. To what degree does operating leverage impact the earnings of the business?

  31. How does working capital impact the cash flows of the business?

  32. Does the business have high or low capital-expenditure requirements?

  Chapter 7: Assessing the Quality of Management—Background and Classification: Who Are They?

  33. What type of manager is leading the company?

  34. What are the effects on the business of bringing in outside management?

  35. Is the manager a lion or a hyena?

  36. How did the manager rise to lead the business?

  37. How are senior managers compensated, and how did they gain their ownership interest?

  38. Have the managers been buying or selling the stock?

  Chapter 8: Assessing the Quality of Management—Competence: How Management Operates the Business

  39. Does the CEO manage the business to benefit all stakeholders?

  40. Does the management team improve its operations day-to-day or does it use a strategic plan to conduct its business?

  41. Do the CEO and CFO issue guidance regarding earnings?

  42. Is the business managed in a centralized or decentralized way?

  43. Does management value its employees?

  44. Does the management team know how to hire well?

  45. Does the management team focus on cutting unnecessary costs?

  46. Are the CEO and CFO disciplined in making capital allocation decisions?

  47. Do the CEO and CFO buy back stock opportunistically?

  Chapter 9: Assessing the Quality of Management—Positive and Negative Traits

  48. Does the CEO love the money or the business?

  49. Can you identify a moment of integrity for the manager?

  50. Are managers clear and consistent in their communications and actions with stakeholders?

  51. Does management think independently and remain unswayed by what others in their industry are doing?

  52. Is the CEO self-promoting?

  Chapter 10: Evaluating Growth Opportunities

  53. Does the business grow through mergers and acquisitions (M&A), or does it grow organically?

  54. What is the management team’s motivation to grow the business?

  55. Has historical growth been profitable and will it continue?

  56. What are the future growth prospects for the business?

  57. Is the management team growing the business too quickly or at a steady pace?

  Chapter 11: Evaluating Mergers & Acquisitions

  58. How does management make M&A decisions?

  59. Have past acquisitions been successful?

  Appendix A: Building a Human Intelligence Network

  Evaluating Information Sources

  How to Locate Human Sources

  How to Contact Human Sources—and Get the Information You Want

  Create a Database of Your Interviews for Future Reference

  Appendix B: How to Interview the Management Team

  Ask Open-Ended Questions

  Be Aware of the Danger of Face-to-Face Assessments of Managers

  Appendix C: Your Investment Checklist

  About the Author

  Index

  Copyright © 2012 by Michael Shearn. All rights reserved.

  Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

  Published simultaneously in Canada.

  No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at www.wiley.com/go/permissions.

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  Library of Congress Cataloging-in-Publication Data:

  Shearn, Michael, 1975–

  The investment checklist : the art of in-depth research / Michael Shearn.

  p. cm.

  Includes index.

  ISBN 978–0–470–89185–8 (cloth); ISBN 978–1–118–14943–0 (ebk); ISBN 978–1–118–14944–7 (ebk); ISBN 978–1–118–14945–4 (ebk)

  1. Investment analysis. 2. Portfolio management. 3. Investments. I. Title.

  HG4529.S47 2011

  332.63’2042—dc23

  2011021446

  For my wonderful wife, loving parents, and beautiful daughters.

  Preface

  This book can help you make better investment decisions by helping you truly understand the companies you’re investing in.

  If you’re like most investors, you make mistakes when you rush into an investment idea without doing the proper work to understand the value of a business. By rushing, you are essentially betting on probabilities that certain assumptions will work out, instead of basing your investment decision on real analysis.

  Too often, investors buy stocks by relying on recommendations from other investors, or on hunches, or because of isolated facts they’ve heard or read about a business. When you make your purchase decisions on these factors and do not take the time to thoroughly understand the businesses you are buying, you’re more prone to make investment mistakes. Your decision-making then becomes dangerous because you don’t really know enough, and you’re relying on other people and the information (or misinformation) they provide about a particular stock. Instead, your investment purchases should be based on understanding the value of a business through in-depth research. If you truly understand the value of a business, then you will be in a position to recognize investment opportunities and can more easily make buy or sell decisions.

  Don’t be daunted by the idea of in-depth research. This book makes the research manageable (more about that in a minute). Also, I’m sure you do research all the time before you spend your hard-earned money: For example, think about any major purchase you’ve made in your life—whether it’s a house, or a car, or an expensive piece of jewelry or electronics. Before you spent all that money on whatever it was, you probably spent some time researching to make sure your money would be well spent. If you were buying a house, you (or your realtor) researched the price of other houses in that neighborhood and other amenities that would make that house desirable (e.g., the school system, ease of commuting, neighborhood parks or pools or tennis courts or shopping, etc.). The more you know about your purchase, the more easily you will be able to recognize a good deal. The same is true when buying or selling a stock. The more you understand the dynamics of a business and the people operating it, the better the odds that you will be able to recognize a good deal on a business.

  Many professional investors believe that in-depth research is a waste of time. To them, great investment decisions boil down to a few simple factors, such as an extremely low stock price. I used to subscribe to this theory myself, but over time, I discovered I was wrong. As I came to appreciate that the value of a business cannot be condensed into a few simple factors, I searched for books that would teach me how to value a business and invest intelligently in stocks. I was looking for a practical book instead of one that focused on broad concepts. In spite of the fact that there are hundreds of books written on the subject of investing, I honestly couldn’t find one that truly helped me.

  My instinct after failing to find a good investing framework was to over-research potential investments. I often ended up reading everything I could get my hands on about a potential investment. As a result, I subjected myself to information overload and was unable to recognize good information. I also kept repeating investment mistakes, such as paying too much for a business or partnering with the wrong management team.

  So I set out to establish a systematic process to force me to think through my investment ideas more carefully and help me avoid repeating the same investment mistakes. Over the past 10 years, I began to use checklists of questions I needed to answer to make informed investment decisions—questions that would guide me in learning about a business’s competitive position, customer positioning, and management strength. To come up with the questions, I studied the past mistakes I had made investing, and I read many books about the common mistakes made by investors and executives. I interviewed private equity managers, venture capitalists, entrepreneurs, chief executive officers (CEOs), hedge fund managers, mutual fund managers, and private investors to help me prepare a more comprehensive list of questions. During the stock market decline in 2008 and 2009, I made significant improvements to the checklists as the decline exposed weaknesses in my investment process.

  As I used the checklists, I discovered that if I could answer the majority of the questions on the checklist, I could more easily value the business by minimizing the number of assumptions I was making about a business’s future prospects. If I was unable to answer a question on the checklist (such as “are its managers honest?”), then I could identify the potential risks I was taking in an investment and the areas that I needed to spend more time researching.

  My ultimate goal was to understand how well I understood an investment by the questions I was able to answer—and those I was unable to answer, which is often even more important. With some companies, I found that the more I read about them, the more questions I had about how the company operated—and I realized this was an indicator that I didn’t really understand that business! For example, I spent a lot of time researching mortgage insurers in 2007 before the credit crisis began. Yet the more time I spent, the more questions I had. I never had enough information to be able to calculate a reasonable range of valuations for the businesses. I felt I was answering too many of the questions with assumptions rather than backing these assumptions with evidence. I therefore determined I was not in a position to value those businesses and I didn’t invest in them. That red flag saved me a lot of money!

  The result of all my research is this book, which describes the checklists I’ve used in my own investing over the past 10 years.

  How This Book Can Help You

  The Investment Checklist is for anyone who’s investing in stocks, at any level—if you’re just starting out and thinking about what you want to invest in, or if you already have a portfolio (of any size) that you want to manage better and watch your money grow (after all, no-one wants to watch their investments lose money, shrink, or disappear altogether!). That said, this book isn’t for stock traders (aka day traders) or people who invest only for short-term gains.

  Instead, this book is for anyone who wants to learn how to value a business and invest for the long term: I wrote it to help you learn what you need to know about specific companies you’re considering investing in, and to help you evaluate whether or not those companies are worth investing in.

  Before you read any further, consider these questions about you and your approach to investing (and be honest): You’re not sharing these answers with anyone else!:

  Do you check stock prices frequently?

  Do falling stock prices make your stomach churn?

  Do you react quickly to positive or negative news announcements about the companies whose stock you own?

  Do you ever feel you’re under time pressure to make buy or sell decisions?

  Do you have high portfolio turnover? Are you buying and selling shares often?

  Do you feel you need to defend your inv
estments when others challenge you?

  If you answered “yes” to any of the above questions, this book can help you make better investment decisions, by helping you research more effectively so you’ll truly understand how a business operates and is managed. As I developed my checklists, the benefits of creating a concise and easy-to-use framework became apparent. In short, the exercise of going through The Investment Checklist lowers your risk by increasing your knowledge of a business. Here’s how the checklists in this book can help you:

  The checklist will help you filter out the noise and instead focus on information that is most important and relevant. There is an unending stream of information available; don’t get bogged down in information overload, as I did when I first started investing. This book tells you what information you really need and where to find it.

  The majority of the questions can be answered by information that is relatively easy to find. You can find most of the information to answer the checklist questions in publicly available Securities and Exchange Commission (SEC) documents or articles written about management and the business.

  The questions should help you understand the business as if you’re the business owner and help move you away from thinking of stocks as pieces of paper. The checklist questions force you to think about the fundamentals of the business rather than just its stock price. Worrying about things such as fluctuations in the stock market (which are outside your control anyway!) is a waste of time. Instead, you will be able to identify the main factors that drive the value of the business, most of the risks the business can encounter, and the things that can go wrong.

  The checklist will help you take a long-term view of your investments. Most people tend to remember recent events more easily. The checklist requires that you answer questions using a long time span, which helps protect you from overvaluing more recent pieces of information. Researching a business over a long period of time allows us to sort through things rationally and puts us in a position to better interpret information.

  The checklist is useful for compiling information that goes against your investment thesis. It is human nature to overweight information that supports your investment thesis and underweight information that is contrary to your investment thesis. The checklist questions help you ensure you’re accepting (or at least recognizing) divergent facts about the business.