The Starting Point
The idea is to spend about 30 minutes “analyzing” an investment opportunity before we commit our hard-earned money. This article is for long-term investors – meaning that you’re willing to ride out the vagaries of the stock price for about 2 years. Day-traders and short-termers (who go in and out of a stock in 3-6 months) won’t find this checklist useful.
I find that for too many people, the starting point is one of two places:
- 1.You like a product or service and the company has a publicly traded stock.
- 2.You’ve heard about a stock from your advisor, friend or CNBC.
Watching CNBC or thinking that “a good product = a good investment” do not qualify as an “investment process”. Neither does staring a price chart. All 3 methods can be grouped under that rigorous investment philosophy called Luck. At The Buylyst, we try to reduce the role of luck in our financial future.
Once we identify an investment idea that passes the “smell test”, the next step is to do a “sanity check” to keep our emotions from driving our decisions. That’s why I’ve put together a quick checklist just to give you some tools, so you don’t go in blind with enthusiasm. We’ve all done it in the past. No need to keep doing it. Who was it who said, “doing the same thing repeatedly but expecting different results is the very definition of insanity…”?
At The Buylyst, we go much deeper than the checklist shown below. Our research takes at least a week from start to finish. Compared to The Buylyst process, the checklist below is very light. and should be followed with some caveats in mind:
- The Buylyst avoids using P/E ratios because Earnings-per-share is an accounting number that often doesn’t capture the economic reality of the business.
- However, P/E ratios used in conjunction with ROE somewhat evens out the accounting shenanigans. That’s a separate topic in the realm of Accounting. I’ll leave it out of the discussion for now, so you’ll have to trust me on this.
- The Qualitative part of the checklist usually takes a lot of work – it requires having a well-thought-out latticework of worldviews, listening to past earnings calls, reading pages and pages of magazine articles and interviews, and doing some independent “channel checks” if possible (like asking industry experts). In the checklist below, I’ve shrunk it down to 20-25 minutes.
For most people, #3 is the hardest to do. That’s one reason why investors subscribe to a service like The Buylyst. We do the work, so you don’t have to. However, for those who haven’t subscribed, this checklist is the second-best alternative.
The Intelligent Checklist: 30 minutes.
OK – let’s get to it right away.
- Is ROE high enough?
- Does the company have low debt?
- Is the Long Term Debt/Equity Ratio less than 2?
- Is it trading at a reasonable valuation?
- Is the P/E ratio less than 20?
- Does the company have a Competitive Advantage?
- In a sentence what is its core competency?
- Does it make a markedly cheaper product or a markedly better product?
- What is the numerical evidence? Have Sales been growing? Has Cash Flow been growing?
- Is their Competitive Advantage durable?
- Competition and Threats? Present and Future.
- Cash Flow Volatility?
- Is Management Competent?
The Numerical Litmus Test: 5-10 minutes
#1 to #3 in The Intelligent Checklist are numerical. Don’t worry, there is no calculation involved. For US stocks, it’s very easy to find these numbers.
I use MarketWatch quite often because it has a lot of information arranged in a way that’s intuitive to me. Of course, you can find these already-calculated numbers in Yahoo Finance or Google Finance as well. Let’s go through this in MarketWatch:
- Let’s say we’re thinking of putting money in Netflix.
- Go to www.marketwatch.com
- Click on the Search icon on the top-right, and type in Netflix, or NFLX if you know the ticker.
- Click on the drop-down choice it shows you – the first one will probably be Netflix.
- Now you get to the Netflix page.
- To get to the 3 numbers we need, click on the “Profile” tab below the price chart. This takes you to the page which has the numbers we need.
- In the “Profitability” section, you’ll find the ROE number right beside “Return on Equity”.
- In the “Valuation” section, you’ll find “P/E Current (without extraordinary items)”. That’s the P/E ratio we’ll use.
- In the “Capital Structure” section, you’ll find the Long-term-Debt-to-Equity number.
OK – for Netflix, this is what I see as of writing this:
- Return on Equity: 27.5. This is actually 27.5% but MarketWatch doesn’t put the % sign. On this measure, Netflix passes the test.
- P/E Current (without extraordinary items): 99.87. On this measure, Netflix fails.
- Long Term Debt to Equity: 198.3. Again, MarketWatch forgets to put the % sign. It should read 198.29%. On this measure, Netflix barely passes the test.
Just based on this, my conclusion is that Netflix is too expensive – too overvalued. When looking at ROE and the P/E ratio in conjunction, you can use this rule of thumb: if the ROE is significantly higher than the P/E ratio (even if the P/E ratio is above 20), it might be worth a look. That means that the underlying returns of the company are very good, and the high P/E ratio may be justified. Again, on this count, Netflix doesn’t pass the test. In fact, here’s how it compares with the rest of the “FAANG” stocks:
But numbers don’t give you the entire picture. Google, for example, is a border-line case. Qualitative factors are more important. This isn’t Physics.
The Qualitative Litmus Test: 20-25 minutes
This section is about #4 to #6 on The Intelligent Checklist. Now, I won’t go through an analysis of Netflix using the checklist. But I will give you some pointers about doing it efficiently.
Does Netflix have a Competitive Advantage? I find that if you can answer the question “What is its core competency?” easily, in one sentence, you’re on to something. Another way of asking this question is “What problem is the company solving?”. The next question is “Are its products significantly cheaper or better than its current competition?” In Netflix’s case, I would argue that price is not their tool of choice; Content is. That’s another way of saying “Netflix competes by trying to offer a better product; a better selection of Content”. The third question is somewhat numerical – “Have Sales and Cash Flow been increasing”?
On the last question, here’s how to use MarketWatch. Go back to the “Overview” page of Netflix. You’ll see a tab called “Financials”. Don’t worry, this is going to be easy. You’ll see that it takes you to the Income Statement. And the top line will be called “Sales/Revenue”. You’ll notice that it spreads out the numbers. But there’s also a little graph on the right side. All you want to do is to see if that graph is upward sloping. If it is, sales have been increasing and that’s great! If not, then you need to step back and think about why sales have declined. On Cash Flow, the procedure is similar. Now, we go to the “Cash Flow” tab, which lies within the “Financials” page. This opens up the Cash Flow statement. In this page, you’ll see a line item called “Cash Flow from Operations” about a third of the way down the page. This will also have a small graph like the one you saw for Revenue/Sales. If It’s upward sloping, great! If not, we’ll need to step back and ask more questions.
Now let’s move on to the questions “Is the Competitive Advantage durable?”. This has 3 components:
- Competition & Threats: Think about the competitive landscape today – for Netflix it’s limited. Amazon Prime and HBO are the only legitimate competitors. That’s great. But what about the future? Disney, Warner Brothers, and Apple will have their own streaming channels. How will that work out?
- Protection: What is Netflix’s MOAT? How will it protect itself from subscriber attrition?
- Cash Flow Volatility: This leads to wild swings in stock prices. So, it’s worth figuring out if cash flow volatility will come from increased competition or from normal macroeconomic seasonality. If it’s the latter, it’s fine. If it’s the former, then you might want to rethink.
Finally, we get to Management Quality. This is complicated and hard to judge. But if you can find two recent interviews of the CEO, you’ll already have done more homework than many retail investors. The idea is to pin down the CEO’s strategy for the company in one sentence. It’s hard to do but we can try.
In the case of Netflix, I would say the strategy is: “buy” volume through cheap pricing while capital markets allow for complete freedom on funding expensive content production and acquisition; and then “eventually” volume (with a little hike in pricing) will reach a level that leads to positive free cash flow.
The Bottom Line
At the end of the day, it’s worth spending 30 minutes to make sure you’re going into an investment with your eyes open. As a recap, you’ll have a rough answer for these 6 questions:
- Is ROE high enough?
- Is the P/E ratio low enough?
- Is Debt low enough?
- Is there a distinct competitive advantage?
- Is the competitive advantage durable?
- Is management competent?
And that’s it. The Numerical Test takes 5-10 minutes. The Qualitative Test takes 20-25 minutes. Boom. Done. You’ve done more homework than most retail investors.