1. Where did the stock idea come from?
A good idea can come from any source – what is important is being able to analyse the company on its own merits. Some sources you trust, others you do not. Let experience be your guide as where you look first.
2. What do you know about the company?
You do not have to know anything to start with, of course, but it certainly speeds things up. If you have heard good reports from all kinds of people, that is usually a warning sign.
Can the stock possibly live up to such high expectations? If your analysis shows it probably can, then great. If it probably cannot, you have almost certainly avoided a big loser.
3. Is it a growth stock, income stock, cyclical stock, or none of the above?
Cyclical stocks typically relate to companies that sell discretionary items that consumers can afford to buy more of in a booming economy and will cut back on during a recession. Examples of companies whose stocks are cyclical include car manufacturers, airlines, furniture retailers, clothing stores, hotels and restaurants. When the economy is doing well, people can afford to buy new cars, upgrade their home furnishings, and go shopping and travel. When the economy is doing poorly, these discretionary expenses are some of the first things consumers will cut. If a recession is bad enough, cyclical stocks can become worthless as companies go out of business.
Some companies reinvest their earnings to fund growth. Others pay higher dividends, often because there are few growth opportunities to fund. Both stocks have a place in your portfolio.
If it is income you need, it is an income stock you want. The usual suspects – your broker, share tables and so on – will answer this question for you. You might as well check out the P/E and dividend cover while you are at it (we would like to stress future or prospective P/E rather than historical P/E which can make the stock look deceptively cheap if the price has fallen recently). If there is no growth, no income and none on the way, go back to number one. (We would categorise this as a speculative stock to invest in, because you would be just gambling on things getting better).
4. Do I have a clue about the industry?
You do not need to be a geologist to invest in a mining stock, but you should at least have a rudimentary understanding of the markets the company operates in, the commodities price cycle, the competition, the industry outlook, and the sector’s history.
Similarly, if you are looking at a technology stock, where the key to analysis may be picking technologies that will survive the industry’s evolution, it is certainly going to help if you talk the talk and have a grasp of the key issues.
5. Does the company make a profit? If so, why? If not, why not?
Not surprisingly, given our focus thus far on the one thing that matters most, the biggest losses are often made on companies that never turned a decent profit.
At the height of the technology stock boom, and immediately prior to the 35% plunge in the tech-heavy Nasdaq index in April/May 2000, the vast majority of listed internet-related companies in the US weren’t making a dollar. In fact, between them they were losing billions. There are sometimes good reasons to buy companies that do not make a dollar, but there are often better reasons not to. This question tells you whether the stock represents a real company that makes money by doing understandable things or a “concept stock” with perhaps loads of potential, but unproven earning power. The risks of these stocks reduce as profits become more likely.
When speculative or “blue-sky” stocks make it big, they can really make it BIG. But very few do and unfortunately these are the ones you hear about over and over. The majority that fail are not discussed. A similar example, the lottery winner is celebrated, but the one million people that bought a losing ticket that week don’t get any air time.
While they do have a place in most portfolios, make sure it is a small place in yours, and be prepared to lose your money if you get it wrong.
6. Is the profit (or profit potential) increasing?
“Increasing profits make increasing share prices,” should be your mantra.
Many other things make increasing share prices as well of course, such as optimists, speculators, growing yields and takeover merchants. However, show me a company that has consistently grown its earnings at a steady clip and more often than not I will show you a company that has grown its share price over time as well. You can get the data to answer this question from the usual sources. On occasions where the rule does not hold and increasing profits produce falling or stable share prices, it’s usually because market expectations have run so far ahead of what any company could hope to achieve that, even though the company may have done quite well, its share price has disappointed. It may also be because the market sees a “shock” around the next corner.
7. Can I explain how the company makes its money?
If the company makes money, you need to know how — but keep your thinking fairly simple at this stage (remember, we only want to know whether to shortlist the stock for now). For example, “Cochlear makes money by selling implants that help hearing impaired people to hear.” Sounds like a simple business with a big target market — could be worth a look! One other quick point: note the wording of this question. If you cannot clearly explain what a company does, do you really understand it?
8. Will the company be around in three years?
Companies go broke the same way people go broke. If you owe a pile of money on your mortgage and do not earn enough money to pay it off, your debts mount up until one cloudy day the bank pulls the plug.
For stocks, you can take a quick “three-year” test by looking at the ratio of the company’s debt to shareholders’ equity. You will find all the information you need on the balance sheet in the company’s annual report. If you go through the full calculation, you will be forced to address a whole raft of issues for different types of company, accounting treatments of various assets and liabilities and so on.
Really, all you want to do at this stage is work out whether the company will be able to keep repaying its debts without any trouble. Equity ownership, remember, normally involves dividend payments, which can be reduced or even suspended for a period if the company needs time to get back on its feet. While you obviously do not want this to happen, a company that is making money and has a low debt burden isn’t likely to be filing for bankruptcy any time soon.
Debt is a different beast. Interest payments to banks and other lenders cannot be reduced or suspended without the real risk of default and liquidation. Excessive debt catches up with everyone eventually.
Most brokers’ reports will provide a “gearing” ratio but, to get an initial feel for how the company stacks up, you can compare non-current liabilities (the debt the company will be paying off for years to come) to total shareholders’ equity (the owners’ stake in the company). Anything over about 80% warrants further investigation and, generally, the lower the gearing ratio, the stronger the balance sheet — but only up to a point. Relatively high gearing is no big deal (or, at least, much less of a big deal) if a company has a stable enough underlying cash flow to service/pay off the debt. (In looking at operating cash flow, in a cyclical stock it may be strong today, but not tomorrow due to factors outside of the business control, for example mining stocks that cannot control the price they sell at).
For example, if you have a $600,000 mortgage outstanding on a home unit, $15,000 cash in the bank, and $300,000 equity in that unit, what is your personal gearing ratio (forgetting whatever else you may have in other assets)? Your gearing ratio is your net debt ($600,000 – $15,000), divided by the total value of your home unit ($900,000) or 65% That should not be a problem if you have a decent regular salary to service/pay off the debt but, if your cash flow is poor and patchy, there is a chance you will not have that unit in three years’ time.
The important question, then, when it comes to stocks is: how resilient is that cash flow to a downturn in operating conditions? While you are visiting the company’s balance sheet, it will take all of 10 extra seconds to check out how much cash it has stashed away. If a stock is trading at $4.50 with $2 in cash (net of its liabilities, of course) on the balance sheet for each share on issue, it is a good bet the share price will not go too far south of $2.
One final point about debt and equity: Do not get into the habit of thinking “debt bad, equity good”. The real trick is the balance between the two. Debt is often a cheaper way for companies to raise money, so funding an initiative by debt can actually boost the relative rate of return to shareholders. The main thing to consider is simply whether there is the overhang of interest repayments or so much debt the company will struggle to pay it off. As we have seen from Dick Smith, financial leverage and debt is an important subject and demands a separate discussion — including looking at liquidity ratio, current ratio, net debt to equity, Net Interest Cover, Net Debt to EBITDA ratio.
9. Is there a special reason for buying now?
Is there a particular reason why the company is more attractive now than, say, six months ago? If this is the case, obviously you will want to fast track it on your list of stocks to investigate. Also, consider whether you are interested in the stock as a trade or as a long-term holding. Know your mind and know what you expect from each stock you hold.
10. Does the stock suit your financial position?
If you have been following this checklist, you should already know whether the stock promises growth or income. However, you need to consider how you are going to pay for it if you decide to buy. Will you have to sell other investments to buy it? How long can you afford to have money tied up in the stock and how long do you expect to have money invested in the company to extract the value you want?
You will need good answers to all of these questions. If you sell a core portfolio position to take a punt on a speculative stock, you will have made your whole portfolio more risky. While the chances of strong outperformance may be improved, so are the chances of significant underperformance. There is nothing wrong with doing that, as long as it is a conscious decision and you understand the risks.
Finally, can your portfolio — not just your individual sharehoholding — cope with the downside if the worst happens? Assuming you have the basic company information in front of you, this whole test should take about 10 or 15 minutes. In addition, if you get past these sorts of questions, you may be on to something and it will be worth taking your analysis to the next stage.