The Investment Checklist
Page 3
Now that you know more about how to generally look for investment ideas, the following sections of this chapter describe a few more formalized ways to begin looking for investment ideas.
Using Stock Screens
A stock screen is a tool investors use to filter stocks, using pre-selected criteria. For example, if you’re an investor looking for cheap stocks, you could enter a set of filters such as: “companies that have enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratios of less than five times that also have market capitalizations over $100 million.”
This produces a list of businesses that fit the limits you’ve just set.
There are many different types of screening tools available. Services range from free services to those with high-end fees, with features and coverage varying by service. The higher-fee services cover a greater number of businesses, including microcap stocks and international stocks, and they often come bundled with a range of analytical tools that can help you further refine searches, such as “search for businesses with more than $100 million in revenues that have CEOs over the age of 60.”
One of the main limitations of stock screens is that they use Generally Accepted Accounting Principles (GAAP) accounting numbers, which rarely present a realistic financial picture of a business. For example, if you are looking at a multiple of last year’s earnings, this can be misleading if the company reported a big loss in the prior year. Investors often need to adjust GAAP earnings to understand the real earnings of a business.
For example, in 2006 and 2007, the average trailing 12-month price/earnings ratio (P/E) for retailer 99 Cent Only Stores was more than 90 times.3 After adjusting the earnings for special charges 99 Cent Only Stores took in those two years, I learned that the adjusted P/E was closer to 12 times rather than the 90 times being reported.
On a standard stock screen, many of my best investments showed up as having a P/E ratio of more than 50 times because GAAP accounted for such factors as restructuring costs that reduced earnings. After I made GAAP adjustments, I found that these ostensibly high price-to-earnings-ratio businesses were really trading at only five times earnings, not 50. Had I relied exclusively on stock screens, I would have missed many of my best investments.
For example, when I was researching the stock of Four Seasons Hotels, which had dropped in price after the September 11 terrorist attacks, its P/E ratio was 85 times earnings. Four Seasons had just taken several restructuring charges, which reduced the earnings of the business. After adjusting the earnings of the business for these restructuring charges (which were due to GAAP standards rather than actual cash charges), the P/E ratio was closer to 10 times earnings. Had my firm relied on a stock screen, we would have never found this investment, which doubled in price in a short period of time.
Keeping an Eye on New-Lows Lists
Newspapers and websites can provide other idea sources like new-lows listings. For example, the online site for the Wall Street Journal offers daily and historical new-lows listing of U.S. stocks—that is, those reaching new 52-week price lows on the NYSE, AMEX, and NASDAQ.
Also, Value Line regularly publishes stock listings such as those that have:
The widest discounts from book value
The greatest percentage price changes over the previous 13 weeks
High 3- to 5-year price appreciation potential
Current P/E multiples and price-to-net working capital ratios that are in the bottom quartile of the Value Line universe
Paul Sonkin, manager of the Hummingbird Value Fund (a micro-cap fund), uses stock screens and new-lows lists, but he believes these tools are misused by investors 99 percent of the time. According to Sonkin, “. . . a lot of investors will put together a screen of low price-to-book or low price-to-earnings stocks, but usually 90 percent of the companies on the screen are cheap for a good reason. Many stay on these lists for a long time.”4 Sonkin believes the proper way to use a screen or new-lows list is to run them on a weekly basis and look for new companies that appear on the list. This way, you are able to separate the companies that deserve to be there from those that may only be suffering from a temporary problem.
My firm has benefited from tracking new-lows lists. For example, I missed an opportunity to invest in Apollo Group, the for-profit higher-education business known as the University of Phoenix, in 2001, when the stock price was near $20 per share. By the end of 2001, the stock price rose to more than $30 per share, and by the middle of 2004, it rose to $100 per share.
Although I missed the opportunity to invest in 2001, I continued to research Apollo Group by attending industry conferences, listening to conference calls, and keeping up with SEC filings. Five years later, I was able to act decisively when the stock price dropped from $60 per share at the beginning of 2006 to $35 per share on November 14, 2006 due to an options backdating scandal. I was able to discover the opportunity because I was continually monitoring the new-lows lists and saw that Apollo Group’s stock price had dropped. Also, because I had consistently followed the business over a long period, I knew investors were overreacting to the scandal. By the beginning of January, the stock was trading for more than $40 per share and by July it appreciated to $60 per share. Had I not prepared in advance and monitored new-lows lists, I would have missed the small window of opportunity to make this investment.
Reading Newsletters, Alert Services, Online Recommendations, and Media Recommendations
There are many publications that tout stocks. It is better to stick to those services that are fact-based, such as Bankruptcy Week or Distressed Company Alert, rather than those services that are more interested in selling subscriptions by marketing high rates of returns to their subscribers. Fact-based publications are those where no opinion is attached and instead corporate events are chronicled. Be aware of self-serving recommendations and less-than-transparent presentations of results. Some newsletters will exclude certain stocks they have recommended in the past when presenting their overall rates of returns, and instead present only those that have done well.
Using Value Line
Value Line is a great source for you to build knowledge on certain businesses or industries. It presents much critical information on a single page. A typical stock report shows 10 years of financial information, including sales, operating margin, depreciation, net profit margin, income tax rate, working capital, long-term debt, and shareholder equity. It also shows historical returns, such as return on total capital, return on shareholder equity, and return on common equity. There is also a quick write-up of significant developments over the last quarter as well as a historical stock chart.
Each week, a new issue comes out highlighting a group of stocks within an industry, such as auto and truck, precision instruments, electric utilities, or medical supplies. I read each issue from beginning to end looking for new ideas. This also builds my understanding of new businesses and industries. I borrowed this idea from Charlie Munger, Vice Chairman of Berkshire Hathaway, who mentioned at an annual meeting that he leafs through these reports regularly to learn more about different types of businesses as well as to find opportunities. The main limitation of this source is that its publications cover only 3,500 stocks, and not all 9,000 publicly traded stocks in the United States.
Following Other Investment Managers
Many investors (professionals included) generate ideas by closely tracking the holdings of well-known investment managers with above-average track records. There always seems to be a hot group of investors that others follow, although most aren’t followed for long. These are usually investors who have had recent success, so the media constantly reports their new holdings.
The problem with following others is that most of these great records were generated by past investments, and investors wrongly conclude that existing and future investments will have similar results. Many of these investors fall in and out of favor (for example, when investors began to question the investment wisdom
of Warren Buffett when he was telling investors to avoid high-priced Internet stocks in 1999), and it is typically when they are out of favor that you should be following their holdings. Investors who manage the largest amounts (i.e., more than $100 million) have to disclose their investments each quarter in an SEC 13-F filing, so following them is straightforward (albeit slightly delayed).
Early in my career, I occasionally sourced investment ideas from these managers. When the filings came out, I would be excited to discover that the investment managers I admired had made some new investments or significantly increased their position in a stock. If it was an investment idea I understood, this excitement translated into higher conviction, sometimes causing me to cut corners on my own research.
There are several disadvantages to following other investment managers:
Most great investment track records come from a limited number of investments. For every 10 investments a successful investment manager makes, only one will appreciate substantially, contributing outsize returns to the investment record, while the others will either mildly perform or underperform.
You typically will not know the reason why a certain investment manager is buying or selling a stock. Perhaps the investment manager is suffering from investment redemptions and he or she needs to sell stocks.
No matter how good they are, all investment managers will make mistakes, and you may be following them into such a mistake.
Investment managers change their strategies. Recognize that the strategies the investment manager followed in the past to generate the superior investment record is not necessarily the strategy the investment manager is following today.
Therefore, in the end, be careful about following the ideas of other investors.
Casually Reading the Business Press
You can generate ideas from the business press by regularly reading publications such as Barron’s, the Wall Street Journal, the Financial Times, Forbes, and Fortune. Consider subscribing to trade journals as well, such as American Banker (if you are interested in financial-services stocks) or Las Vegas Review-Journal (if you are interested in casino stocks).
As you read the articles, you’ll not only ground yourself in industry basics, but you’ll uncover descriptions of management teams you’d like to invest with. The best investment ideas usually come from those businesses that are in distress. Focus on those articles that are not success stories but those about distress, to give you better odds of finding a well-priced investment.
For example, First Manhattan senior managing director Todd Green remembers how he first became interested in the diversified industrial conglomerate Tyler Corporation. Green read an article in Forbes (in 1990) where CEO Joseph McKinney said he would not consider doing a leveraged buyout (LBO) because this would put him on the opposite side of the table from shareholders. This was during the days of a serious amount of LBO activity, and the comment signaled to Green that the CEO had the right attitude regarding the alignment of shareholders and management interests. Green purchased the stock on April 26, 1991 at $3.07 per share and sold it on June 8, 1998 at $9.99 per share, a compound rate of return of more than 18 percent.5
Buying Shares to Track a Business
You can buy a few shares in a stock that meets your criteria to force yourself to follow the business. By purchasing a very small piece of a business, you’ve guaranteed that you will not forget the business, and that you’ll have consistent reminders about that business. Paul Sonkin of the Hummingbird Value Fund calls this his grab bag. In his personal account, Sonkin has purchased one share of more than 300 companies. In the mail each day, he usually receives something from some of the companies. He has followed some of the companies for many years, and he uses this method as a way of filling his in-box with companies that he has already screened as being interesting.
For example, Sonkin was able to invest in Control Chief Holdings, a manufacturer and marketer of wireless remote control equipment primarily used in the railway industry, which was trading for $250 per share. Sonkin had followed the business over some time and learned that the business had more than $147 per share in net cash and estimated that it had $25 per share in earnings power. Therefore, at an enterprise value of $103 per share, Sonkin bought the stock at four times normalized net income, an extremely low price.6
Don’t Ignore Your Existing Investment Portfolio
Admittedly, it is more exciting to discover opportunities outside of your portfolio, but it’s not necessarily more beneficial. Many investors forget to look at their existing portfolio for ideas. Often, your best opportunities are right in front of you. If a stock you hold drops in price, this may represent the best investment opportunity for you, especially compared to a stock you know less well.
For example, when the S&P 500 dropped 36 percent in 2008, there was an abundance of opportunities. Instead of attempting to analyze many of the new opportunities being offered, my firm decided to analyze our own portfolio holdings that were trading at significantly lower prices than they had just weeks or months before. At one point, our core holding Whole Foods Market traded at close to four times enterprise value to free cash flow, which means we could have bought the whole business (including debt net of cash) and paid for it in four years out of existing depressed free cash flow. We ended up buying more of our existing holdings, such as Whole Foods Market, which helped us generate a net return that was far superior to the S&P 500. Had we analyzed new potential holdings, we probably would not have increased our existing holdings and not generated an excess return.
Research Upcoming IPOs
You can regularly research IPOs, spin-offs, and stocks of companies that are exiting bankruptcy, all of which are new businesses to the stock market. You can subscribe to various services that will alert you to these new entrants, such as Gemfinder’s Spinoff & Reorganization Report. Once alerted, you should read the prospectus that accompanies an IPO, spin-off, or stock exiting bankruptcy, because these are especially rich in information and are much more useful than a standard 10-K filing. The biggest advantage of tracking these businesses is that there is not a public price to influence you. You can calculate a reasonable valuation range for the business in advance, and then compare your value to the business’s trading price.
For example, I analyzed pediatric nutrition business Mead Johnson Nutrition before it was spun-off from parent Bristol-Myers Squibb. Because, there was not a public price to influence me, I determined that the stock was worth $40 per share and that I should buy it at any price below $30 per share. When the price of the spin-off was set at $27 per share in February 2009, I purchased the stock, which quickly increased to $43.70 at the end of 2009. Had I not prepared in advance, I would have missed this opportunity.
How to Filter Your Investment Ideas
So far in this chapter, I have shown a few of the ways you can gather investment ideas. The rest of this chapter demonstrates ways to filter these results and begin evaluating investment candidates that you may want to include in your set of potential investments.
Criteria Is a Filter
When filtering through the many investment opportunities the stock market is offering at any given time, it is important for you to establish criteria of the types of businesses and management teams you are searching for. These criteria serve as a filter, so you don’t have to review thousands of investment opportunities and therefore can reject investment ideas quickly. If you have ever purchased a home, when you first started looking, you were probably overwhelmed by the number of houses that were available. At some point, you probably began to establish criteria for the types of houses and areas you were interested in, and this helped you narrow the list of houses that were potential candidates for purchase. The investment criteria you develop will work in the same way.
Your criteria can be as simple as looking for a simplified business with a large market opportunity, managed by a great management team, and trading at a low price. You can also set criteria of what you do not wa
nt to invest in. For example, you may want to avoid businesses that have a high dependency on commodity resources, such as exploration and production (E&P) businesses, because oil prices are difficult to forecast. By articulating and following strict criteria, you can put the odds of making a successful investment in your favor.
Table 1.1 is something you might want to consider using in order to make comparisons among different types of businesses. You can list what your preferences are for a business, such as these:
Table 1.1 Sample Criteria Checklist
KEY: √ = Possesses, Χ = Does Not Possess, — = Don’t Know
A recurring revenue stream
A business with high organic growth prospects (i.e., growth that is not accomplished by acquiring or merging with other businesses)
Management that has a long tenure at the business
A competitive moat
Strong existing or potential financial characteristics, such as high free-cash flow
High existing or potential returns on invested capital
Limited competition
Low capital-expenditure requirements
A diversified customer base
A strong balance sheet
A check mark indicates that the business possesses a certain attribute, such as a high return on invested capital, whereas the X mark indicates that it does not. You can make a simple tally of how many attributes the business exhibits. This serves as a scoring system and helps you compare different businesses from different industries.
Evaluating the business in each of these 10 areas will help you understand the tradeoffs you are making when investing in a particular business. Perhaps you found an investment with a strong competitive advantage, yet the business has limited future growth prospects: Using the criteria in Table 1.1 clarifies the advantages and disadvantages of such a business as well as its potential dangers. The more closely a business meets your stringent criteria, the less risk you are taking. For example, it is easier to monitor a business with limited competition rather than one that has a lot of competition. If a business meets only four or five of your criteria, you can usually pass on the business, as most investment mistakes are made when you stretch your criteria.