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Good old checklists…

I believe it is important to have a checklist before making an investment.  Very much like buying a pre-owned vehicle, a used car buying checklist can help us avoid buying a “lemon” by reminding us of specific checks or to be aware of certain faults.  Therefore, given the risk inherent risks in investing, an investment checklist can help improve our chances of successful investing.

Obviously not all investors would have the same checklist, the checklist would depend on the investor’s investing strategy and the types of securities he/ she is looking to purchase.  For myself, my investment strategy is build around minimising risks by purchasing securities which are selling at prices lower than their intrinsic value (commonly called value investing). Considering the breath of the investment universe, I believe a principle based checklist which I believe will have broader use than a prescriptive one.  I have developed a simple checklist over time from learning from the great investors, reading books on investing and personal experience. My checklist, in no particular order is:

  1. Know what I am buying.
    This fundamental principle sounds simple but there are few subtle points.  Do I know enough about the industry and the company’s business activities? Are there any potential technological advancements which have the potential to disrupt the industry? Is it within my circle of competence?  Warren Buffet once remarked: “You have to stick within what I call your circle of competence. You have to know what you understand and what you don’t understand. It’s not terribly important how big the circle is. But it’s terribly important that you know where the perimeter is.”
  2. Am I able to value the security with a reasonable degree of confidence?
    The value of a company is the present value of its future distributions so it is important to be able to predict the company’s future cash flows with some degree of certainty.  So I would be more confident in making forecast for a company like Woolworth (with its stable cash flows) compared to a company such as Fortescue Metals (whose cash flows are very much tied to volatile iron ore prices).
  1. Avoid highly geared securities
    I stay away from companies which are highly leveraged.  Although leverage has the potential to greatly magnify returns, it also increases the risk exponentially and since my core strategy is risk minimisation, I prefer companies with low or no debt.  To assess whether a company is highly geared I look at the ability of the company to service its debt obligations (interest coverage ratio) and the overall quantum of debt in the capital structure (debt to equity ratio).  In general, I like companies to have a interest coverage ratio (EBITDA – capex/ interest) of at least 5x and a net debt to equity ratio not more than 30%.
    Warren Buffet has this great saying on debt “If you’re smart you don’t need it, and if you’re dumb, you got no business using it”.
  1. Avoid companies whose management doesn’t act in the shareholder’s interest
    Sometimes it is hard to identify good management just by reading the annual reports and other public documents.  Compounded with that, the general trend these days is to change top management (CEO) every few years so it is hard to gauge how “good” the incoming CEO is. So I think one solution whether a culture of acting in the shareholder’s best interest exists.  I avoid companies whose management puts its needs before the shareholders needs.  Examples of these are overpaying for acquisitions with little or no strategic benefit, unnecessary risk taking by management (maybe due to misaligned incentive system which rewards management for taking huge risks), constant issuance of shares (placements) which dilutes the shareholder’s interest etc.
    Identifying good management can be challenging but avoiding companies with a culture of bad management is an easier way to avoid the landmines.
  1. Understand why the market is valuing the security at the current price
    This is what Howard Marks calls second level thinking.  In general I believe the market is fairly efficient most of the time; so if I do find an undervalued security, I am coming to a pretty bold and arrogant conclusion.  Basically I ‘m saying I’m right and that the entire market with all of its participants is wrong with regards to the pricing of the security.  To achieve that second level thinking, we must invert and understand why the market is pricing the security as such.  Once I understand the reasons for the market pricing, I am then in a better position to assess whether I think the market has overpriced or underpriced the security and this is  typically related to the probability of some future event occurring.  My default position is that the market is fairly efficient most of the time in pricing securities.
  1. Buy the security when it’s price is lower than it’s value (margin of safety exists).
    The margin of safety concept is a concept articulated by Benjamin Graham as the central concept of investing in his book The Intelligent Investor.  Valuing a business is difficult and precise assessment of its intrinsic value is not possible.  The best we can do is to make an approximation of a company’s intrinsic value (say within a range).  Therefore, we should only invest when there is clear bargain and when a clear margin of safety exists.  The principle is similar to say building a bridge, where the daily maximum load is expected to be 100 tons, engineers would always build the bridge so that it can support a load greater than this, e.g. 130 tons.  I wouldn’t want to cross a bridge where the current load is a 100 tons and whose capacity is also 100 tons!
  2. Diversify
    Investing is about the future and since the future is uncertain; there can be no certainty in investing.  All we can do is to invest in securities which have a greater probability of making a profit than a loss.  We may perform the best analysis and invest in a company with say a 90% chance of success and a 10% chance of failure but the failure scenario can prevail (bad luck) which will cause us to lose money on the investment. However, this does not mean our decision to invest was flawed, it was simply bad luck.  So to avoid bad luck wiping out all of my capital and forcing me out of the game, diversification is important.  The age old adage; don’t put all your eggs in old basket is acutely meaningful in investing.  I diversify by trying to invest in securities which are not highly correlated (different sectors).  Diversify but don’t over-diversify, most fortunes are made by owning a single company (most billionaires tend to have the bulk wealth in one entity) and not by owning all 200 companies in the ASX 200.  How many companies to hold in a portfolio to achieve a satisfactory level of diversification? This is personal choice but for me seven to fifteen securities in my portfolio is a good balance in terms of portfolio concentration, diversification and ability to follow these companies closely.

This is my checklist to buying a security.  All feedback/ comments are much appreciated….