Stock Picking Checklist for the Casual Investor

​Although not popular these days, it used to be investing was all about estimating what something was worth and trying to buy below that value.  This is what we do when we buy houses, cars, or groceries but for some reason people like buying stocks after they have moved up in price.  The latest example is Nikola Corporation which produces (or plans to produce) electric vehicles. In their latest quarter, they had revenue of $36,000 (not a typo!) and lost $100 million but they have a market cap of $13.8 billion!  If you own a business doing annual sales of $150,000, just think what it could be worth if you went public!  These crazy valuations would never happen in the private market, but anything can happen in the public market.  Back in the tech bubble of 1999, the rule of thumb was if a company was trading for more than 10x revenue, it was significantly overvalued and a good shorting opportunity.  Today, many companies trade for over 1,000x revenue.  Very painful if you started shorting the stock at 100x revenue!

I still approach investing the old-fashioned way where you determine what something is worth and only buy at a discount to that value.  One of the benefits to this approach is increased conviction when the markets fall.  If I own stock in a company that I think is worth $100 and the price falls to $75, I do not panic and sell.  In fact, I might even buy more.  But if you own stock in a company that is worth $100, and it trades for $500 it’s hard to know when to sell if it starts falling.  Momentum is great on the way up, but unfortunately it works on the way down as well.
 
There are several ways to value a business but the three I use the most are:
 
1)Discounted cash flow – best used for a high-quality company with stable margins and cash flow
2)Liquidation value – best used for a struggling company that has gotten too cheap and people have totally given up on it.  Most of the time these companies survive and the returns can be excellent, if you buy them cheap enough.
3)Sum of the parts – best used for holding companies or companies in a diverse group of industries.  Think G.E. or Berkshire Hathaway.
 
At this point, people are probably thinking this is all great for a Finance guy but I’m not one so I will just invest in things that have gone up a lot or companies mentioned on CNBC or Twitter.  Even if you don’t follow one of the valuation approaches listed above, you can still determine if the price is reasonable for the company you are considering.  It only takes a few minutes to look up a company’s financials in Yahoo Finance or one of the other many sources.  They say most people spend more time researching a vacation or a new refrigerator than they do a stock.
 
If you look at the annual returns of the great investors, you expect to see several years of amazing outperformance.  In reality, their success normally comes from avoiding losses.  Keep in mind, if a stock drops 80%, you need a 400% return to break even.  This is very much a game of winning by not losing.  Therefore, following a simple checklist of what not to do can be beneficial.  For example:
 
1)Don’t invest in companies that are losing money
2)Don’t invest in companies that are burning through cash
3)Avoid IPOs
4)Never pay more than 30x earnings (I rarely pay more than 20x)
5)Avoid companies that recently made a large acquisition (most acquisitions destroy value)
6)Avoid companies that have heavy insider selling (you can find this at gurufocus.com)
7)Avoid commodity businesses like steel, mining, chemicals, energy etc. unless you are good at predicting economic cycles.
 
I’m not saying there are never opportunities in these types of companies, but the odds are stacked against you and may require a lot more research.  For example, as a rule I don’t like to invest in companies that recently made a major acquisition.  Studies show nearly 70% of all acquisitions either destroy value or add no value.  The easy approach is to just take a pass on acquisitive companies.  The alternative is to do a deep dive on the acquisition and determine if it really is a good idea and if the price being paid is reasonable.  Most acquisitions are driven by ego, not value creation.  I’m sure part of this is the fact that executive compensation is tied to the size of the company, not the value being created for shareholders.  There are exceptions and I would put Berkshire Hathaway in that category.  It’s highly unlikely Warren Buffett overpays for a company.
 
This is a very basic checklist designed to keep you out of trouble.  Ideally, you should be doing more research if you are investing in individual stocks, but this basic checklist should help you avoid the large blowups that can occur with stock picking.  With sites like Finance.yahoo.com and Gurufocus.com you should be able to work through this checklist in less than 10 minutes.  
 
   
 
 
 
Questions or comments, feel free to email me at [email protected]
 
Disclaimer: Askfinanceguy.com is not an investment advisor, brokerage firm, or investment company.  This blog is for educational and/or entertainment purposes only. Use this information at your own risk. Do not consider anything on this page to be legal, tax, or investment advice.