Using Check lists in Investing

I wrote up results from a couple of small / mid cap investment trusts recently. At the end of that post I mentioned the usefulness of check lists in investing and indeed in other aspects of life and business. There is apparently a good book on this called the Checklist Manifesto, by Atul Gawande, although I have not read it, it is mentioned and the author is featured in this article. This is from another site I came across recently which, although it is selling a European stock ranking system, does include some interesting free content such as this. If you sign up for his free e-mail updates you can get a fuller description of the background to his check list which is detailed at the end of the above article.

Personally I have tended to go through certain aspects of a Company fairly regularly when researching it, but as you never stop learning in this business I am looking to formalise my own investment check list. As a short cut on my screening spreadsheet I have devised a kind of binary check list to help with filtering stocks which are likely to be displaying the characteristics I look for and meet certain minimum financial security tests. These triggers are based on:

Net yield level (>2%), dividend growth forecast (>0), dividend streak (>0), dividend cover (>=1.5), interest cover (>=3), Altman Z (>=1.8), Piotroski (>2), EPS Revisons (>=0), Price (>=200d SMA), 1 year Relative Strength (>0). 

This then gives a maximum score of 10 if all triggers are passed and that would be a starting point for research plus some of the other higher scoring stocks like 8 and 9's. The beauty of this is that you can then see at a glance what a stock does fall down on if it is not a perfect ten. It can also be used to filter out the junk or weaker stocks which fail the minimum financial security hurdles. I have one final check which I like to call my Spinal Tap score because it goes up to 11. This is from a funny film which is worth checking out if you haven't seen it. This adds on a screen to identify if the stock would be a Quantitative Value stock (as per the book in my reading list), although here I broaden out the qualification to the top two quintiles to give a longer list of names and adds another value measure.

Over and above this list of financial checks any thorough investment research should include an assessment of the business, its prospects, financing and management. A good such list comes from another book on my recommended reading list The Little Book of Value Investing (Little Books. Big Profits) - By Christopher H. Browne. He suggested to look at the following:

1) Pricing outlook for the Company
2) Can they raise Sales, Turnover or Revenue
3) Can they increase profits on existing sales (gross margin) from price, mix or costs
4) Can they control costs or even cut them
5) If sales rise, how much falls through to the bottom line (do costs rise with sales or is it operationally geared)
6) Can it be as profitable as it was or as profitable as competitors (good for assessing recovery / catch up potential)
7) Does it have non recurring expenses
8) Does it have loss makers that could be turned around, shut or sold
9) Is the Company comfortable with forecasts (look for in line IMS updates and or earnings upgrades)
10) How much can the Company grow over the next five years and how
11) What is the Company likely to do with any surplus cash generated by the business
12) What is the competitive outlook for the Company / industry
13) How do the finances compare with competitors
14) What would it be worth to a buyer (like an Venture Capitalist) he calls this the appraisal method
15) Does the Company intend to buy back shares
16) What are the insiders doing (directors dealings)

In addition as a reminder in case you didn't see my post the other day on a couple of Small / Mid Cap funds which got me started on this post, the Diverse Income Trust managers use the following - extracted from their recent half year report:

"There are five criteria that the managers use to determine the scope for the business to deliver good and growing dividends. 

1) The prospect of turnover growth - If a business is to sustain and grow its dividend, then the portfolio needs to invest in companies that will generate more cash in the coming years. Without decent turnover growth, this is near-impossible to achieve over time. 
2) Sustained or improving margins - A business needs to deliver significant value to its customer base if it is to sustain decent margins. Unexpected cost increases cannot be charged on to customers if they are anything less than delighted with their suppliers. Turnover growth will not lead to improved cash generation if declining margins offset it. 
3) A forward-looking management team - Businesses often need to make commercial decisions on incomplete information. A thoughtful and forward-looking team has a better chance of making better decisions. 
4) Robust balance sheet - There are disproportionate advantages to having the independence of a strong balance sheet in a period of elevated economic and political risks. Conversely, corporates with imprudent borrowings can risk the total loss of shareholders' capital. 
5) Low expectation valuation - Many of the most exciting stocks enjoy higher stock market valuations but almost none can consistently beat the high expectations baked in to their share prices. Those with low expectations tend to be less vulnerable to disappointment, but conversely can enjoy excellent share price rises if they surprise on the upside. Companies that best meet these criteria on a prospective basis are believed to be best positioned to deliver attractive returns to shareholders, as well as offering moderated risk.These criteria, used in reverse, can also be useful in determining the timing of portfolio stocks that should be considered for divestment. So a business in danger of suffering a period of turnover declines, for example, would naturally be expected to generate less cash flow in future years and thereby struggle to sustain their current dividend over time, let alone grow it." 

Finally, as part of my effort to formalise my own check list I have just ordered The Investment Checklist: The Art of In-Depth Research. If I remember I'll try and write up a review when I have read it and perhaps update you on how my own check list is coming along.