This guide is for investors who want to strike a balance between selecting a few high-quality stocks and a large number of good-quality stocks. Keep in mind that focusing on either quality or quantity is a sound investment objective, as successful investment strategies typically span both ends of the spectrum. It should be noted that the smaller the number of stocks that are in one’s investment strategy or intended portfolio, the longer the amount of time that should be spent assessing individual stocks. This is given the premise that not all investors have the luxury of time.
If an investor had an hour or two to assess a single stock, what should they focus on?
To reiterate, qualitatively, the prerequisite is that investors must understand the stock’s business or at least have an interest in learning about it. There are many ways to do this, such as reading about the business on the company website, watching videos and listening to podcasts from industry experts, trying the company’s goods and services, and, best of all, reading the company’s annual or financial reports.
Quantitatively, the guide will be more comprehensive than relying solely on a scoring table to assess a stock. Instead of relying solely on a scoring table to select stocks above a certain threshold, the investor should also maintain a checklist of criteria a stock must meet before being added to the investment portfolio.
Key aspects an investor should cover in the checklist are outlined below.
See also: How to invest if you have 30 min to spare
1. Setting up stock filters
The first item on the checklist is setting up stock filters. These filters should be more specific than those used when filtering a scoring table. The scoring table does not include any quantitative filters for the company’s financial performance, but the checklist should.
The quantitative filter should be sufficiently broad to capture what an investor considers the “value” of a company. As a guide, the revenue, net income, operating cash flow (OCF) and free cash flow (FCF) of a company are components investors can use to determine the “value” of the company. If a company has had growing revenue, positive net income, OCF and FCF, it is considered a positive “value” company.
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A deeper filter would also weight these components to determine the “value” of the company. For example, if revenue, net income, OCF and FCF were weighted at 10%, 20%, 30% and 40% respectively, then a company which has 10%, 20%, 30% and 40% growth for the components respectively would have a “value” of (10% x 0.1) + (20% x 0.2) + (30% x 0.3) + (40% x 0.4) which would equal to 30%. This positive 30% is now the company’s “value” and would pass the checklist filter for companies with, say, “value” growth above 25%.
The next important filter to add is the stock’s price movement over the selected period. For example, filtering companies that have increased their share price by over 25% in the past year.
Essentially, the two main additions to the checklist initial filter compared to the scoring table initial filter are the “value” and share price movement. The weights and period for “value” growth are subjective to the investor, but the period for both “value” growth and price movement should be the same. This enables a comparison of value growth with price growth over the same period.
To easily filter out potentially undervalued stocks, the checklist filter should include positive “value” growth companies and negative share price growth companies over a given period. The rationale is that investors can purchase more valuable stocks at a lower price.
This doesn’t mean that all stocks that have risen in price are overvalued. It is always a relative comparison between the “value” growth and the share price growth. In fact, there are three permutations of potentially undervalued stocks using this relationship.
The first and easiest way is the one mentioned: the “value” growth (VG) is positive, but the share price growth (SPG) is negative. The second occurs when both VG and SPG are positive, but VG > SPG. For example, the VG is 10%, but the SPG is only 5%. The third option is the least obvious and is used only in very high-risk investment strategies, such as turnarounds, and is not recommended. It occurs when both VG and SPG are negative, but SPG is more negative than VG. For example, the VG is –30%, while the SPG is –50%. Overall, the VG is always higher than the SPG across all relationships.
An example of a checklist stock filter would be large-cap, dividend-paying stocks with a three-year value CAGR greater than 10% and a three-year price CAGR less than –10%.
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2. Analysing the filtered stocks
There are two steps to analyse the filtered stocks if time is a light constraint.
The first step is to use a checklist to verify whether the filtered stocks meet the minimum requirements for each financial metric or component. These are the same metrics used in the scoring table: historical performance, profitability, yields, attractiveness, financial safety, and sentiment. The difference here is that this minimum-requirement test would also be conducted against the company’s peers or a self-curated list of competitors.
This is to assess whether the filtered company is fundamentally sound rather than blindly scoring it. It would also reflect the company’s quantitative position relative to peers and prompt investors to examine peers that pass the minimum requirements checklist in greater detail. This minimum-requirement checklist should be simpler than the scoring table itself, as it is intended to filter out companies that are, at a minimum, of good quality across all financial aspects.
For example, a net debt-to-equity ratio of less than or equal to 50% would be required to pass, but the scoring table would score a stock with 50% net debt-to-equity as the absolute minimum. Following this, an investor can run the selected company’s scoring table against peers if time permits.
The second step is to conduct a quantitative valuation of the company if it has met all requirements. A discounted cash flow (DCF) analysis is recommended to determine the company’s fair value, based on expected future cash flows and a discount rate. There are many iterations of a DCF model, and some may be extremely complex, but a simple DCF analysis would suffice in most cases. There will be a much more detailed explanation of the DCF method in subsequent articles of this series.
3. Conclusion and summary
Having a checklist is one way to ensure all key facets of a company review are covered. The first part of the checklist should cover the filter and be more specific than the scoring table filter.
Suggested checklist items include a market cap range, industry or sector exclusions, listed exchanges, liquidity and accessibility measured by free float, and share price volatility measured by the stock’s beta. The checklist filer should also include “value” growth and share price growth.
The second part of the checklist covers a more general test initially but is followed up with a more specific valuation to determine the fair value of the company. There are many ways to determine the fair value of the company, but the DCF method is recommended if only one can be chosen due to time constraints.
If the fair value is higher than the company’s current share price, it is undervalued and investors should add the stock into their portfolio.
The following and final part of this series will cover how to invest if you have the luxury of time and will cover a much more thorough procedure. It will be for investors who wish to focus and hold only a handful of high-quality stocks in their portfolio. Quality in this respect is measured by the depth of analysis, not by how undervalued it is. As such, this should cover very high-conviction stocks.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation, solicitation or expression of views to influence readers to buy or sell stocks. Any personal investments should be made at the investor’s own discretion, after consulting licensed investment professionals, and at the investor’s own risk. The author of this article does not hold or own the stock featured in this article or have a vested interest in it at the time of writing.
