Before You Buy Your Next Stock, Ask Yourself These 10 Questions

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#1
Before You Buy Your Next Stock, Ask Yourself These 10 Questions

I think you’ll agree with me when I say:

It can be difficult to invest for the long-term with the amount of “market noise” out there.

Everyday as you watch the financial media, you have many analyst sharing their opinions about the market...

Bull markets! Bear markets! Trade War! China Slowdown! Blah, Blah, Blah...

Where do you even begin? How can you filter out the "noise" and focus on things that really matter?

With a checklist, you can ignore the "noise" and focus on identifying high-quality investments that will help compound your portfolio.

So here I've compiled a list of key questions that you should ask yourselves before investing in a stock:
 
1. How does the business make money?
Let’s start with the most basic question. In the world of finance, companies are typically categorised by its size. We have large, mid, small and even micro cap stocks listed in the exchange. Large cap companies tend have a diverse range of income from multiple business segments. While small cap companies are more concentrated and only focus on 1 or 2 revenue streams. This is why it is important for us to understand how the business makes money and what are its main source of revenue.

Understanding its revenue model is important. The revenue model often determines the consistency of cash-flow that the business generates. For example, a main source of revenue for a civil engineering company are the in-flow of construction projects awarded by clients. The more projects awarded, the more money this company makes. However, as economic activity shrinks, less projects may be awarded, hence, less profits for the company. In contrast, a utility company that supplies electricity for the whole country or city makes money by charging customers a monthly bill. In comparison, this revenue model is much more consistent and is less likely to be impacted by economic cycles.

Other examples of revenue models are:
  • Licensing
  • Rent
  • Subscriptions
  • Advertising
  • Production
  • Manufacturing
 
2. Who are the core customers of the business?
Once you’ve understood how the business makes money. You now have to know who their customers are. Companies with a wide customer base are less prone to customer concentration risk. This means that should they lose a customer, it is unlikely to deal a great impact on its revenue. Conversely, a company that makes money from 2 or 3 major clients are more prone to this risk. Losing a customer would mean a 30-50% lost in revenue.

Another definition of customer concentration is when the majority of a company’s customers come from a certain industry. For example, in the oil market crisis of 2014/2015, shipyard operators had a tough year as oil companies cut down on offshore exploration and production activities amid a slump in global crude oil prices.

These operators derived the bulk of their income from energy-related projects and it was estimated that between 70% and 80% of the shipbuilding and ship repair revenue came from oil and gas projects.
In such an instance, these operators are at risk of suffering from slower orders or slower collections should the oil industry face a prolonged slump.

3. Who are its competitors?
The degree of competition or how fiercely competitors compete determines the long-term success of the business. In an industry where competition is plenty, there are no market leaders, therefore, profits and margins are marginal. In contrast, an industry with few dominant companies are the notoriously known for leveraging on their size advantage. These companies will do whatever it takes to keep competitors away. Going against them would require vast amount of resources and a good strategy without any guarantees of success.

A recent example is the entrance of TPG Telecom into the Singapore market, since announcing its entry into Singapore, the incumbents (existing telcos) have aggressively undercut subscription plans to retain customers and protect market share. The incumbents were willing to incur less profits in the short-term to create high barriers to entry for TPG Telecom.

Invariably, competition impacts market-share and profits. Hence the less competitive the industry, the more profits a company makes.
 
4. Does the business have a competitive advantage or an economic moat?
High-quality companies generates sustainable excess-profits. These companies have an edge over its competition, this is also known as competitive advantage.

Just imagine, if you had all the money in the world, would you be able to build a company that could overtake Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its vast amount of trademarks, patents and brand name products? Or even Alphabet Inc.’s Google with its legions of tech engineers and AIs?

If your answer is no, that’s because these companies have a durable competitive advantage – they do things their competitors can’t reproduce.
When a market or product yields high profits, naturally it will attract competitors. Competition will eventually eat up market share as it saturates the supply of products or services in the market. In other words, competition makes it difficult for most firms to generate long-term excess profits since any advantage is always at risk of imitation. Sustainable competitive advantages deters competitors and protects the business’s market share.
 
5. Does existing management have experience and skills related to the business?
Track record matters. You want to look for senior managers who have a proven record in their respective companies or industry. As Warren Buffett would say “staying in your circle of competence”.

Take Microsoft’s Satya Nadella for example, prior to becoming Microsoft’s CEO in 2014, he worked in several of its divisions such as R&D, Cloud and Business Solutions for 22 years and held many senior level positions within the company.

In the years since becoming CEO, Nadella has exceed expectations, as reflected on Microsoft’s stock having tripled, with a 27% annual growth rate. In December 2018, Comparably name him the best CEO of a large company in the United States, citing Nadella’s employee reviews. This simply proves that if a CEO has a track record of doing well in related companies or within the industry, he/she has the necessary competence to grow the company.

6. What are the future growth prospects for the business?
Future growth would have to come from increase in revenue and a business that addresses a large and growing market will eventually grow as well. An attractive business is one that grows for multiple years ahead, thus keeping an eye on growth industries will help you find prospective gems.
Growth is more sustainable if it is supported by innovations or secular industry trends. To help you identify secular growth, think about the industry’s job-growth potential. Ask yourself if the industry is one where future workers will work.

A business may grow organically or inorganically. Organic growth simply refers to the company’s ability to increase output and sales naturally. On the other hand, inorganic growth happens when a company acquires another company to access to new markets through and is considered a faster way for a company to grow. In a recent example, Disney has formally completed its takeover of 21st Century Fox in a deal worth $71 billion. The company has said that the deal is designed to help the company increase its international footprint and expand its direct-to-consumer offerings.

Organically, there are 3 ways for a company to increase its revenue:
  1. Sell more of its core products to existing markets (increase market share). To do this, a company can employ various strategies such as increasing production capacity, improve distribution network or invest more in marketing.
  2. Sell more of its core products to new markets. This strategy is about reaching new customer segments or expanding internationally.
  3. Create and sell new products to existing markets. This strategy is about developing supplement products as "add-ons" to existing products. The main motivation to do this is to increase Revenue per customer.
On the other hand, inorganic growth can be classified into 3 types of strategies:
  1. Related diversification also known as horizontal refers to entering a new market with a new product that is related to a company’s existing product offering. Disney's acquisition of 21st Century Fox is an example.
  2. Unrelated diversification refers to entering a new market with a new product that is completely unrelated to a company’s existing offering. Think SPH's acquisition of M1.
  3. Vertical diversification refers moving backward or forward in the value chain by taking control over activities that used to be outsourced to third parties like suppliers or distributors.
Typically, young and small companies grow organically as its products and services may still have plenty of room to reach its maximum potential. Moreover, young and small companies often do not have the financial resources to acquire other companies to boost growth. A small company that acquires another funded by debt is a major red flag.

Inorganic growth is often pursued by large companies. These companies have enough financial resources to make acquisitions after years of consistent profits. Inorganic growth is sometimes preferred as it is considered a faster way for a company to grow compared to organic growth. That said, businesses that grow inorganically are often more risky as acquisitions might not turn out to be accretive. 

7. Is management's investment focus on building long-term shareholder value, or has it engaged in a growth-for-growth's-sake strategy?
Investment decisions that provide both short and long term benefits are ideal, but good managers should be willing to sacrifice short-term results to create long-term shareholder value. Poor managers, on the other hand, have a myopic focus on short-term results and have less concern for long-term consequences.

Valeant Pharmaceuticals, a drug manufacturing company, made headlines after allegations of improper accounting.

Prior to the scandal, Valeant was a Wall-Street darling and Michael Pearson, its CEO, became a star. In a short time span, the company went on a spending spree and rapidly acquired other pharmaceutical companies to produce lots of growth. After acquiring them, Valeant would then push to cut-down on R&D to reduce operating expenses. This move helped boost Valent’s EPS year after year and Wall Street loved it.

For years, Valeant made money not by providing economic value to customers but by financial engineering and by gaming the system.
The best-performing businesses over the long term, as measured by shareholder returns, are managed by CEOs who have a purpose greater than solely generating profits. Jeff Bezos is a prime example and a truly admirable CEO, under his leadership, Amazon puts the customer at the center of everything they do.

In a talk at the Economic Club of Washington, Bezos said:
Quote:“The No. 1 thing that has made us successful by far is obsessive compulsive focus on the customer as opposed to obsession over the competitor.”
Quote:“I talk so often to other CEOs and founders and entrepreneurs, and I can tell even though they’re talking about customers, they’re really focused on competitors” he added.
As one of the most valuable companies in the world right now, Amazon has reached near mythic status for its superior service and customer service strategy.
 
8. How much debt does the company owe relative to its operating income?
High levels of debt significantly impact cash flows as interest payments fluctuates. A company that borrows too much will spend the bulk of its earnings to repay debt and forgoing to opportunity to reinvest back into the business.

There are several advantages to businesses with low levels of debt. First, the business has less risk of entering bankruptcy, allowing you, as an investor, to sleep better at night. Second, a strong balance sheet allows the business to be opportunistic. Businesses that have strong balance sheets are often able to gain competitive ground, because they are able to invest in their business in ways that their leveraged competitors cannot.
Personally, I refer low-debt to debt that can be paid back in less than three years out of existing operating income.

9. Can the stock be purchase at a reasonable valuation? How would you value it?
To prove the importance of valuation, a study was done on the performances of 2 sets of portfolios; Value (low P/E & P/B stocks) and Glamour (high P/E & P/B stocks).

In a 33 year period (1980-2013), historical performance of the 2 portfolios shows that the Value portfolio generated an average yearly return of 14.1% while the Glamour portfolio averaged 8.3% annually. The difference meant that the Value portfolio outperformed Glamour portfolio by 5.8% annually.

Hypothetically, $10k invested in each portfolio would mean that the Value portfolio generated generated about $777k while Glamour generated only $138k over the 33 years – that’s a difference of $638k!

In other words, the Value portfolio generated 5 times more profits than Glamour. This proves that when investing in stocks, PRICE DO MATTER. The price you pay can make a difference between a potential 10 bagger or a 2 bagger.

There are 2 conventional approaches to valuation. The first, measures the value of a business to the present value of expected future cash-flows. The second, estimates the value of a stock by looking at the pricing of ‘comparable’ assets relative to a common variable such as earnings, cash-flows, book value or sales.

Choosing the right valuation method for the appropriate business is as critical as everything else. So please take time to understand the business and value it accordingly.

10. Is there enough margin of safety to offset errors in your valuation?
A good company is not always a good investment. A good investment is a good company bought at the right price. Margin of safety is the difference between the intrinsic value of the business and its share price. For example, you identified APPL’s intrinsic value to be $240 per share while its share price is $160. This would mean that buying APPL shares at $160 will give you a margin of safety of 33%.

Warren Buffett compares margin of safety to driving across a bridge:
Quote:“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.”

In the same statement, Buffett also said “You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.”

Seth Klarman, well-known value investor and author of the book “Margin of safety” wrote:
Quote:“Since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”

In this short paragraph, Klarman was emphasizing the importance of having a wide margin of safety given that investors are capable of making mistakes and are prone to errors when evaluating a business or calculating its intrinsic value.

The benefits of having an investing checklist are manifold and they range from reducing the stress, to improving quality of investment ideas, to becoming more informed about the companies that you are investing in.

If you are not having a checklist, or if you are looking for ways to leverage the benefits of utilising an investment checklist, ask these 10 questions before buying your next stock to take your investing to the next level.

Now what I’d love to hear from you is this…
What are some of the things you look out for before investing in a stock?
Leave a comment below and let me know what you think.
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#2
Questions and checklists are great. But the reality is that different individuals are likely to have different answers to the same set of questions; and that is how the market for stocks exist. So, the other part of the equation should include how to improve our ability in getting the right answers to these questions. And the right answers make the difference between investment success and failure.

In any case, I believe an investor should come up with their own questions, even if he ends up with the same set of prescribed questions. This is so because understanding the rationale of the question is important.

To be able to know what questions to ask, an investor needs to know what/where the critical points of the business/company are. This knowledge -- of the critical points of the business -- may be learned from other, but has the deepest impression when it is learnt by oneself.

For a learner investor, I will recommend the following:

1. Read and learn whatever you can from Graham, Buffett, etc
2. Apply what you have learnt either by buying a number of stocks, either on 'paper,' or through a small but meaningful (enough to make you feel upset, should there be losses) amount of money.
3. Write down your reason why you bought those stocks.
4. Wait a few years, and observe how the businesses of your portfolio companies behave.
5. Reflect on what worked, and what didn't.
6. Make the necessary changes.
7. Repeat steps 1-6 as many times until your 'investment success rate' improves.

After doing this for some time, you will know what questions to ask, and why they are important.
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#3
hi ruzaini,
thanks for the informative post. I like to use specuvestor's asset/business/structure framework.

Value investing starts from the asset n work to the right (business n then asset). But over the years, i realized from OPMI standpoint n investing in asian markets, we should start from the right - ie. figure out the structure part before moving to the business n then asset.

Your points are mainly for asset n business. Just wondering if there is anything to share from structure standpoint?
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#4
(30-04-2019, 06:27 PM)weijian Wrote: hi ruzaini,
thanks for the informative post. I like to use specuvestor's asset/business/structure framework.

Value investing starts from the asset n work to the right (business n then asset). But over the years, i realized from OPMI standpoint n investing in asian markets, we should start from the right - ie. figure out the structure part before moving to the business n then asset.

Your points are mainly for asset n business. Just wondering if there is anything to share from structure standpoint?

any chance you could share abit on the asset/business/structure framework?
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#5
hi dxdx,
I searched for some of specuvestor's past posts and below are those which might shed more light:

Why it doesn't really matter even if you got an undervalued asset and good business: https://www.valuebuddies.com/thread-157-...#pid132082
Explaining ABS structure: https://www.valuebuddies.com/thread-4097...l#pid66355

others:
https://www.valuebuddies.com/thread-6321...#pid109846
https://www.valuebuddies.com/thread-6102...#pid103856
https://www.valuebuddies.com/thread-5434...l#pid89312
https://www.valuebuddies.com/thread-5511...l#pid90801
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#6
To add, the structural bit very much depends on management integrity and more so if majority shareholder happens to be CEO.
A double edged word. Below is why minority will usually end up on the losing end.

1. The CEO/Majority shareholder pays himself first. Dividends will happen if he is in the mood.
2. Chances are minority shareholders cant hold on to the shares as long. (see point one)
3. If it is a holding company, it is like kueh lapis, not sure how much benefits will flow to the shareholders in the end. You have almost 0 say in funds allocation.
4. For short periods of time, accounts can be engineered to depress or elevate the profits/share price. Depending on what the majority shareholder(s) have up their sleeves.
5 The goods news is if you have an unlimited holding timeline, usually the payout is relatively fair in the end if the business perfroms.
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#7
(04-05-2019, 09:13 AM)Big Toe Wrote: To add, the structural bit very much depends on management integrity and more so if majority shareholder happens to be CEO.
A double edged word. Below is why minority will usually end up on the losing end.

1. The CEO/Majority shareholder pays himself first. Dividends will happen if he is in the mood.
2. Chances are minority shareholders cant hold on to the shares as long. (see point one)
3. If it is a holding company, it is like kueh lapis, not sure how much benefits will flow to the shareholders in the end. You have almost 0 say in funds allocation.
4. For short periods of time, accounts can be engineered to depress or elevate the profits/share price. Depending on what the majority shareholder(s) have up their sleeves.
5 The goods news is if you have an unlimited holding timeline, usually the payout is relatively fair in the end if the business perfroms.

I like these points.

And I agree that 'ABS' is a useful approach to understanding stocks.

1) Using a coffee and toast retailer as an example, the chairs, tables, stove, and refrigerators are assets. Left on their own, these inanimate object do not generate anything; if they are put on carousell, no one will offer above cost price for them.

2) Businesses put assets to use to generate returns. Stove to boil water, refrigerator to store inventory, clean chair and tables provided for dining customers; all serviced by human operators. How the human operators decide on how to utilise the assets, and what asset to use to begin with, will impact the returns generated by the business. Hence, (exceptional/average) profits are built on the backs of (hardworking/unmotivated) employees and (talented/mediocre) managers.

Some business perform better than others because of particular assets they own, that their competitors do not. But for similar-sized businesses, this is usually not the case; if you can afford it, then so should I. In ideal cases, businesses that perform better than their competitors usually operate their assets more efficiently. But it is also not uncommon for them to have access to particular benefits that their competitors do not. This is generally not obvious to observers, since it usually borders on public-sensitive issues such as collusion and cronyism.

3) If a business is a Christmas present, then the wrappings over the present are the 'structure.' Or more accurately, the legal entity a business reside in. Shareholders of many defunct s-chips will have understood how the wrappings on their present never seemed to be able to come off; all they could do is gaze and marvel at what could be inside the box, but never actually being able to open it. Though eventually, many were reveal to be empty boxes.

At each of the ABS level, danger awaits the prospector. Sometimes we fail at understanding the value of the assets on the books. Sometimes we fail at understanding the ability/efficiency of the business. Sometimes we fail at understanding how tightly wrapped the present is.

On top of all these, or perhaps because of it, we may also fail at paying a fair/bargain price for the company.
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#8
Thanks Weijian for pulling out the A-B-S explanations. I can use this as ref when people ask what’s A-B-S Smile

Just to add that Asset can also be cash flow generating asset not like Gold or diamond which are generally non cashflow generating, which I term as “accounting asset”. And there are assets like pte planes or membership etc that are simply “accounting assets” because of their significant values for expense capitalisation purpose else they would have been written off.

In one of the link I mentioned REITS like to package lemons together with good assets. So individual Assets we can evaluate, but we can’t break them up as OPMI. Similarly we can’t ex-cash evaluation because cash might be part of the WC of the Business (even if not the controlling shareholder is for some reason not taking it out), just as sometimes the money losing assets are to complement the money making assets in the overall business eg newsprint vs advertisement. It’s pretty bizarre to me that sometimes I hear analysts recommending to dispose this or that without understanding how the whole business work. Sometimes it happens in M&A that once profitable business sours because the newco refuse to do some less profitable business. Looking at silos rather than the full business model is hazardous

That said even a great business like Synear or Vard for example can be destroyed by Structure. IPT, cost transfers, asset stuffing, leverage, remuneration, company domicile & regulation etc. It can take years for the Structure to strip the business dry, though generally it is easier to change a Structure than to build a Business for eg levering up. I’m actually not sure even with unlimited holding period will OPMI turn out ok without certain catalysts (including deaths) just because the underlying business is good, and pretty sure disadvantaged compared to opportunity costs.

Like it or not as OPMI we are buying the A-B-S wholesale; rather than have visions of grandeur in being a vulture fund or controlling shareholder. Like in Challenger case, OPMI are still followers: following Pangolin.
Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give. –William A. Ward

Think Asset-Business-Structure (ABS)
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