A little bit Investing, A little bit personal

👋 Hey!

It’s been a while.

Loads of people have been asking me to start writing again… and by loads of people I mean my wife… literally nobody else has requested this comeback 😂.

Anywho.. Here is basically everything I do before investing in a stock and I have also included a step-by-step guide showing you how to set up your own brokerage account and investment portfolio.

Always happy to chat all things investing so please reach out if you have any questions - [email protected]

How to Value a Company

Firstly, there are endless opportunities in the market -  faffing about trying to jump in on every half brained twitter thread is a recipe for disaster.

Looking back, this was my major f*ck-up starting out. I had no set approach, if I liked what I saw, I bought it.

It’s like those Chinese restaurants where the menu is a full-on 60 page novel and you want something from ever page. But you obviously don’t do that because….. you would die…. and your body tells you when your full. Your body tells you, you don’t need anymore.

Unfortunately, you portfolio lacks the biological mechanisms to tell you when it’s fully satiated. So you just gorge and gorge on every stock that catches your eye until you eventually explode (your portfolio that is)

Weird analogise aside…just don’t do what I did starting out. (To be honest, that seems to be the overarching theme of this entire newsletter… ‘Don’t be like Mike’)

Take time to figure out your preferred style of investing and go after opportunities within that space. Refine your focus.

The exact approach you take will depend on the game you decide to play (day trading, Swing trading, investing) and the type of companies you decide to focus on (high-growth vs. value etc)

For me I look for:

• Typically large cap and capital intensive. 

• Quality companies with a competitive advantage over their peers.

• Companies showing CONSISTENT growth over time (one blockbuster quarter doesn’t quite cut it)

• Justifiable leverage, positive cash flows, stable growth numbers and healthy ROIC.

• Recent price action.

Setting out your criteria from the outset will help you filter the investment universe and focus in on the companies you are truly interested in.

The Stock Pickers Checklist

Here are 10 questions I ask myself before investing in any company 

1. Do I Understand the Business

This one is pretty straightforward. Always invest within your circle of competence. If you don’t understand what the company actually does, you’re not going to have the conviction to hold it during the inevitable rough spells.

2. What are the Sales/Revenue numbers

You want to see consistent sales & profit growth of 7-10%+. Profit trumps revenue here.

No shit Mike…

Clearly wanting to see sales and profits rise is pretty basic stuff but there are some things to watch here.

Make sure the higher revenues and net income you see are actually adding to shareholder value (higher earnings per share (EPS)). Dilution of shares is common and often overlooked. Companies regularly issuing share capital will function to reduce your % ownership in the company over time and should be avoided.

• If shares outstanding are increasing, you want to make sure this is creating some sort of shareholder value. (higher EPS over time)

• If S/O is going down, you want to make sure the buybacks are being bought at a price that makes sense.

Excessive stock based compensation is another way your shares can be diluted over time. Free tools like SimplyWallSt.com will provided information on the stock based compensation breakdown for specific companies.

SEC forms such as an S-3 filing can be found on the likes of ‘BAM SEC’ - These filings will help you spot bullshit companies like Nikola who just endlessly issue shares, warrants, convertibles, ATM’s at the detriment of existing shareholders.

Remember, higher income doesn’t mean higher value for shareholders. Make sure your EPS is increasing over time.

3. Does the Company Have a Durable Economic Moat

You want to invest in clear market leaders with strong pricing power.

Those companies are often characterised by high and stable ‘Gross Margins’ (+30%) as well as high and stable ‘Returns On Invested Capital’ (+20%).

ROIC is similar to ‘Return on Equity’ but it includes debt – think of it as money available to pay the people who have provided capital to the business vs. the amount of money those people have put in.

I also look at how capital intensive a company is. For me this can sometimes be misconstrued as a negative, but this is probably the most enduring moat of all.

Take the likes of Apple and Amazon for example. These are two capital intensive business that take billions of dollars to run, so the probability of some ‘shoestring budget’ start-up disrupting their business model is zero. The sheer amount of capital needed to get up to scale to compete with these names is the most powerful moat of all.

For anyone looking to figure out how to ACTUALLY invest. I have written a free step-by-step guide, covering everything you need to know.

From how to create your own online brokerage account to what investments to choose - and everything in between.

Enjoy 😁 

4. Does the Company Have a Strong Balance Sheet

Basically, all you’re doing here is checking can the company withstand severe temporary adversity.

The three main ratios I look at here are:

• Debt/Equity Ratio: This just tells you how much debt you have per $1 of equity. You're looking for this number to be less than 1.

• Interest Coverage Ratio (EBIT/Interest payments): indicates how easily a company can pay back the interests on its outstanding debt. You want this number to be higher than 10.

• Net Debt / Free Cash Flow: (Number of years it would take the company to pay down its debt) - You want this number to be lower than 4.

Debt isn’t bad when it’s allocated properly and some companies in ‘asset heavy’ sectors will naturally have higher debt ratio’s. The mistake is buying companies using excess levels of debt in order to operate and grow. If a business is heavily leveraged, one bad year, where they can’t cover interest expenses could bankrupt the business.

5. What is the Cost of Running the Business

Here you are just looking at capital expenditure. This will vary depending on the business model and the growth stage of the company. Taking Apple and Amazon as the example again.

Apple generated a free cash flow of about $110 billion last year and are set to have a pretty consistent Capex output of about $11-12 billion.

Amazon on the other hand generated roughly $30 billion last year with a Capex spend of $50 billion as they pump profits into building out their global distribution business.

Neither approach is bad. The point here is, if your Capex is not falling over time, then you want to make sure it is being allocated efficiently and growing revenue over time.

Always look at the trend. Have the costs of running the business changed? If expenses are going up while the company’s sales are not… red flag.

The ’CAPEX/Sales’ and ’CAPEX/Operating Cash Flow’ are 2 metrics I use here.

A simple approach is to look for companies with a ‘CAPEX/Sales’ lower than 5% and ‘CAPEX/Operating Cash Flow’ lower than 15%.

6. Is the Company Profitable.

This seems obvious, but so many people invest in companies without understanding how much money a company makes, how much money that company holds and who they owe money to.

The ’Gross Margin’ and ’Free Cash Flow Margin’ are 2 of the best metrics to look at the profitability of a company.

In simple terms, gross margin is the amount of money the company made selling their product minus the direct cost of making that product.

The higher the gross margin, the better (30%+). This will vary by industry. Tech companies, for example, will have very high gross margins, as once the network effects and IP is established, the cost to the company of adding one additional users is minimal. Meta’s gross margin is 78% for example (this potential for multiple expansion once a network reaches critical mass is why everyone freaks out about the growth-tech industry)

Free cash flow margin shows the percentage of sales which are translated into pure cash for the company. It’s similar to net income but net income represents a company's accounting profit, whereas free cash flow presents whether a company's cash balance increased or decreased.

Think of ‘free cash flow’ as ‘net income’ without the accounting shithousery.

7. What are the Risk Factors

Is the company trying something new and untested? The more uncertainty around the product or service, the greater your margin-of-safety needs to be.

Who are the competitors and how successful are they? If other players are more established, this company may have a tough time breaking into the market. 

There will always be risks, you just need to make sure the pros outweigh the cons and you have a sufficient ‘margin-of-safety’ in place to protect if your base case for the stock doesn’t play out.

8. Long-Term Trends.

We want to make sure the company will remain relevant into the future.

This one sounds easier than it is.

I think we can all agree that cybersecurity , Artificial Intelligence , Lithium batteries , bio genetics and Robotics will all play a larger role in society as we move forward.

But here’s the catch, finding companies that genuinely embody the potential of these expanding markets that have yet to be burdened by a significant "premium.” is rare.

Another issue here is – spotting a trend doesn’t give you a competitive advantage. For example, everyone in the market is screaming ‘Invest in A.I.’ right now, but what does that even mean. We have no idea who the eventually winners will be in this space.

In 2002 everyone say the developing trend of cloud computing but not a single person could have predicted that an ecommerce store would be the one to dominates the industry. The safe money was on IBM as the obvious winner but 20 years on, Amazon’s AWS business has emerged as the market leader – despite not being on anyone's radar when the trend was emerging. The same has happened, time and time again.

It’s easy to spot the trend, but very difficult to pick the eventual winners. Don’t just presume your conviction on a particular trend will automatically translate into market beating returns. If only it were that easy.

For these reasons, I tend to gravitate away from emerging trends until such time as the initial mania has passed.

If you are going to lean into emerging trends, always re-examine your conviction on both the sector and companies every few months. These are fast changing technologies. Don’t just presume your original thesis still stands.

9. Does the company have strong insider ownership

You want the people running the company to have skin in the game.

Websites such as www.simplywallstreet.com (awesome free resource) break down the top shareholders and the percentage of insider ownership in each company.

10. How does the company compare to it’s peers.

This is arguably the most important part. In investing everything is relative so comparing companies to their closest competitors is crucial.

To do this, you can compare all characteristics I mentioned above (revenue, moat, capital allocation, profitability etc,) and see how the company compares with it’s main rivals and it’s sector as a whole. Free resources like stratosphere.io are great for this.

Finally, make sure the valuation (price you are about to pay) isn’t way outside the industry average. You can do a high level overview of the valuation by charting the company’s median P/E (price to earnings ratio) over the last 5 years to check if the company is trading above or below it’s 5-year average ‘value’. You can also compare the companies various valuation metrics vs. it’s competitors. 

A lot of investors do more in depth analysis here such as discount cash flow models (DCF) to determine a fair value or price target but for me, while it can provide some vague idea of intrinsic value it’s mostly just fun with numbers.

DCF models take largely unknowable future cash flows over the next ten years and discount them by a made up risk based discount rate. You then take an even more unknowable terminal rate and try and adjust for future debt which you also couldn’t possibly know.

The risk here is, you base your entire investment thesis on a complex, yet entirely made up number (your best guess is still a guess). As soon as one of your assumptions change, your misguided conviction falls apart just as fast.

I’m not saying that price targets are a waste of time…. but ya…. just not for me. comparative analysis will always be my go to.

This post is far too long already - But If you’re anything like me, none of this will really make sense without a step-by-step example.

So next week I will examine some specific stocks using just this checklist and some free online resources.

Stay tuned.

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