Chapter 1: Adopt a Checklist Approach to Investing

Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises

Aug 09, 2024

Welcome to Chapter 1 of the draft manuscript serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.

I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the final manuscript in real time.

Chapter 1 explores the benefits of using a checklist approach to quality-driven value investing.

Chapter 1

Adopt a Checklist Approach to Quality Investing

A successful journey favors the prepared.

Like airline pilots during takeoff and landing, quality-driven value investors adopt checklists to ensure they conduct the due diligence necessary for long-term portfolio safety and destination success.

Chapter 1 introduces the checklist approach to stock picking. It emphasizes employing a rigorous yet straightforward methodology when researching and analyzing a company’s business model for current wealth and its share price for present value.

Checklist-driven investment research has contributed to our family portfolio’s market-beating performance. For example, as of the writing of this chapter, the QVI Real-Time Stock Picks had achieved alpha on an average per holding equal-weighted basis vs. the S&P 500 Index benchmark since its inception in 2009.

Please don’t take just my word for the positive impact of using an investor checklist. The investing universe’s most recognizable names employ a checklist approach to researching and analyzing stocks destined to outperform their targeted market benchmarks.

Superinvestors Bill Ackman, Warren Buffett, Benjamin Graham, Tony Kynaston, Charlie Munger, Mohnish Pabrai, and Guy Spier are among the household names often cited for adopting a checklist approach to achieving portfolio alpha.

This chapter summarizes my market-beating investment checklist, expanding on each with more depth in subsequent chapters. Readers can use this template to develop or enhance their unique investment research checklist.

Checklist Investing Defined

An investment checklist for researching and analyzing stocks, exchange-traded funds, or any financial product is beneficial to ensure we conduct the due diligence necessary for sound decision-making toward long-term portfolio success.

Airline pilots must perform a mandatory checklist of items pre-flight before takeoff from the departing airport and again before the final descent to the arriving airport.

Although airplanes crash more tragically than markets or portfolios ever could—in each case, thankfully, the occurrence is rare—it is fair to presume that we should pick investments to build portfolios navigating a prescribed checklist of urgent items as we have come to expect from the pilots flying us to our travel destination.

Sample Investment Research Checklist

For education purposes, I will share my proprietary list of essential metrics developed over the last 15 years that have led to an alpha-achieving basket of stock picks chosen for high-quality business models and value stock prices at the time of portfolio inclusion.

Quality Stock Selection Objective

Buy and hold the common shares of US exchange-traded, predominantly dividend-paying, well-managed, financially sound businesses that produce easy-to-understand products or services, have enduring competitive advantages from economic moats, enjoy steady free cash flow, and are trading at a discount to the perceived intrinsic value at the time of purchase. Then, of utmost importance and perhaps the biggest challenge, practice patience in waiting for the investment thesis to play out as projected over a long-term horizon.

Remember that many online brokerages and financial sites provide accessible metric calculations for the suggested equity investment research checklist. Therefore, there is no need to fret over the formulas.

Company Current Wealth Checklist

Limit due diligence to a company’s current wealth instead of unreliable predictive analysis or business modeling overkill. The following items aim to answer the crucial question, “Is this a company whose current wealth implies a quality, enduring enterprise?”

Value Proposition

The value proposition defines the competitive advantages a company’s product or services offer its customers compared to the industry, sector, or broader market.

Company profile briefly describes the enterprise and its products or services. Do we understand the business model? Is it within our circle of competence?
Stock profile favors large, mid, and small capitalization stocks trading on major exchanges. Avoided as speculative are microcaps and over-the-counter (OTC) shares.
Economic moat is a company’s products or services’ competitive advantage over other businesses within the same industry. Morningstar is the leading authority on economic moat research and credits Warren Buffett, founder and chairman of Berkshire Hathaway (BRK.A, BRK.B), with coining the term. Alpha-rich investors target companies with clear competitive advantages. An investor can streamline the value proposition of an enterprise with a moat assignment of wide, narrow, or none.
Value proposition elevator pitch describes why we believe the targeted company is a high-quality, enduring enterprise in one or two sentences. Quality-driven investors eliminate companies whose value propositions cannot be easily defined.
Due diligence resources provide a more in-depth analysis of the all-important value proposition. For example, visit the company’s investor relations webpage and its most recent Form 10-K Annual Report submitted to the US Securities and Exchange Commission (SEC) or the required report of the domiciled country’s financial securities oversight agency.

Chapter 2 explores the value proposition in-depth.

Returns on Management

The company’s returns on management or fundamentals checklist measure the performance strength of the business’s senior executives.

Revenue growth is the compounded annual growth rate of revenues or net sales over the specified period. When analyzing a business, stay biased toward established growth instead of postulated executive guidance and speculative sell-side analyst projections.
Gross profit margin is the total profit a company makes after deducting its costs, calculated as total sales or revenue minus the cost of goods sold, expressed as a percentage.
Net profit margin is the percent of revenues remaining after paying operating expenses, interest, and taxes divided by sales for the trailing twelve months, also known as NOPAT or net operating profit after taxes. Remember to screen for profitable companies to avoid unnecessary speculation. Quality-driven investors prefer companies with double-digit net margins.
Return on equity is the income available to common shareholders for the trailing twelve months divided by the average ownership equity from the most recent fiscal periods, expressed as a percentage. Reveals how much profit a company generates from shareholder investment in the stock. Target a return on equity of 15 percent or higher to uncover shareholder-friendly management.
Return on invested capital is net income after taxes divided by the average of total equity plus the sum of total long-term debt, other liabilities, deferred income tax, and minority interest expressed as a percentage. Measures how well a company uses its capital resources to generate excess returns. Target a return on invested capital above 12 percent.
Weighted average cost of capital illustrates the corporation’s capital costs, weighing each category in proportion. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in the calculation. Return on invested capital must exceed the weighted average by a comfortable margin to demonstrate management’s capital allocation abilities.

Chapter 3 explores returns on management in-depth.

Enterprise Downside Risks

The enterprise downside risks checklist discovers and rates the safety margins of the targeted company’s business model.

Long-term debt coverage measures a company’s current assets divided by its long-term debt. A favorite of the legendary value investor Benjamin Graham, long-term debt coverage demonstrates balance sheet liquidity or an enterprise’s capacity to pay down debt in a crisis. At least one-and-a-half times current assets to long-term debt is ideal.
Debt-to-equity is another ratio used to evaluate a company’s financial leverage. Calculate debt-to-equity by dividing a business’s total liabilities by its shareholder equity or total assets minus total liabilities. An ideal ceiling is 80 percent. In other words, investors should become concerned only when a company’s debt is nearing or exceeding its shareholder equity.
Short-term debt coverage or current liabilities coverage, commonly called the current ratio, is a company’s total current assets divided by total current liabilities for the same period. The current ratio measures a business’s near-term balance sheet liquidity. Target higher than 1.00.

Chapter 6 explores enterprise downside risks in-depth.

Stock Price Present Value Checklist

In addition to the company’s current wealth, limit due diligence to the stock price’s present value instead of assumptive, and thereby unreliable, calculations such as discounted future free cash flows.

The following items seek to answer the crucial question, “Does this stock’s present value convey a temporarily discounted share price?”

Shareholder Yields

Conventional market wisdom holds equities as riskier than treasury bonds. Therefore, securities should reward shareholders with yields above the government benchmark to justify owning the stock instead of the bond.

My proprietary shareholder yields checklist uncovers the equity bond rate of the company’s common shares to measure how the targeted stock compares to the prevailing yield on the US Ten-Year Treasury intermediate-term note.

Earnings yield is the inverse of the price-to-earnings ratio and indicates how much a company earns each year per common share relative to the stock price. The earnings per share represents the portion of the operation’s profits allocated to each outstanding share of common stock. Target an earnings yield greater than 6 percent or the equivalent price to earnings multiple below 17 times.
Free cash flow yield indicates how much a company generates in free cash flow each year per common share relative to the stock price. Free cash flow per share is the cash available after operating expenses and capital expenditures divided by shares outstanding at the end of the most recent fiscal period. Target a free cash flow yield of 7 percent or higher, or fewer than 15 times the inverted price-to-free cash flow multiple.
Dividend yield reveals how much a company expects to pay in average dividends for twelve months forward relative to the current share price. Whether or not we are an income-motivated investor, remember that dividend-paying stocks generate shareholder compensation in the short term while we’re waiting for capital gains to compound over time.
Dividend yield on the cost basis is the annualized dividend payout divided by the cost basis of the common shares held in a portfolio. Consider high dividend yields only when calculated on a cost basis. Yield-on-cost often reminds us that buy-and-hold quality-driven value investing is superior to risky forward high-yields. For example, as of this chapter’s writing, seven long-held quality stocks in the QVI Real-Time Stock Picks were yielding between 6 and 18 percent on a cost basis.
Payout ratio is the dollar amount of dividends paid divided by after-tax earnings. Target payout ratios below 60 percent to ensure the company’s board of directors has the earnings and free cash flow to cover and raise the dividend instead of the dreaded cut or elimination.
Ten-Year Treasury Note is a debt obligation issued by the United States government with an intermediate maturity of 10 years upon initial issuance. The prevailing yield is the fixed interest payment to the bondholder divided by the closing price of the note. Compare the average of the selected stock’s yields on earnings, free cash flow, and dividends to the prevailing yield on the Treasury.
Owners’ earnings is a further test of shareholder value by adding earnings per share growth plus dividend rate growth annualized. Seek a minimum five-year positive double-digit sum for an adequate shareholder return.

Chapter 4 explores shareholder yields in-depth.

Valuation Multiples

I have found that as few as four valuation multiples are necessary to estimate the intrinsic value or margin of safety of a targeted quality enterprise’s stock price. In other words, what is the present value of the shares?

Price-to-sales ratio is the closing stock price divided by the sales per share over the preceding twelve months. The price-to-sales ratio measures the stock price relative to revenue. Target fewer than 2.0 times or below the selected stock’s industry, sector, or market benchmark medians.
Price-to-trailing earnings ratio is the closing stock price divided by the sum of GAAP diluted earnings per share over the trailing twelve months. Price-to-trailing earnings is the inverse of the earnings yield. GAAP is the acronym for generally accepted accounting principles. Although a hit-or-miss multiple, target a price-to-trailing earnings ratio fewer than 17 times or below the selected stock’s industry, sector, or market benchmark averages.
Price-to-operating cash flow is the previous closing stock price divided by cash flow from operations per share for the most recent fiscal year. Target a single-digit price-to-operating cash flow multiple for the best value.
Enterprise value to operating earnings or EV to EBIT is the stock’s market capitalization plus the company’s debt, minority interest, and preferred shares minus total cash and cash equivalents or EV divided by earnings before interest and taxes or EBIT. Enterprise value to operating earnings is a leading sentiment indicator that measures whether the market has overbought the stock, a neutral or bearish signal, or oversold it, a bullish signal. Target an EV to EBIT of fewer than 15 times.

Chapter 5 explores valuation multiples in-depth.

Share Price Downside Risks

When assessing the share price downside risks of a company’s common shares, focus on two metrics that offer a harbinger of the security’s asymmetrical risk/reward potential.

Beta gauges a stock’s volatility or systemic risk compared to the market as a whole. As a long-term investor, use a five-year beta trend line and screen for stocks lower than 1.25 or no more than 125 percent volatility in the market. For example, the S&P 500 Index beta is constant at 1.00.
Short interest represents the percentage of outstanding shares that investors betting against the stock have borrowed to sell short and have yet to cover or close their positions. The short interest as a percentage of the float provides a sentiment indicator of whether the so-called smart money in the market is predicting the stock price will fall. Target stocks below 5 percent short.
Performance vs. sector and market charts the selected stock’s historical total return performance against its peers. Investing in individual common stocks should aim to beat the benchmark indices over time. If not, an average return from index investing makes more sense than underperforming the market.
Catalysts involve anticipated outcomes, i.e., confirmations, and surprise events, i.e., contradictions, that could accelerate or decelerate the investment thesis. Catalysts are the equivalent of a “bulls say, bears say” analysis. It is speculative but also a process to eliminate personal bias and consider other investors’ opinions on the company and stock. Online brokerages and fintech investing sites offer catalyst-related information.

Chapter 6 explores share price downside risks in-depth.

Reach Your Investing Destination Safely

Just as airline pilots use mandatory checklists to depart from and arrive at airports safely and successfully, mindful quality-driven value investors build alpha-achieving portfolios with research and analysis checklists that increase their chances of constructing and maintaining a safe and profitable basket of the stocks of quality businesses.

Subsequent chapters will expand on this primary checklist of metrics toward picking the winning stocks of enduring enterprises by focusing investment research on a company’s current wealth and a stock price’s present value.

About the Author

David J. Waldron is the contributing editor of Quality Value Investing, and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, TalkMarkets, ValueWalk, MSN Money, Yahoo Finance, QAV (Australia’s #1 Value Investing Podcast), Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a post-secondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.