The Investment Checklist

The Art of In-Depth Research

Michael Shearn

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118149454
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

A practical guide to making more informed investment decisions

Investors often buy or sell stocks too quickly. When you base your purchase decisions on isolated facts and don't take the time to thoroughly understand the businesses you are buying, stock-price swings and third-party opinion can lead to costly investment mistakes. Your decision making at this point becomes dangerous because it is dominated by emotions. The Investment Checklist has been designed to help you develop an in-depth research process, from generating and researching investment ideas to assessing the quality of a business and its management team.

The purpose of The Investment Checklist is to help you implement a principled investing strategy through a series of checklists. In it, a thorough and comprehensive research process is made simpler through the use of straightforward checklists that will allow you to identify quality investment opportunities. Each chapter contains detailed demonstrations of how and where to find the information necessary to answer fundamental questions about investment opportunities. Real-world examples of how investment managers and CEOs apply these universal principles are also included and help bring the concepts to life. These checklists will help you consider a fuller range of possibilities in your investment strategy, enhance your ability to value your investments by giving you a holistic view of the business and each of its moving parts, identify the risks you are taking, and much more.

• Offers valuable insights into one of the most important aspects of successful investing, in-depth research
• Written in an accessible style that allows aspiring investors to easily understand and apply the concepts covered
• Discusses how to think through your investment decisions more carefully

With The Investment Checklist, you'll quickly be able to ascertain how well you understand your investments by the questions you are able to answer, or not answer, without making the costly mistakes that usually hinder other investors.

CHAPTER 1

How to Generate Investment Ideas

There are many ways you can generate investment ideas, some qualitative, some quantitative. Quantitative methods include looking at specific financial or operating metrics, whereas qualitative methods rely on more subjective characteristics, such as management strength, corporate culture, or competitive advantages. Whether you are running a complicated stock screen or simply getting ideas from other investors, all methods have their own advantages, limitations, and risks. Ultimately, the best method of generating ideas for you is the one that gives you the largest number of opportunities.

This chapter explores why stocks become undervalued, how to generate investment ideas, how to filter these ideas, and how to keep track of them. These steps are critical to creating a pool of stock ideas.

How Investment Opportunities Are Created

You can’t manufacture investment opportunities. Instead, you need to be patient, and you have to be ready for the right opportunities. It is important to understand that good investment ideas are rare, and consistent success in the stock market is elusive. Those investors who believe that they can make money year after year in the stock market are setting themselves up for disappointment. Most investors are far too optimistic: They often think they’ve found great ideas when they haven’t.

In contrast, investors with the best long-term track records have made most of their money with just a handful of investment ideas. For example, Warren Buffett states that his investment success is due to fewer than 20 ideas, such as the Washington Post newspaper, Coca-Cola, and GEICO. In short, you need to mentally prepare yourself in advance with the idea that you will not have many outstanding investments in your lifetime. Most investments you make will produce mediocre results, but a few can provide outstanding results.

The best investment opportunities usually come in big waves, such as when entire markets decline. There have been several recent examples: the Asian financial crisis of 1997 to 1998, the Internet bubble ending in 2000, and the recession starting in 2007. There were many buying opportunities in 2008 when the S&P 500 dropped 36 percent. This was caused by forced selling. The market sell-off was exacerbated by the indiscriminate selling of stocks by money managers who were forced to sell stocks to fund client redemptions. Even if these money managers knew these stocks were undervalued, they had no choice but to sell. This forced selling created artificially low prices—which created a rare opportunity for investors.

Other kinds of forced selling include situations when stocks are thrown out of an index because they no longer meet the minimum standards to remain in an index. Many investment managers who exclusively invest in stocks found in a particular index (such as the S&P 500) are forced to sell when the stock moves out of the index. Spin-offs (where a business divests a subsidiary) create a similar situation when the business that is spun off does not fit the investing criteria of an investment manager. Forced selling decreases prices—which creates opportunities.

Besides broad market sell-offs that create forced selling, the stock market has a way of magnifying different types of business and industry-wide risk that cause the stock prices of businesses to drop. To learn which area of the stock market is in greatest distress, look for those areas where capital is scarce. Scarcity of capital creates less competition for assets, which decreases prices. Ask yourself, what areas of the stock market are investors fleeing, and why?

You may want to begin by looking at the percentage change in prices of certain industries found in common indices such as the materials, energy, or financials subset of the S&P Composite 1500. For example, the price performance for components of the S&P Composite 1500 from April 23, 2010 to June 7, 2010 showed that:

• Materials were down 18 percent
• Energy was down 17 percent
• Utilities were down 9 percent

With that information, you might start researching the materials industry, looking for stocks that have significantly dropped in price. Ideally, you want to identify those stocks where the baby has been thrown out with the bathwater—and then rescue that baby!

Most stock price drops are due to some type of uncertainty about the business, and there are many possible reasons:

• Litigation fears
• Accounting irregularities
• Accusations of fraud
• Health concerns (such as swine flu)
• Execution problems due to a flawed strategy
• Management concerns
• Executive departures
• Government intervention or regulation
• Loss of a customer
• Technological changes
• Credit rating downgrades
• Competitor announcements
• Or a myriad of other reasons

In most of these cases, investors automatically assume the worst-case scenario and tend to sell stocks first and ask questions later. Once the reality starts to set in that the ultimate outcome will not be as bad as expected, then stock prices adjust and typically rise. Ideally, you want to identify those areas where the outlook is most pessimistic and identify whether the sources of pessimism are temporary or permanent. Let’s look at an example.

Case Study: Investors’ Pessimism about Heartland Payment Systems Proved Unfounded

In 2009, Heartland Payment Systems found itself in what appeared to be a disastrous scenario. Heartland helps small and mid-sized merchants with credit-card transactions, providing the physical card machine and payment-processing services that enable customers to use credit and debit cards in retail stores. In 2008, computer hackers installed spyware on Heartland’s network and had gained access to the systems that process Visa, MasterCard, Discover, and American Express transactions.

After discovering the problem, Heartland announced details concerning the breach, including the number of months the spyware might have gathered card numbers and the number of transactions that the company usually processed. Framing it as potentially the largest data breach in history, the New York Times noted that 600 million or more card accounts were vulnerable, and quoted a data security analyst who said that there could be as much as $500 million in losses and other expenses if you added it all up. Early estimates were that Heartland would have to pay $2 per card for MC/Visa to reissue each affected card. The result? Investors quickly sold the stock. The price plummeted from $18 per share before the breach was announced (on January 6, 2009) to as low as $3.78 per share on March 9, 2009.

However, other investors with a solid base of research on the company and industry knew several things that helped them take advantage of this situation:

• First, they focused on Heartland’s transaction count of 100 million transactions per month, and they recognized that not all of those would be from unique accounts. People tend to go the same places more than once. Later, more conservative estimates of stolen cards emerged at about 140 million cards, instead of 600 million.
• Second, there was publicly available information about a similar case involving retailers TJ Maxx and Marshalls that had been settled recently. In that case, the average settlement per account to the issuing banks to replace cards was about 70¢ per card.

In 2010, Heartland agreed to pay MasterCard, Visa, and American Express $105 million—not the $500 million that was originally estimated by news sources. This amount, which averaged 81¢ per card, was similar to the recent TJ Maxx and Marshalls case. More important for investors was the fact that this was a far cry from the first potential loss estimates. Investors who already held stock in Heartland shouldn’t have immediately sold the stock on the news. They would have been rewarded if they had purchased more of the stock to decrease their cost basis. Also, investors who didn’t already own Heartland stock should have bought at this time because this one-time event was nowhere near as devastating as the sources in the press made it out to be. After investors realized that the liability from the breach was lower than they anticipated, the stock price recovered to more than $13 per share several months later (by the end of 2010).

In sum, if you had purchased the stock after the breach was announced, you could have tripled your investment!

Be Wary of Exciting New Trends that Turn out to Be Fads

You must also learn to identify those areas of the stock market that are benefiting from abundant sources of capital, which drives up prices, so you can be careful investing in them. Wall Street is good at pitching stories, and investors tend to get excited by what they believe is an important new trend. However, many of these exciting major trends turn out to be fads that are based on speculation, rather than fundamentals. Let’s look at a couple of examples.

In the 1960s, investors bid up the stocks of conglomerates that were increasing their earnings through acquisitions. Businesses such as James Ling’s LTV (Ling-Temco-Vought), bought unrelated businesses to increase and diversify their revenue streams. Growing quickly, they used their high stock prices to purchase other businesses. LTV acquired company after company, growing from the 204th largest industrial company in 1965 to the 14th largest in 1969—only four years later!

Yet by 1970, under the pressure of enormous debt, antitrust threat, and a generally bearish market, LTV’s stock had plummeted, as did the stock of several of the other recently ballooned conglomerates. From a high in 1968 of $136 per share to a 1970s low of $7 per share, LTV ended up selling many of its acquisitions at clearance prices.1

The 1990s gave us another kind of speculative boom, what we now call the Internet bubble. Technology stocks provided rates of return that dwarfed their actual growth or profits (if they had any profit at all). For example, computer manufacturer and services company Sun Microsystems was once valued as high as 10 times revenues when its stock traded for $64 per share. CEO Scott McNealy recalls that heady period: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100 percent of revenues for 10 straight years in dividends.” McNealy noted that his assumptions include a few major obstacles such as getting shareholder approval for such a plan and not paying any expenses or taxes. Furthermore, McNealy noted that Sun Microsystems would also have to maintain its revenue run rate without investing in any R&D. McNealy asked, “Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?”2

How to Spot Investment Bubbles

To understand where current bubbles exist, ask, “Where is a lot of money being made very quickly?” Look at the Forbes magazine list of billionaires. What industries are the new billionaires coming from? For example, in the early 1980s, the Forbes list was populated mainly by individuals in the oil and gas industry. Also, monitor initial public offerings (IPOs) coming to market. Are the IPOs that are quickly rising in price concentrated in a certain industry, as Internet stocks were during the technology boom of 1998 to 2000?

When capital is abundant, it searches for other similar businesses to duplicate success. The IPOs of technology businesses caused many other technology businesses to be formed and seek to go public. Here are a few signs of a bubble:

• Lots of available capital
• Higher levels of leverage
• Decreased discipline from lenders as they try to get h...