Criteria for evaluating stocks
a review of my current investment criteria
With the downtime over the weekend, I thought it would be a good time to tackle a tangential topic related to individual stock evaluations, specifically what criteria to use?
Why have investment criteria?
As an investor in stocks of individual companies, I believe it’s important to have some criteria by which to evaluate the desirability of a stock. Having set criteria helps provide guardrails for investors and avoid being overly influenced by emotions. When evaluating the latest meme stock and feelings of FOMO is high, it provides a sanity check with guidelines made during a more rational time. Even more importantly, regular review of individual investments against these criteria can provide guidance on when to sell as well as when a specific investment criteria is no longer working and should be changed.
What qualifies as investment criteria?
Before listing investment criteria, it’s important to settle on exactly what qualifies. To me, it’s important that investment criteria are not just filters applied during stock screening. For example, a PE ratio of < 20 does not qualify as an investment criteria. Instead, investment criteria should represent larger concepts that can then be broadly applied while still being as specific as possible. In the PE ratio example, an investment criteria may instead be that the stock is discounted relative to fair valuation by 20%. Perhaps how we arrive at that conclusion of what is fair valuation may differ by company but the general concept stays the same.
My Investment Criteria List
I list here my own personal set of investment criteria and the reasons why I picked them. These have evolved over time and I hope would continue to evolve as I continue to learn. Note that I specify criteria for both the company and the stock.
The company should be net income positive. Since the underlying value of the company is based on how much cash the company can generate, I prefer companies that have demonstrated they can at least generate some level of positive returns. This still leaves the question of scaling and sustainability but at least it demonstrates the concept is viable. While this may result in missing out on initial appreciation, I believe the risk/reward profile is generally better once this hurdle is overcome. Methods of valuation I use are based around metrics such as DCF and EPS and without a positive income, considerable additional guesswork must be included.
The valuation of the company must be attractive. In the ideal situation, I would like to invest in great companies at a substantial discount. However, this is often not possible especially during times such as now when the overall market is quite overvalued. To fit this criteria, I think it’s acceptable if it’s either a great company at a fair valuation or a fair company at a great valuation. Incidentally, Warren Buffet once said it is better to buy a great company at a fair price than to buy a fair company at a great price. However, since then, the rate of introduction of truly disruptive technology has increased dramatically in the last few decades and this in turn has put more frequent challenges on great companies with previously unassailable moats. Numerous examples of this abound such as Blockbuster, GM, Toys R’US, etc. As a result, I am less sure which is preferred over the other and consider both under the category of “attractive valuation”.
Shareholder friendly management. As a shareholder, I look for companies that consistently return value to the shareholder. It’s important that management does not dilute and increase share count excessively as this directly dilutes the the proportion of the company owned per share. Even in cases where overall share count is not increasing, high levels of stock based compensation can be a concern as it implies the company is spending a large portion of their cash flow to buy back shares to offset that compensation. I am still on the fence regarding whether this is necessary in some highly competitive sectors to retain talent so at this point, as long as overall stock dilution is not excessive, I would still keep the company under consideration even if it counts as a bit of a negative. On the positive end of returning value to shareholders, buybacks and dividends are considered a positive with consistent buybacks holding an edge over dividends due to the flexibility of when I can choose to redeploy this cash. Dividends are taxed first before being redeployed whereas buybacks would raise the value of the stock and I can then decide when to take the tax hit from selling before redeployment.
Sector diversification and exclusions. This particular criteria applies based on the other holdings in my portfolio. In particular, I believe it is best to diversify across at least 3-4 sectors thus individual investments that provide this diversification should be valued over those that create too much concentration in a single sector. I mainly choose this to provide some protection against macro headwinds against a specific sector that are often impossible to predict. (ie a natural disaster, major legislation change, etc).
Clean balance sheet. The main consideration here is to ensure the company has enough margins to adapt to any sudden changes that may happen to their business. A heavily leveraged company is akin to a fish swimming upriver and would find it that much harder to adapt to new changes given the burden of the existing debt. A (total debt-cash)/EBITA ratio of 3 or less is desired here.
Disclaimer: Any information contained here is not intended as, and shall not be understood or construed as, financial advice. I am not a financial advisor and this is only a documentation of my personal investment journey and decisions. You should always do your own research before making any final decision on investments.