What is the industry like?
Maybe more important than selecting the right stock is selecting the right industry, at the right time.
- Is the industry too hard for me to understand?
- What is the concentration of customers and suppliers like?
- Is the industry mainly competing on price?
- Can the industry be characterized as rapidly changing?
- Does the industry have a history of good returns/created wealth?
- Is the industry protected or hindered by regulation?
- Does the industry have structural advantages or headwinds?
- Does the companies in the industry benefit from economies of scale?
- What is the industry cycle like, and where in that cycle are we now?
Ideally, the company would be profitable, growing, require little new capital invested in the business, and have low financial risk while generating a lot of free cash flow.
- Do I understand the accounting and how they make money?
- Profitability and cash flow:
- Is the company growing in an economically sustainable way?
- What are the Gross and Operating margins?
- How stable are the Gross and Operating margins?
- Is the company profitable over a business cycle?
- Are the profits converted to free cash flow?
- What are the returns on equity and the ROIC?
- Capital allocation:
- Are reinvestments in the business made in an economically sound way?
- Are the acquisitions creating value?
- Is the dividend policy sound?
- Are repurchases of shares made at good prices?
- Financial risk:
- Is the short term debt sufficiently covered by the short term assets?
- Is the debt level reasonable?
- What is the quality of the assets (odds of overvaluation on the balance sheet)?
- Is the company close to breaking any covenants or contingencies?
- Would I underwrite the equity if it was a bond?
- What is the cash conversion cycle like?
Cheaper is better, all else being equal.
- How much would I want to pay for the whole company?
- What is the valuation like using margins from a slower part in the cycle?
- What is the valuation compared to the long term average of the industry it’s in?
- Is there any reason to value the case on a SOTP basis?
- Are there any significantly undervalued or overvalued assets on the balance sheet?
- Will it revalue within 2 years?
- What will trigger this realization of value?
- What is my expected return over the full holding period, and what annual return does that equal?
Red flags and risks
- Do I suspect the company to be fraudulent?
- Does management or the chairman have any big failures in the baggage?
- Is the business fragile, robust, or antifragile?
- Are there any uncommon related party transactions?
- Are there any celebrities or politicians involved?
- Check for financial shenanigans
- Lots of deferred or accrued revenue?
- Other weird deferrals/accruals?
- Unusual accounting practices?
- Recent accounting policy changes?
- Are there especially weird macro conditions affecting the business right now?
- Are there risks of corruption, seizure/loss of assets, or similar?
- Why does this opportunity exist?
- What will cause the valuation to increase?
- Are management and the board honest and able?
- Are their incentives aligned with yours?
- Do they have skin in the game?
- What is the ratio of jargon-to-info in the corporate comunications?
- Who are the largest shareholders?
- Silver bullet (what if the business disappeared overnight?)
- How would I evaluate the company if I became CEO/CFO overnight?
- Could I handle being locked into this position 5 years?
- Is there reason to suspect significant loss on currency?