Investment Checklist - Part2

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In my previous post on Checklists here, I provided an overview on the checklists and the benefits of using them.  In this part, I have listed the checklists I follow while analyzing a security for potential investment.  As I mentioned, every investor may have a long or small checklist based on their need and its more of an individual preference.  Indian companies are notorious for corporate governance and one needs to be very diligent in their evaluation exercise.  As I mentioned before, it is the safety of the investment and its downside  that is more important than the upside.  Our idea is to reduce the errors of commission than committing errors of omission.

Business Overview :

• What do they do and who are the customers?
• How do they make money?
• How did they evolve and which regions do they operate in?

Business Quality:

• What is the customer concentration for this business. Are they diversified?
• What customer problems do they solve? How dependent is the customer for its products?
• Are the product replacement cycle short or long? 
• What are the customer retention rates?
• Does it have pricing power? How big is the impact on the end customer when they raise prices?
• How intense is the competition? Do they all compete on price?
• How diverse is the supplier base and what is the supplier bargaining power?
• What is the value added product  percentage? 
• Does it sell commodity?  If yes, is it a low cost producer?
• Are there any cheaper replacement product/service from domestic or international sources?
• What is the demand growth and what is the capacity growth?
• Is the business capital intensive or working capital intensive?
• Does it have any business moat like licenses, patents, mindshare, economies of scale ?  Are these sustainable?
• Is the business cyclical, counter cyclical or recession resistant? How did it perform during major down cycles in economy?

Financial Metrics:

• Has the ROE, ROCE of the business always been consistent and above risk free rate?
• Is the debt conservative and serviceable?
• Is it earning decent return on reinvested capital?
• Are the margins sustainable?  Is it a cyclical high and likely to go down?
• Are the metrics like asset or working capital turnover improving and sustainable?
• Are the profits inflated due to deferred or low tax rates or low depreciation? 
• Are the profits inflated due to one time income which will not repeat or fictional earnings that are not actual cash adds ?
• Are there outstanding warrants or options that would dilute the equity significantly going forward?
• Does it generate positive operating cash flow consistently and is the operating cash flow to net profit relationship consistent?
• Are there too many off balance sheet items like contingent liabilities which could jeopardize the business?

Management:

• What is the reputation of the directors?  Have they been involved in any previous scams or legal issues? Do they have required industrial knowledge.
• How passionate is the management about the business?  Does it hire professional to manage?
• Is the management candid in reporting issues transparently or they only trumpet the good news?
• Are all the transactions reported clearly without hard to understand financial jargons or incomplete reporting?
• What is the percentage of management compensation?  Is it reasonable and in line with peers? Have they taken higher compensation when the business faltered?
• Has the management paid for some unreasonable expenses of the management like overseas medical treatment or visit etc?
• Do the insiders involve in too much of trading?  Are their investments pledged?
• Do the insiders offer warrants or shares to themselves frequently?
• Are there too many related party transactions which is of any concern?
• Are all the buys and sells of assets or investment well document with mention of the other parties involved?
• Is the subsidiary reporting transparent and clear?
• Are they hoarding cash?  Do they employ it effectively or return it back to shareholders?
• How have they behaved in the past in diversifying into unrelated businesses or overpaying for other acquisitions which did not add value?
• Has the management bought stock before and is it stop the price from sliding down or to take advantage of low prices to buy back stock?
• Are their operation and financial metrics better or in line with its peers?
• How do they deploy the cash generated?  Are they throwing good money after bad business or expansion for the sake of growth?

Growth:

• What is the projected growth rate?  Is it above nominal GDP growth?
• Is the growth sustainable and scalable for the next 5 to 10 years? How?
• Does the management concentrate on top line or bottom line growth?
• Is the bottom line growth happening due to short term cost cutting which would reduce future profitability and growth (eg.  Reduction of R&D expenses or advertising expenses)
• Is the growth steady with internal accruals or they are growing too quickly?

Valuation:

• Is the business available at a price that would provide reasonable return better than risk free rate?
• Does the return have any margin of safety in the even of reduced profitability.  How much is the margin of safety.
• Is the free cash flow yield above hurdle rate?
• Is the business available at a reasonable discount to its historical valuation band?
• Is the valuation at discount to its peers?