August 30, 2024 • 1hr 18min

TIP656: Mastering Stock Selection with an Investment Checklist w/ Clay Finck

We Study Billionaires - The Investor’s Podcast Network

In this episode, host Clay Finck provides a comprehensive overview of how to build an investment checklist, based on the book "The Investment Checklist" by Michael Shearn. The goal is to ensure investors cover all critical factors before taking a position in a company. Finck emphasizes that while it can be tempting to quickly fall in love with an investment idea, proper fundamental research is essential. A thorough checklist helps guard against bias and overoptimism while ensuring no major factors are overlooked. The episode covers understanding business basics, evaluating strengths and weaknesses, key financial ratios, assessing management quality, and evaluating growth opportunities. Finck notes that great investments are rare, so thorough analysis is crucial for long-term success.

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Key Takeaways

Investment checklists are crucial for slowing down the analysis process and ensuring critical factors are not overlooked before making an investment
Great investment opportunities are rare - most investments won't be home runs, so proper expectations and thorough analysis are important
Understanding the customer perspective is vital but often overlooked by investors focused solely on financials or competitive advantages
Management quality and incentives are key factors that can make or break an investment over the long-term
Capital allocation skills are distinct from operational skills - finding managers good at both is rare but valuable
Growth is not always good - profitable, disciplined growth at a steady pace is preferable to rapid growth at all costs
Passion, honesty, transparency and competence are key traits to look for in management teams
Insider buying can be a strong positive signal, while insider selling is less conclusive
How a company treats employees is indicative of long-term potential and culture
Understanding growth opportunities and risks is crucial, especially for companies trading at high valuations

Introduction

In this episode, host Clay Finck provides a comprehensive overview of how to build an investment checklist, based on the book "The Investment Checklist" by Michael Shearn. The goal is to ensure investors cover all critical factors before taking a position in a company.

Finck emphasizes that while it can be tempting to quickly fall in love with an investment idea, proper fundamental research is essential. A thorough checklist helps guard against bias and overoptimism while ensuring no major factors are overlooked.

The episode covers understanding business basics, evaluating strengths and weaknesses, key financial ratios, assessing management quality, and evaluating growth opportunities. Finck notes that great investments are rare, so thorough analysis is crucial for long-term success.

Topics Discussed

Generating Investment Ideas (4:47)

Market dislocations and forced selling can create opportunities, but are unpredictable
Stock screeners can filter for metrics like growth, returns, market cap
Look for out-of-favor sectors on new lows lists
Leverage your investor network and communities for ideas
Follow 13F filings of successful investors

Understanding the Basics of a Business (6:47)

Consider if you're genuinely interested in learning about the business
Evaluate as if you were becoming CEO or full owner
Understand how the business generates earnings
Analyze how the business has evolved over time
Assess foreign market exposure and associated risks

Understanding the Customer Base (8:31)

Shearn emphasizes that customers are the lifeblood of a business, and the quality of customers determines the quality of the business. Key questions to consider:

Who is the core customer?
Is the customer base concentrated or diversified?
How difficult is it to convince customers to buy?
What is the customer retention rate?
Is the business customer-oriented?
What pain point does the business solve for customers?
How dependent are customers on the company's products/services?

"One of the main pitfalls in researching a business is viewing the business from your own perspective instead of viewing the business from the customers' perspective." - Michael Shearn

Determining Primary Risk Factors (10:32)

Review the Risk Factors section of 10-K filings
Consider operational risks like commoditization, deregulation, technology shifts
Assess balance sheet risks and leverage
Evaluate cyclicality and recession resistance
Analyze working capital needs and capital intensity

Evaluating Strengths and Weaknesses (19:19)

Assessing competitive advantages is crucial for determining sustainability of cash flows. Key questions:

How easily can the advantage be copied or replaced?
How quickly might competitors replicate it?
Does the company have pricing power?
What are the industry dynamics and barriers to entry?

Common sources of competitive advantage include:

Network effects
Brand loyalty
Patents
Regulatory licenses
Switching costs
Cost advantages from scale/location/assets

Key Financial and Operating Ratios (28:25)

Return on Invested Capital (ROIC) - Shows profit generated relative to capital invested
Operating Leverage - Degree earnings increase relative to sales growth
Coverage Ratio - EBITDA divided by annual interest expense
Current Ratio - Current assets to current liabilities
Debt to Equity Ratio
Industry-specific operating metrics

Evaluating Earnings Quality and Management (32:53)

Assessing earnings quality:

Compare cash flow from operations to net income
Look for aggressive vs conservative accounting practices
Analyze revenue recognition policies
Assess recurring vs one-time revenues

Evaluating management quality:

Look for passion, honesty, transparency, and competence
Assess tenure and insider experience
Evaluate compensation structure and incentives
Consider insider buying/selling activity
Assess capital allocation track record

"Most investors overlook the human aspect of operating a business. Yet in most cases, the future success of a business is directly tied to the quality of its people." - Michael Shearn

Evaluating Growth Opportunities (1:06:51)

Understand how the company grows (organic vs acquisitive)
Assess management's motivation for growth
Determine if historical growth has been profitable
Analyze future growth prospects and addressable markets
Consider if growth pace is too rapid or steady

"You need to be careful about investing in businesses run by CEOs who are self-promoting or those with larger-than-life personalities. These CEOs make themselves the brand rather than the business." - Michael Shearn

Conclusion

Building and utilizing a comprehensive investment checklist is crucial for thorough analysis and avoiding critical mistakes. Key areas to focus on include:

Understanding the business model and customer base
Assessing competitive advantages and industry dynamics
Analyzing key financial metrics and ratios
Evaluating management quality, incentives and capital allocation
Understanding growth opportunities and associated risks

While checklists help ensure thorough analysis, investors must remember that great investment opportunities are rare. Proper expectations, discipline, and continuous learning are essential for long-term investing success.

The episode concludes with information on the TIP Mastermind community for serious investors looking to network, share ideas, and attend exclusive events. Those interested can apply at theinvestorspodcast.com/mastermind.