7 Questions to Help You Pick Better Stocks
Focusing on What Really Matters Can Make Finding Good Investments Easier
When putting together a portfolio of stocks for your family, there are seven basic questions that every investor should ask. The answers can help uncover competitive strengths and weaknesses, providing a better understanding of the economics and market position of the business.
1. What Are the Sources of the Company's Cash Flows?
John Burr Williams taught us that the value of any asset is the net present value of its discounted cash flows. Before the investor can even begin to value a business, he has to know what is generating the cash. It is important to be specific and avoid making assumptions.
Take Coca-Cola, for example. Billions of people across the world are familiar with Coke’s products. When you see it on the shelf of your local grocery store, you may have concluded that it was the Coca-Cola Company that sold the bottled goods to the grocer. In reality, a look at the most recent 10K reveals that, although the company does sell some finished beverages, almost all of its revenue is derived from the sale of “beverage concentrates and syrups” to “bottling and canning operations, distributors, fountain wholesalers, and some fountain retailers.” In other words, it sells the concentrate to bottlers, the largest being Coca-Cola Enterprises (a separately traded public company).
These bottlers create the finished product, shipping it to your local store. It may seem like a small distinction seeing that Coke’s ultimate success depends upon the products sold in stores and restaurants; approached from another angle, however, and the investor can quickly surmise how vitally important the relationship between Coke and its bottlers is the bottom line; it is the bottlers who are actually selling the most Coke to the public. This arrangement happened because of a historical quirk that made two men and their families very rich.
2. How Much Cash Is Generated By the Business and When Does That Cash Flow Into the Treasury?
Once you have identified the sources of cash in a business, you need to estimate the amount and timing of those cash flows. A company that generates $1,000 today may be worth more than one that generates $30,000 in 50 years because of the time value of money.
3. Are the Cash Flows Sustainable?
There was a time when horse-and-carriage manufacturers and streetcar companies were considered blue chip stocks on Wall Street. The long history of industry profitability led many investors and analysts to believe that these businesses would always be solid as a rock. Those who were astute realized that past history was of no value in projecting future cash flows due to a shift in the competitive landscape arising from the advent of the automobile.
One of the ways to evaluate the sustainability of cash flows is to examine the barriers of entry for the market or markets in which the company operates. It is going to be much more difficult for a competitor to enter a business which requires hundreds of millions of dollars in startup capital than it is for a retailer, which can be opened for a minuscule fraction of the cost (e.g., there are very few entities in the world that could start an airplane manufacturer to go head-to-head with Airbus or Boeing, but you and your friends could probably gather the capital necessary to lease a space at the local mall and start your own business).
4. How Much Capital Does the Business Require to Operate?
Some businesses require more capital to generate one dollar of profits than others. A steel mill requires huge investments in property, plant, and equipment and then produces a product that is a commodity. An advertising firm, on the other hand, requires very little in the way of capital expenditures to keep the business going, generating tons of cash for the owners relative to investment. The less capital a business requires to run, the more attractive it is to an owner because the more money he or she can extract in the form of dividends to enjoy life or reinvest in other projects.
5. Does Management Have a Shareholder-Friendly Disposition?
The way management treats shareholders is the single most qualitative determinant of success. A CEO that is willing to push for share repurchases when a company’s stock has fallen rather than acquire another business is much more likely to create wealth than one who is bent on expanding the empire.
6. Are Management's Actions Consistent With What They Say in Their Public Communications to Investors?
If management has stated in the last three annual reports that debt reduction is the most important priority, yet they have engaged in multiple acquisitions or started multiple new businesses, they are not being honest. As a business owner, you only want to be in partnership with those whose actions match their promises.
7. Is the Stock Price Attractive Relative to Growth Adjusted Earnings?
Stock price is the absolute determinant of return. A disciplined investor will find company ABC attractive at $10, but not at $12. A business generating $5 in profit per year is an excellent buy at $20 per share; the earnings yield is 25 percent. The exact same business sold at $200 per share, however, is only boasting an earnings yield of 2.5 percent — half the rate available on risk-free United States Treasury bonds at the time I originally updated this article in 2014! Even if a high growth rate were expected, it is lunacy to acquire the stock at the latter price.
Sometimes, looks can be deceiving. With a company that is growing profits rapidly, a lower earnings yield today might be better five or 10 years from now than a higher earnings yield that is expanding at a slower rate. To adjust for this, you can try to use the Dividend Adjusted PEG ratio.