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Final Checklist for Buying Stocks

Modified on January 9, 2019

The current article is the summary of the key aspects of stocks analysis learned by us until now and puts them together in the form of a checklist for buying stocks. This article also provides further clarifications on the check list by answering investors’ important queries like:

  • What to do when no company/stock meets all the checklist paramters
  • What weights to be given to different parameters in the checklist for buying stocks.

“SelectingTop Stocks to Buy” is a series of articles that focuses on the process of selection of stocks for investment. In this series, we have learned about:

In previous articles, I have provided readers with key takeaways in form of crucial parameters that an investor should use while analyzing stocks. Articles on financial analysis, valuation analysis, business & industry analysis and management analysis contained summary checklists that can be very handy for any investor. 

In the current article, I have compiled at one place the parameters that an investor should check each stock, before investing her hard-earned savings. This article can serve as a final checklist for buying stocks for any investor, which will become very useful while doing detailed analysis of stocks.

The Final Checklist for Buying Stocks

Criteria Value Remarks

FINANCIAL ANALYSIS

       
1 Sales growth CAGR >15% for last 7-10 years Growth should be consistent year on year. Ignore companies where sudden spurt of sales in one year is confounding the 10 years performance.
Very high growth rates of >50% are unsustainable.
2 Profitability NPM >8% Look for companies with sustained operating & net profit margins over the years
3 Tax payout >30% Tax rate should be near general corporate tax rate unless some specific tax incentives are applicable to the company.
4 Interest coverage >3
5 Debt to Equity ratio < 0.5 Look for companies with D/E ratio of as low as possible. Preferably zero debt
6 Current ratio >1.25
7 Cash flow CFO > 0 Positive CFO is necessary.
It’s great if CFO meets the outflow for CFI and CFF
8 Cumulative PAT vs. CFO cPAT ~ cCFO Cumulative PAT and CFO are similar for last 10 years

VALUATION ANALYSIS

1 P/E ratio Read: 3 Principles to decide ideal PE ratio to pay for a stock Such companies provide good margin of safety
2 P/E to Growth ratio (PEG ratio) < 1
3 Earnings Yield (EY) > 10 year G-Sec yield EY should be greater than long term government bond yields or bank fixed deposit interest rates
4 P/B ratio < 1 However, I find P/B ratio irrelevant for sectors other than financial services
5 Price to Sales ratio (P/S ratio) < 1.5 James O’Shaughnessy: Buy if P/S ratio is < 1.5 and sell if >3
6 Dividend Yield (DY) > 0% Higher the better.
DY of >5% is very attractive. However, do not focus a lot on DY for companies in fast growth phase

BUSINESS & INDUSTRY ANALYSIS

1 Comparison with industry peers Sales growth > peers The Company must show sales growth higher than peers. If its sales growth is similar to peers, then there is no Moat
2 Increase in production capacity and sales volume Production capacity & sales volume CAGR ~ Sales CAGR Company must have shown increased market penetration by selling higher volumes of its product/service
3 Conversion of sales growth into profits Profit CAGR ~ Sales CAGR A Moat would result in increasing profits with increasing sales. Otherwise, sales growth is only a result of unnecessary expansion or aggressive marketing push, which would erode value in long term
4 Conversion of profits into cash cPAT ~ cCFO If cPAT >> cCFO, then either the profits are fictitious or the company is selling to any John Doe for higher sales without having the ability to collect money from them
5 Creation of value for shareholders from the profits retained Increase in Mcap in last 10 yrs. > Retained profits in last 10 yrs. Otherwise company is destroying wealth of shareholders

MANAGEMENT ANALYSIS

A) Subjective parameters

1 Background check of promoters & directors Web search There should not be any information questioning the integrity of promoters & directors
2 Management succession plans Good succession plan should be in place Salary being paid to potential successors should be in line with their experience

B) Objective Parameters

3 Salary of promoters vs. net profits No salary increase with declining profits/losses promoter should not have a history of seeking increase in remuneration when the profits of the company declined in past
4 Project execution skills Green/brownfield project execution Company should have shown good project execution skills with cost and time overruns.
Exclude capacity increase by mergers & acquisitions.
5 Consistent increase in dividend payments Dividend CAGR > 0 Dividends should be increasing with increase in profits of the company
6 Promoter shareholding > 51% Higher the better
7 Promoter buying the shares Insider buying ++ If promoter of a company buys its shares, investors should buy too
8 FII shareholding ~ 0% the lower the better

OTHER BUSINESS PARAMETERS

1 Product diversification Pure play Company should be either a pure play (only one business segment) or related products. Pure play model ensures that the management is specialized in what they are doing.
Entirely different unrelated products/services are a strict NO. An investor should rather buy stocks of different companies, if she wants such diversification.
2 Govt. influence No govt. interference in profit making No cap on profit returns or pricing of product.
No compulsion to supply to certain clients.

Margin of Safety

MoS in Purchase Price Earnings Yield (EY) EY > 10 Yr G-Sec Yield Higher the EY than 10 Yr G-Sec Yield, the better
MoS in Business Model Self Sustainable Growth Rate (SSGR) SSGR > Achieved Sales Growth Rate Higher the SSGR than achieved Sales Growth, the better
Free Cash Flow (FCF) FCF/CFO >> 0 Higher the FCF as proportion of CFO, the better

Credit Rating

1 Credit Rating History BBB- & above Current credit rating should be minimum BBB-
Credit rating should have been improving over the years

To see a live example of analyzing a stock on this checklist for buying stocks to determine whether the stock has the qualities of an investment-worthy stock, you should read: Equity Research – Ambika Cotton Mills Limited. In this article I have analyzed Ambika Cotton using the parameters listed above.

Investors should always keep in mind that, no checklist for buying stocks could ever be complete for doing stocks analysis. However, the parameters in the above checklist test any company and its stock on some of the tough performance parameters. Hence, an investor can be reasonably certain that the stocks, which pass the above checklist for buying stocks, will have sound fundamentals and are available at reasonable valuations. If she diligently follows these parameters, invests only in stocks that promise good fundamentals and never overpays for them, then she can be reasonably certain of good returns from her portfolio over long term. 

Temporary periods of stock price fluctuations, business cycles where even good companies would not be able to maintain sales growth & profitability, would definitely come in between. However, the investor should keep her patience and not act on impulse and stay invested in a company until the time inherent business strength of the company is intact. She would reap great benefits of such investing behavior.

No checklist for buying stocks is paramount. Hence, an investor should not restrict themselves to the parameters mentioned above. She should read further about investment analysis and add/remove parameters from the above list as per her understanding.

Monitoring stocks in an investor’s portfolio is also equally important. An investor should delineate her monitoring activities into ongoing activities, quarterly activities and annual activities. (Read: How to Monitor Stocks in Your Portfolio)

Let us now address the key queries asked by investors about the checklist for buying stocks, which are essential for further clarification on the use of the checklists.

 

Investors’ queries on the checklist for buying stocks

What to do when no company meets all the investment checklist parameters?

Dr Vijay.

I read your e-book “Peaceful Investing: A Simple Guide to Hassle-free Investing”. It is a very nice work.

I am a new investor. I have some basic query:

For investments, it is very difficult for a single company to fulfill all parameter in the checklist.

So please let me know your priority or the percentage weight on the parameters, which are most important and the parameters where you believe that some compromises can be made.

If you have written an article on it, then please let me know.

Author’s Response:

Hi,

Thanks for writing to us!

In case, an investor is not able to find any company, which meets all the parameters and the investor still wishes to make investments by relaxing the selection parameters, then we usually advise investors to follow the following approach:

Out of the key analysis parameters: financial, business, valuation, management and operating efficiency parameters, if the investor wishes to relax, then the parameter, which may be relaxed is the valuation parameter. Retaining all other parameters indicates that the companies, which the investor will consider for investment, will have good fundamentals.

However, an investor should keep in mind that by relaxing the valuation parameter, i.e. by investing at the higher price (high P/E ratio); the probabilities of future returns would be lower. Therefore, it may happen that the business of the company is doing good but the stock price is not moving higher because it had already reached a very high level when the investor initially purchased the stock.

An investor should read the below article to understand the risks that she may face when she invests in companies at a high valuation.

Further advised reading: Hidden Risk of Investing in High P/E Stocks 

Further advised reading: 3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors

Therefore, an investor needs to tone down her future return expectations accordingly when she invests in stocks at a high price.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Weights of different parameters of the checklist for buying stocks

Dear Dr. Vijay

I follow your blogs/tweets and have learnt a lot. You are doing a great job in educating people who aspire to be value investors.

I saw your tweet where you had mentioned about promising stocks in 150/150 segment. I refer to the checklist for buying stocks that you had posted, which had the list of criteria’s one should look for when choosing a stock, esp. for long term investing (e.g.: PE ratio of < 10, Avg 5 yrs. Sales CAGR of > 20%, PAT margin > 10% etc.,).

I wanted to understand your thought process when you hunt for small and emerging companies (in 150/150 segments):

  1. which of the check list criteria would you give more weightage than others while looking at such micro-caps
  2. which one’s you may ignore (as I’m not sure if there’ll be micro-cap companies which would satisfy all the criteria mentioned in the check list)

Note: By the way, I use Screener to search for companies for further study (reading annual reports, company presentations etc.,) based on the check list you had blogged beginning of the year

Regards,

Author’s Response:

Hi,

Thanks for your feedback & appreciation! I am happy that you found the articles useful!

Thanks for asking the query on this section as here your query and its response would be helpful for other readers of the website as well.

I have mentioned that 150/150 segment (₹150 cr. market cap / ₹150 cr. sales) has surprised me with promising stock picks. This is because whenever I have search for stocks, I noticed that most of the stocks meeting my criteria have been from this segment and have given good returns to me.

Another point to be stressed here is that I do not specifically put filters of sales=₹150 cr. or market cap = ₹150 cr. while searching for companies. It’s just that most of the stocks that pass the filters are incidentally from 150/150 segment.

Coming to your specific queries:

  1. All the criteria are equally important. No parameter is more or less important than other. An investor should analyse the stocks and satisfy herself on all the parameters.
  2. An investor should not ignore any parameter. It might be difficult/time consuming to find stocks meeting all the parameters. However, an investor does not need to find hundreds of stocks meeting all the parameters. Finding one or two stocks in a year, is good enough.

However, once an investor has spent enough time in the market and has analyzed many companies, then she would have formed her own approach to stock investing. She would have created her own set of criteria to select stocks which would suit her investing style and temperament. Then she would realize that her criteria might or might not be same as the check list shared by me on this website.

Read: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it clarifies your concerns.

Regards,

Vijay

 

Do a high FII shareholding and the presence of multiple business segments make a company a safe bet for investors?

Hi Sir,

I read your article. Almost all the criteria mentioned above in the checklist are good. However, I am a bit confused regarding two criteria:

1st is FII shareholding: Most of experts and the available information on the internet claim that a higher foreign institutional investor (FII) holding means that a stock is good stock. This is because, the FIIs do better research than retail investors. So it is a safe bet if FIIs are increasing stakes in a particular stock.

2nd is diversification: Pure play company is a good bet to rely on. However, if a company has a diversified business, then it is unlikely that all of the diversified products would have negative returns at any one point of time. Therefore, the safety increases with diversified products as they won’t witness a fall in sales at the same time.

Thanks for sharing good information.

Regards,

Author’s Response:

Hi,

Thanks for writing to us and sharing your inputs.

1) FII Shareholding:

We do not believe that as a rule all the FIIs do a better research than retail investors. We believe that the quality of research work in both the segments of FIIs as well as retail investors vary across a huge spectrum. Effectively in parts both FIIs as well as retail investors do quite good research. However, simultaneously, we notice that many times the quality of research work by both FIIs as well as retail investors leave a lot to be desired.
Therefore, we do not believe that a mere presence of an FII indicates that the company/stock is a safe bet. We believe that investors should take investment decisions based on their own research and not rely on inferences from presence of FII shareholders in any company.

2) Diversification:

We believe that both the following scenarios both bring diversification benefits to the investor:

  1. the presence of diversification of different businesses within a single company as well as
  2. the presence of multiple pure play business companies in the portfolio.

However, out of these two scenarios, we prefer (ii). This is because it is simpler and easy to analyze and understand a pure play company. Analyzing a company, which has many businesses becomes difficult as we find it comparative difficult to understand all the parameters, which may influence its business.

Therefore, we prefer to get diversification benefits in our portfolio by investing in many pure play companies, which are simpler to analyze and understand.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

P.S.

I would like to know how you felt while reading this series “Selecting Top Stock to Buy”, your experiences of stock markets, the checklists you follow, parameters you find paramount for analysis and any other inputs that you believe would improve the blog & its articles. You may write your inputs in the comments below or contact me here.

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