The Informed Investors Checklist for Selecting Winning Stocks

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." -- Warren Buffett

Have you every caught yourself saying – “I wish I invested in that stock before it took off”? We’ve all wanted to kick ourselves for not buying the latest stock to take the market by storm. Mine is Amazon. On May 30th, 1997 Amazon made is debut on the Nasdaq trading at $1.50 per share. Fast forward 20 years, Amazon now trades above $1,100 (as of December 2017). If I only had invested in 100 shares of Amazon during it’s IPO, that one-time investment would now be worth over $1.1M.

In all fairness, Amazon wouldn’t have hit my radar in those early days of the company, it’s not easy picking the next Amazon. Why is that? Before companies make it big they are still unproven, and with all the variables that go into determining whether a company will rise to the top of a fast-growing industry no one can really predict who will win. Legendary investor Peter Lynch thinks about this investor conundrum in terms of baseball, suggesting investors should wait until the third inning before getting into the game as buying before the lineup is announced introduces unnecessary risk.

While there are no guarantees in stock market investing, you can dramatically improve your batting average by bringing a sound approach focused on the fundamentals to the game. Read on below to learn more about the checklist I follow when picking stocks, plus a link to the spreadsheet I use to screen and compare stocks I’m considering buying. And, I promise – no more baseball analogies.

The Informed Investor’s Checklist:

1. Always have an investment hypothesis: You must understand why you are buying shares in a company before you make the final purchase. “Because my friend recommended it” is NOT a good enough answer to why you bought a stock. An investment hypothesis is the reasoned justification for purchasing shares in a company. Having an investment hypothesis also helps you set the time horizon for when to sell a stock. You should only sell a stock when the hypothesis is realized, or when the hypothesis is no longer reasonably achievable.

There can be several types of investment hypothesis’s, you might think a company is undervalued, or that a company is in a high growth industry that they are poised to capture, or you may choose to invest in a company because it historically has grown its dividend payouts and you want the income stream in your portfolio.

One of the more successful investment hypothesis I had informed my purchase of a company called Western Digital. It was my belief the market was undervaluing the company. Western Digital develops data storage solutions, anything from flash drives, to devices, to large enterprise solutions. Many of the metrics used to help indicate if a company is properly valued or not - its Price to Earnings (P/E) ratio, Price to Book, and others, were all signalling Western Digital was being undervalued by the market. What was driving this discount was Wall Street’s belief the storage market was undergoing a major transformation from local storage solutions, which was Western Digital’s traditional bread and butter, to cloud storage solutions. What I felt Wall Street missed in its low valuation of Western Digital was that the vendors who were providing cloud storage services themselves needed the same storage hardware from companies like Western Digital to be able to provide these services at scale. As soon as Western Digital recovered to a more “fair” market valuation, I exited the stock and looked for other opportunities to invest my gains.

2. Understand what the company you are investing in does to make money: When it comes to choosing what stocks to invest in, sticking to companies that you understand is a prudent strategy. Just as you wouldn’t set up a legal practice without going to law school, you should not invest in companies where you are not able to explain how the company makes money. 

Before you say, “I don’t know much about companies outside of the industry I work in”, consider all the products and services you encounter throughout your daily life. The bank you use, the restaurant chain you visit regularly, the smartphone you check every five minutes, your Internet provider, the hotel chain you remain loyal to. I only started to look at Starbucks as an investment opportunity after I realized that I was not the only person who had an expensive habit of regular visits to Starbucks.

Sticking to what you know is not only the safer investment strategy, but it also won’t limit the returns you can generate. Even Warren Buffet, billionaire CEO of Berkshire Hathaway, was wise enough to admit that he isn’t smart enough to predict what the future of the tech industry will look like, so he chose to avoid it almost entirely over the course of his investing career. He’s done ok.

Of course, just understanding how a company makes money is not enough. You need to assess if they will make more money in the future.

3. Assess the quality of the business: You get what you pay for in life. It’s no different with stock investing. This is not to say you shouldn’t buy stocks at an attractive price or look for bargains when a quality company goes on sale due to market corrections. Warren Buffet put it best:

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

My search for quality companies focuses on two key factors – i) Does the company have a defensible moat to protect it against competitors, and ii) Is the company led by strong leaders?

Defensible Economic Moat
A moat is a long-lasting competitive advantage. When company’s have a defensible moat, they can generate strong and consistent profits. There are many ways company’s can create a defensible moat – a strong brand, a patent, a low-cost advantage, high switching costs, etc. Facebook has created a strong moat due the network effect it has created. People are less likely to leave the social network because most of their friends and family are on Facebook.

Strong Leadership
When you are investing in a company, you are also betting on the ability of the company’s CEO and leadership team to deliver strong results. Look for companies with experienced leadership that has vision and a track record of driving growth and navigating through tough times successfully. I also prefer companies where management has a material equity position in the company themselves. You can trust them to be good stewards of the company’s financial position given their “skin in the game”.

4. Focus on the fundamentals: When I decide to invest in a company I tend not to look at macro economic events like what the government is likely to do with interest rates in the future, or will inflation rise soon? Not only is predicting these events impossible, but if they do occur the affects will be felt across the stock market (not just the company you are investing in) and they will pass in time. By focusing on selecting quality companies trading at a reasonable price, and investing for the long term, your bets are likely to endure despite a few small setbacks along the way. 

While I don’t look at macro economic conditions in my investment decisions, I very much analyze the micro economic conditions of a company. The top financial metrics I review when considering a stock investment are listed below. Many of these metrics for individual companies can be found on financial websites, including my favorite Morningstar.com.  

a) Earnings growth: As company earnings (after tax net income) grow so too should the stock price. I want to see growth in the companies I invest in, preferably earnings growth, but I do on rare occasions make exceptions for the right high growth tech companies. In these seldom cases I will settle for revenue growth provided the company is re-investing its profit into growing the business.

b) Earnings yield: A company’s earnings yield helps determine if a stock is reasonably priced based on current earnings and is calculated by: 

Earnings per Share

Price per Share 

I look for earnings yield that are 7% or more. Although I’d prefer a company’s earnings yield to be 10% or higher, with today’s high valuation of the stock market this is harder to come by.  

c) Price to earnings growth (PEG): The invention of investing legend and Warren Buffet teacher Ben Graham, the PEG ratio is another indicator of a company’s current valuation. It’s distinction from other valuation methods, such as the Price to Earnings (P/E) ratio (basic valuation ratio of a company’s current share price compared to its per-share earnings) is that because the PEG ratio factors in earnings growth it provides a more forward-looking view of a company and its growth potential. The PEG ratio is calculated as: 

Price to Earnings Ratio

Annualized Earning Per Share Growth (over five-year period)

The lower the PEG ratio the better. A PEG ratio below 1.0 implies the market is not fully                    valuing the company’s growth potential. (Source: Forbes)                                       

d) Debt-to-Equity Ratio: This metric gives you a sense of whether a company has taken on too much debt. If a company is too leveraged, high debt loads can become problematic in an economic downturn if the company is not generating enough cash flow to service its debt. The debt to equity ratio is calculated as:

Total Liabilities

Shareholder Equity

While lower debt-to-equity ratios are preferred, there can be good reasons for companies to use debt. Increasing debt during expansion can help new companies scale much faster than they would otherwise. And, context matters – certain capital-intensive industries that are well established such as utilities and industrial manufacturers generally have higher debt-to-equity ratios than fast growing companies. Compare the company’s debt-to-equity ratio to its peers in the industry to put it in relative terms. 

e. Return on Equity (ROE): Assessing the effectiveness of a company’s leadership can be difficult from afar. That’s why I rely on ROE to help me evaluate how effective management is in generating profits from the money invested in the company. Basically, is leadership effective at generating returns from the capital invested by the company’s owners (i.e., it’s shareholders). The ROE is calculated as follows:  

Net Income

Shareholder Equity

A word of caution, ROE is not an effective measure for early stage companies that are not yet            profitable due to their strategy of growth re-investment.  

Putting it into Practice

I place equal importance on each of these measures – if a company seems to be undervalued, as measured by it’s earning yield, but if the debt-to-equity ratio is too high, I will pass on the investment. You should use these, and other financial metrics, to screen stocks. If a stock you are considering does not meet the minimum threshold you’ve set for each of these measures then move on to evaluating other, more attractive investments. 

While I view these metrics as the most important, there are several other measures I use in analyzing the fundamentals of a stock I am considering. For example, I often favor dividend paying companies, so I will look at it’s historical dividend growth rate. To hopefully help make your life easier in evaluating stocks I have posted the Excel stock screener spreadsheet I’ve created myself here. There are also other good stock screener apps and programs that are freely available. However, I have yet to find a free one that includes all the financial metrics I track. If you know of one, please share 😊. 

While I cannot promise following this checklist will lead you to finding the next Amazon and generating a 1,000% return, following this approach will help make you a much more informed investor. And, that’s much better then the alternative.

Important Disclaimer: Before buying individual equities you should ask yourself – Am I willing to invest my time to do the research necessary to make an informed investment?  If the honest answer to this question currently is no, then it’s critically important to adopt an investment style that is suitable – in this scenario that would be the “Couch Potato Investor”.  There is absolutely no shame in adopting a couch potato strategy, only shame in losing all of your retirement cushion due to playing the stock market like it’s one big casino! 

The Importance of Mindset in Wealth Creation

"Think and Grow Rich" 

- Napoleon Hill, Best Selling Personal Development Author

We all have met those people who appear to be rich, but who in reality are living pay check to pay check. From the outside these high rollers seem wealthy, but the same fancy cars and clothes that create the perception of wealth are what is causing these high earners from accumulating and building true wealth.   

Some may know Mike Tyson today as the unlikely star of the Hangover trilogy, more importantly Mike Tyson had an illustrious boxing career in the 80’s and 90’s. Mike Tyson earned significant income over the course of his boxing career, and his net worth is reported to have peaked at an estimated $300-$400 million, certainly enough for his kids, grandkids and future generations to live amazingly comfortable lifestyles.  Why is then that in 2010 Mike Tyson reported that he was “totally broke”, basically living pay check to pay check to cover his monthly expenses?  Sure, the boxing icon has been marred by drug and alcohol problems, criminal indictment, hangers-on and boxing’s most preeminent and controversial promoters’ Don King; but Mike Tysons’ inability to turn the income he earned over his boxing career into sustainable wealth most likely comes down to his lack of financial planning and self-discipline.

Contrast Mike Tyson’s story with the template Magic Johnson has created for other pro athletes to follow in managing their money.  The hall of famer former Lakers point guard made an especially important financial decision early on in his career, admitting to himself he knew nothing about business.  That is why he solicited counsel from successful power brokers that used to sit courtside at the L.A. Forum.  Now he runs Magic Johnson Enterprises which has a net worth of $700M and interests in a promotional company, a nationwide chain of movie theaters and a movie studio; not to mention his ownership interest in the Los Angeles Dodgers.  

Unfortunately, there are far more Mike Tyson like stories than Magic Johnsons’ financial success story in the professional athlete universe.  Amazingly, over 78% of former NFL players have gone bankrupt or are under financial stress within two years after they stop playing and within five years of retirement.  An estimated 60% of former NBA players are broke.   ESPN even produced a 30 for 30 documentary about this unfortunate phenomenon called Broke. 

Are professional athletes that go broke so different than the average person that goes broke?  There are a lot of parallels. It is only the scale of the issues that are different.  So, we can learn a lot from these professional athletes to ensure we are translating the income we do earn into wealth that can give us the freedom to pursue our own, unique big-league dreams.

One of the primary reasons for far too many millionaire athletes ending up broke, revealed by the ESPN documentary Broke, was not taking accountability for their own financial well-being and trusting the wrong people to handle their financial affairs.  This is one definite parallel between the average investor and professional athletes, as many Canadians outsource their financial future to an unknown advisor.  Many people spend more time per year getting their hair cut than reviewing and maintaining their financial plan.  It’s amazing how little time we spend participating in the planning and ongoing management of something as fundamental to our well-being as our financial future, or how little time we spend vetting the professionals who are supposed to be the purveyors of this good fortune.

Financial advisors can add a lot of value to your financial success.  Just make sure you are diligent in your search and that you always remember: 

Nobody cares about your money and financial future as much as you do – nobody! Whether you decide to be a do-it-yourself investor or work with a financial advisor, if you want to build wealth it starts with you being the CEO of your financial freedom.

Building wealth starts with this mindset of being the CEO of your investment portfolio.  It’s not rocket science, but there is a commitment required on your end to turn this mindset into practice.  In my humble opinion, financial freedom is very achievable for the average person if you are willing to commit to these eight disciplines:

1. Start now on the road to money mastery and become an apprentice, learning from the best
By learning the tools, strategies and skills needed for managing money as early in life as possible you will become wealthier, faster. You can further build your knowledge base in many ways (reading investment books, taking basic investor courses, joining investment clubs) and it should be done over time – don’t expect to learn everything you need to learn about successful investing in a few months.

2. Begin saving and investing as early as you can to benefit from the power of compounding
Albert Einstein famously once said “Compound interest is the greatest mathematical discovery of all time”, and you can put this powerful math concept to work for your wealth accumulation by starting to invest early in life, no matter how small your contributions may be.  Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal.

Consider two versions of your investor self – one who starts investing early in life and one who waits until later in life. If you invest $10,000 at age 25, assuming a return rate of 7%, the investment would be worth $150,000 at age 65.  Alternatively, getting a later start at age 35 would result in growing the initial $10,000 investment to only $76,000 by age 65. That 10-year head start provides more than a doubling compounding effect on your principal investment– that’s a lot of cheeseburgers in retirement.  Time is a huge multiplier and financial lever. And, it’s never too late to get started.

3. Invest in yourself 
Your greatest source of income over the course of your life will be you and your career.  There is a high return on professional development investment you make in yourself.  Investing in yourself and your career offers income expansion, which can be leveraged to invest in your financial future.

4. Live within your means
This does not necessarily mean that you need to sacrifice your enjoyment of life. As outlined here, there are money saving practices that can be used without feeling any real squeeze. It is the difference between being cheap and being frugal.  What is needed is to be more strategic and frugal in your spending, while allocating a set percentage of your income automatically into an investment account.  This savings allocation will grow as your income inevitably increases as your career progresses over the years.

5. Invest within your limits  

Investing within your limits doesn’t just apply to how much money you invest, as it goes without saying you shouldn’t over extend yourself financially to invest in the stock market.  Equally important is to invest within the limits of your current investing knowledge base.  Although stocks can offer some of the best upside, it’s like playing Russian roulette with your financial future if you don’t know anything about investing in the stock market or why you are buying a stock.  If you aren’t interested in investing your time to learn more about the stock market currently, that’s totally understandable – there many more fun things in life to do.  However, you can still benefit from the capital growth benefits of the stock market and minimize your risk while doing it safely with Exchange Traded Funds (ETFs) and working with a financial advisor.  

6. Be disciplined  

Stick to safe and proven investment strategies, don’t be lured by making a fast buck by investing blindly in a “can’t miss stock” your friend tells you about over a latte.  

Be disciplined in your investing style, don’t let emotion play into your investment decisions.  Never buy on rumor, do your own research.    

7. Take the long-term view  

Investing for the long term, versus short term trading, will let you ride out the unavoidable ups and downs of the market, stabilizing your average returns and mitigating the loss of capital.  

As we lengthen our investment horizon, the average annual rate of return over that timeline becomes less variable. Financial service provider Schwab.com studied the highest return, lowest return and average annual return of the S&P 500 over various holding periods from 1926. They found that as you move from a one-year holding period to a three-year, 10-year, and finally to a 20-year holding period, the number of negative returns experienced goes down. In fact, there’s never been a 20-year period with a negative return.

This means that the longer your time in the market, the more likely you’ll receive the long-term average annual rate of return.  Sure, investing in the stock market carries some risk, but by extending your time horizon as an investor you’re lowering this risk while stabilizing your likely return.  

8. Set Your Financial Goals 

Having clear financial goals is critical to keeping you motivated and committed long term to your plan for financial freedom. If they are going to truly motivate you, to cause you to stay on course with your savings goals and building your investor knowledge base, it’s critical you go beyond vague goals like – “I want to be a millionaire”.  It must touch on that life aspiration or human emotion that can motivate you, over the course of your working life, to go into overdrive in pursuit of an important goal.  For me, it includes securing financial freedom in life to pursue the sort of work that inspires and fulfills me, while providing an enriching life for my family.  Whatever financial freedom would inspire you to do – be it pursue advanced education, volunteer, travel the world, philanthropy, leave a financial legacy for your kids; choose your wealth goals carefully.  They are your goals and will help to keep you motivated on the journey.

Top Money Saving Tips for Wealth Creation

Most people don't get excited about saving money. But, for one of the world's wealthiest people, Warren Buffett, I suspect it brings him a lot of satisfaction. We all know Warren Buffet as the "Oracle of Omaha", a legend in the investing world. What most people don't know is that he is also legendarily frugal. He loves the simple things in life, such as McDonald's hamburgers and Oreo's. In fact, he still lives in the Omaha, Nebraska home that he bought in the 1950's for $31,500.  Check out more of his frugal quirks here.

So what does Warren Buffett know that most of us don't.  I would argue it's his understanding that personal savings is a cornerstone of any realistic strategy to build wealth.   

While many believe to the contrary, the simple fact is that it is your personal savings rate—not your investment choices—that is the most important determinant in growing sustainable wealth over time 

And, the good news is that saving money doesn’t need to necessarily infringe on the enjoyment of your life.  In fact the top five tips I adopted into my life, as described below, did not have a material impact on my quality of life and they netted me almost $5,000 in annual savings.

1. Use your company’s group insurance provider: Many of us will work for organizations that negotiate, on behalf of their employees, group insurance rates that are more competitive than rates you would be able to negotiate on your own.  Take advantage of these lower group rates for your home and automobile insurance needs.  I did, it took me one phone call and signing a couple forms, and it saved me $600 a year as compared to what I was paying with my previous provider.  So simple, yet so impactful. 
2. Consider switching to a variable mortgage rate: One of the most commonly debated personal financial decisions an individual can make when shopping for a new home is whether to opt for a fixed or variable rate mortgage.  Like many first time home buyers I opted for a five year fixed mortgage rate, which satisfied my conservative side by locking into a rate and having a “predictable” monthly mortgage payment.  I made this important decision without really investigating the variable rate mortgage option, which offers an interest rate that fluctuates with the lenders prime interest rate.  Had I analyzed more thoroughly, not only would I have saved a considerable amount of money over the course of my five year mortgage, but I would have debunked one of the more common myths associated with variable rates that prevent many from benefiting from the cost savings of a variable mortgage – that most variable mortgages keep your overall monthly mortgage payment amount the same during the term.  Most lenders will just adjust what amount is allocated to pay interest and what amount is allocated to pay down principal, if lenders prime interest rates fluctuate during the course of your mortgage term.  The potential for savings by choosing a variable mortgage rate over a fixed mortgage rate are real.  A study done by Dr. Moshe Milevsky, associate professor of finance, Schulich School of Business, York University, found that based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed rate. The average savings was $20,630 over 15 years per $100,000 borrowed (Source: http://www.milliondollarjourney.com/avoid-the-5-year-fixed-mortgage-trap.htm) 
3. Cut the cable chord and subscribe to Netflix: There is a movement afoot people that involves breaking the stranglehold the cable companies have had over our downtime for the last half century.  #cuttingthecord is about being an empowered consumer by cutting the cords of your cable box (i.e., cancelling your monthly cable service) and choosing to pay only for content and services that you want; not just watching what’s on TV based on the bundling of channels cable providers have put together to optimize their profits.  Cutting the cable chord does not mean depriving yourself of entertaining content, quite the contrary.  There are many incredibly compelling alternatives to cable that have emerged over the last few years from Netflix to Google Chromecast, Amazon Fire TV, mlb.com and NHL Game Center.  Join the movement, cut your cords and watch your content on your terms, while putting savings in your pocket each month. 
4. Give up your traditional phone line in favour of keeping just your mobile phone and Skype for long distance: While I can still remember the phone number of the house I grew up in, my parent’s current home, I could not at the same time tell you the phone number of the last land line I had.  That tells you a little about the gap between younger generations and the baby boomers, but it also serves as a good reminder of the fleeting relevance of a traditional phone line.  Like the cable industry, the telecom industry is undergoing a transformation with more and more customers cutting their traditional phone line and opting to rely solely on their unlimited mobile phone plans for local calls and Skype, Facetime or some alternative for long-distance calls.  
5. Stop using your debit card in favor of your credit card for your purchases:  This only applies for those that can stick to using a credit card only for stuff they would buy anyway and never carry a balance on the card. In addition to the savings on debit fees for each transaction, you can redeem the reward points you accumulate with each purchase on your rewards credit card trips, consumer goods or in some cases cash.  Some estimates suggest $1,000+ in rewards is possible, especially for middle income families.  Most of these reward based credit cards also offer excellent insurance coverage, and zero liability on fraud protection. If you lose your card or it’s stolen, you are protected on any future purchases. If you lose cash or it’s stolen, well, it’s gone.

If some of the above saving tips don’t appeal or work for you, there are many other tips plastered all over the internet – from breaking your daily specialty coffee habit, to using programmable thermostats to conserve on energy to using no-frills banks or discount brokerage. 

So, get excited about saving money. And, don't let anyone tell you that you are being cheap, it's called being frugal. Just tell them Warren does it. 

What are your top money saving tips? Share in the comment box.