For most of the retail investors, investing in few and diversified mutual and index funds will provide a good long-term return. That approach will require a minimum time and effort from an individual investor and should achieve a satisfactory capital growth if the investments are held for a long-term.
However, if you do want to carry out your own stock picking to achieve a market-beating return, then an investor should have his or her own checklist before purchasing any stock.
I have created my own investment checklist and will go through each of the main components in the detail. This is not a final checklist and I am always trying to find other indicators that will help me to choose a better investment.
1) Return On Capital Employed (ROCE) to be at least between 15-20%, averaged for the past 5 years
ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. Higher the number, better its profitability. In a current low-interest environment, where average return on a saving account or from a government bond is yielding 2-3%, I am looking for a company which provides a good return (15 to 20%) compared to the safe but low return from government bond.
ROCE number can be calculated using a company's financial reports or can be obtained easy from websites such as MorningStar.com.
2) No debt or low debt: net gearing is not more than 20%
In an ideal investment, I'm looking for a company which doesn't have any outstanding net debt. However, for a time to time, a company may borrow capital to finance an acquisition or to finance an expansion project.
I like to see a gearing ratio, which is a ratio of owner's equity to borrowed funds, not more than 20%, as this will give enough capacity for a company to service its debt obligation in severe economic conditions. You can also use Free cash flow to debt ratio to determine the company's capabilities to pay down its debt.
Net gearing ratios for Utility companies are generally higher due to the regulatory framework under which they operate and hence this rule doesn't apply to their valuations.
3) Company management does talk about their mistake
As companies are run by people and not by computers, it is normal for a management team to make a mistake running a company. This could be related to misallocation of capital to a failed project or an expansion or an issue with a business acquisition.
The management always has more information about the company than the investors. And, hence, the management can hide a previous or an ongoing issue to the public and it would be very difficult for an individual investor to find out about this issue until its too late. Hence, I would like to see an honest management team where they are not hesitant to admit their mistakes in annual reports, conference call or in other public forums.
4) Positive Free Cash Flow (FCF) for at least last 4 out of 5 years
In most of the companies, the net income doesn't normally equal to a free cash flow number. Therefore, positive FCF numbers for the past few years will indicate a company's strong ability to generate cash from its profit.
Ideally, a company should have a long history of free cash flow generation for 10 years and an ability to increase cash flow every year. However, it is possible that for a short-term, a company may spend cash generated within the business to expand its products or services and hence may have 1 or maximum 2 years of low or negative cash flow. But, in a long-term, the company's FCF capacity will determine its valuation.
5) What is an exit strategy?
It is very important for an investor to determine the holding period of a stock before he or she decides to buy it. If a company fulfils all of the above 4 criteria and an investor understands the company's competitive advantageous position in the sector, then the investment can be a part of the portfolio for a long-term (5 to 10 years).
However, if the company doesn't fulfil some of the above-mentioned criteria or it fails after a couple of years of holding period, then the investor will need to carry out in-depth valuation again and then to decide whether the company should be part of the portfolio or need to be sold.
Important Information: This is not an investment advice so you need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.