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A Prudent Stock Market Investor's Checklist: Navigating the Four Pillars of Fragility
In my previous posts in the fragility series which can be found here Fragility Analysis | Budget Tiger (budgetiger.in), we have explored the four fundamental pillars of fragility which an investor needs to be aware of to eliminate fragility in their portfolio:
Avoid investing in Fragile Companies
Avoid investing in Overvalued Companies
Avoid investing in Companies having Management with fragile mindset
Avoiding Shorter timeframes
By following the above four pillars, we can reduce the impact of bad news and let good news do its magic for our portfolio.
In this post I have provided a consolidated checklist covering various aspects of all the above four pillars for enabling an investor to eliminate fragility in their investments.
Understanding the Role of Checklists
In the world of investing, as in many aspects of life, the power of simplicity should never be underestimated. This is where a checklist comes into play. A checklist is a curated list of essential tasks, designed to ensure that we do not overlook crucial steps. It helps to turn broad, overarching principles into tangible, actionable steps.
Checklists have gained popularity in a wide array of fields, from aviation to medicine to investing, due to their ability to streamline complex processes and minimize errors. They act as a valuable tool to keep us focused and structured in our approach, ensuring that we follow consistent, disciplined steps in decision making.
Importance of a Checklist in Investing
In investing, a checklist plays an indispensable role. The investing landscape is vast and often filled with noise - countless companies to evaluate, numerous financial metrics to consider, and a constant stream of market news and events. A well-crafted checklist helps investors navigate this landscape with ease, breaking down complex investment decision-making into a series of structured, manageable steps.
Moreover, a checklist acts as a guard against potential pitfalls such as emotional decisions, biases, and impulsive behavior. It encourages a systematic, rational approach that aligns with one's investment principles and objectives, serving as a compass during both calm and stormy market conditions.
Utilizing the Checklist Effectively
Every time you consider a potential investment, go through each item on your checklist. Take your time, perform due diligence, and make sure you are comfortable with each aspect. If a potential investment doesn't satisfy all items, it may not align with your investing principles, and it might be wise to consider other opportunities.
In short, a checklist should not be seen as a shortcut or a strict set of rules. Instead, it should be considered a tool to facilitate disciplined and well-informed investment decisions. It fosters an environment of systematic analysis, reducing the chances of missed or hasty decisions that could lead to potentially unsound investments.
Remember, the ultimate goal of investing is not merely to chase returns, but to build a portfolio that aligns with your principles, risk tolerance, and long-term financial goals. A well-structured checklist can be your trusted ally in this rewarding journey.
In our exploration of the investing landscape, let's distil the four fundamental pillars of fragility into a practical checklist.
Pillar 1: Avoid Investing in Fragile Companies
Is Equity as a % of Balance sheet size more than 65%? (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates the company’s balance sheet is healthy as the company has limited obligations
Is Breakeven sales as a % of Actual Sales less than 28%? (indicates the percentile is in top 60 percentiles of all listed companies) - Lower percentage indicates the company’s Profit & Loss statement is healthy as the company has flexibility to experiment
Is ROCE more than 13%? (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates that there is some inherent strength in the business model of the company
Is Cash Flow from Operations as a Multiple of Yearly Debt Obligations Plus Depreciation more than 1.1x? (indicates the percentile is in top 60 percentiles of all listed companies) - Higher percentage indicates the company’s cash flows are healthy as the company is generated adequate surplus cash flows which will enable it to experiment or share it with shareholders
Is the company in a growing/ mature industry and not in a declining industry?
Have the company’s sales and profits grown in the past 5 to 10 years? (decline in sales and profits for a brief period of say 1 or 2 years is forgivable considering the same may be attributable to randomness/luck/cyclicity or whatever we call it)
Pillar 2: Avoid Investing in Overvalued Companies
Examine the valuation metric Price-to-Earnings (P/E) and get convinced that it is not too high? (higher P/E implies that the company is assumed to deliver high growth rates which makes our investment fragile as valuations get corrected if the company does not meet the required growth expectations. Achieving lower growth rates are always easier than higher growth rates )
Have I examined the PEG ratio based on the last 5 years growth rate in earnings? (ratio of less than 1 is considered favourable)
Have I examined the PEG ratio based on the last 20 years growth rate in earnings? (ratio of less than 1 is considered favourable)
Have I examined the PEG ratio based on the future 5 to 10 years growth rate in earnings? (ratio of less than 1 is considered favourable)
Is the company PEG -ve? (-ve PEG indicates that the earnings of the company are declining. It is suggestable to avoid such companies unless the decline in earnings is temporary)
Pillar 3: Avoid Investing in Management with Fragile Mindset
Whether Management used external funding like equity instead of Debt for growth in the past? (same can be analyzed through cash flow statements)
Whether Management built/maintained adequate cash reserves for rainy days with surplus cash flows generated from operations?
Whether management after maintaining adequate cash reserves distributed/shared surplus cash generated from operations with shareholders in the form of dividends or buyback?
In investor concalls, annual reports and media interviews, management should not be giving any importance to share price? (If managements focus is on long term growth rather than short term stock price valuations, then it indicates that management has long term perspective)
Whether Management has a frugal mindset? (Management should not be spending in swanky offices or unnecessary expenses which may not be required for business. Spending Patterns in personal life of Management can also be observed)
Management should not have inclination for taking Debt
Shares of Promoters should not be pledged (Borrowing against pledge of shares is the extreme case of borrowing and generally used as a last resort for borrowing when all other options are closed)
Salary paid to promoters as a % of Sales should not be high
No major related party transactions
Promoters have not issued warrants for themselves at much lower price than market price
Company should not be paying royalty to group companies/ related parties
Google search with Management and/or company name along with keywords like fraud, legal disputes, SEBI, etc should not reveal any adverse findings
Promoters having skin in the game is desirable (A Promoter who has majority shareholding in a company and the shareholding contributes to the majority portion of networth of the Promoter has lot of skin in the game as compared to a promoter who has less than 50% holding in a company and also the shareholding contributes to only a small portion of net worth. A Promoter who has more skin in the game has more incentive to ensure that the company performs well)
Pillar 4: Giving Time for Our Investments
Have I invested funds that I won't need in the short-term, allowing my investments to weather market volatility?
Am I prepared to remain patient during market downturns, understanding that drawdowns are temporary and can potentially be followed by recoveries?
Am I committed to staying invested for an extended period (5 to 10 years or more), giving my investments the time they need to potentially reap benefits?
Do I have adequate contingency funds so that I need not dip in my equity investments in the time of need - (This is to avoid dipping into equity investments during bear market phase)
This checklist is more than a mere list of to-dos. It's a blueprint for investing style wherein we reduce the impact of bad news on our portfolio and let good news do its work for our portfolio. This is an approach to creating a portfolio that eliminates fragility and is as antifragile as it is rewarding. Remember, the key to success in investing lies in our approach, not in the whims and fluctuations of the market. Let's craft our investing strategy with a commitment to these four pillars, and navigate the investing journey with confidence and serenity.
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