Checklists and Questions
This is from the Wayback Machine as part of this article have been written over the past decade or so.
I get a lot of questions about how to evaluate stocks and what measures and tools should be used.
This wraps up a lot of those questions.
Don't read this document unless you are willing to buckle down and explore the nuts and bolts of small-cap deep-value investing.
Over the past three decades, I have spent hundreds, if not thousands, of hours exploring the methods top investors have used to produce high returns. I have read groundbreaking academic studies (along with the very boring ones) in search of the tools needed to produce market-beating, wealth-building returns.
This document contains everything I've learned about small-cap value investing over the years -- the tools I use, the techniques I like, and how I use them together to find stocks with the potential to provide long-term returns that are measured in multiples.
It is a lot to think about and a lot of work to do, so be prepared before you dive in!
Wall Street's favorite message for individual investors is that the financial markets are too complicated, so most people should leave the complex investing stuff to the professionals. For a small fee, they say, we will take care of everything, so you don't have to concern yourself with all these fancy formulas and complex research.
Unfortunately, many people buy into that mystique, handing over their hard-earned money to pay for the beautiful office buildings and huge bonuses that most Wall Street firms pay their people as a result of all those "small" fees. The truth is you can do it all yourself, and you'll probably do a better job than these "pros," especially when it comes to small-cap deep value investing.
I am not going to tell you that this system is really easy or doesn't take a good deal of time. I will tell you that it is not as complicated as you may have been led to believe, and it can be done as long as you have knowledge of basic math, a familiarity with basic accounting measures, and are willing to put in the time.
We start with a good stock screener to uncover a list of candidates. We want to look for non-financial companies that trade at low multiples of Enterprise Value to Earnings before Interest and Taxes and financial companies that trade below book value. Research and experience have taught me that these are the measures that work best when evaluating small companies.
The enterprise value (EV) in the ratio includes both the market capitalization and the company's debt. It provides a more holistic view of the company's overall worth.
Unlike market cap, which only considers equity, EV accounts for the entire capital structure, including debt and cash.
EBIT is less susceptible to manipulation than net income (NI) because it excludes tax effects.
By using EBIT, the ratio normalizes for differences in tax rates across companies.
It is also the method that many of the most successful potential acquirers use, including many private equity analysts.
The reason for tangible book value with financial companies is similar.
It is the measure potential buyers of a small banks and insurance companies will use to make pricing decisions.
Once we have a list, our job becomes taking out the trash. We want to eliminate all those companies with weak financials, declining prospects, bad management, too much debt, or any other characteristics of a bad business that can destroy wealth.
Clifford Asness is one of the best-known quantitative investors. He has become a billionaire by managing money using his academically based findings at AQR Asset Management. AQR does not evaluate companies in the traditional manner but relies on historical data analysis to discover which characteristics lead to market-beating returns. Asness recently examined the idea of small-cap investing and found that taking out the trash was the key to success in small-cap investing.
In his 2014 study, "Size Matters If You Control Your Junk," Asness concluded:
"A significant size premium emerges, which is stable through time, robust to the specification, more consistent across seasons and markets, not concentrated in micro caps, robust to non-price based measures of size, and not captured by an illiquidity premium. Controlling for quality/junk also explains interactions between size and other return characteristics such as value and momentum."
Taking out the trash gets rid of the high-risk companies and leaves us with a pool of companies with the characteristics that historically lead to higher returns.
The Piotroski F-score
Joseph Piotroski is a professor at Stanford University who focuses on financial reporting issues. He examines things like how investors use accounting issues for valuation and risk measurement, as well as how politics, legal and regulatory issues, and the decisions of financial institutions affect the capital markets.
As an assistant professor at the University of Chicago in 2002, Piotroski wrote the paper "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers," which explored the value of "taking out the trash." He found that just 44% of all deep-value stocks had positive returns in the two years following purchase.
He took it a step further and developed a nine-point model to help measure financial strength using common balance sheet measures found in the quarterly reports that companies must file with the SEC. Four of the nine points measure profitability, three evaluate liquidity, leverage levels, and capital structure, and the final two help measure a company's operating efficiency. Each measure is worth one point to a company that passes that particular measure. The more points a company has, the stronger its conditions and prospects are at a given moment in time.
The Altman Z-score
The Z-score is also useful when considering non-financial companies that have some debt on the books. The Altman Z-score uses elements of the financial statement to determine the likelihood of a company experiencing serious financial difficulty over the next few years.
It was developed by Professor Edward Altman of New York University, one of the world's leading experts on distressed securities. It has been used to measure the viability of corporations for 50 years now. The Z-score is used by bankers, credit analysts, and equity analysts to identify companies that may experience financial distress. There have been several studies that show that higher Z-scores lead to higher performance and that companies with lower scores often see their stock underperform the indexes by a significant amount.
The formula uses five factors from the income statement and balance sheet:
A. Working Capital / Total Assets
B. Retained Earnings / Total Assets
C. Earnings Before Interest and Taxes / Total Assets
D. Market Value of Equity / Total Liabilities
E. Net Sales / Total Assets
Once we have these numbers, the formula for calculating the Z-score using the five factors is:
(1.2 x A) + (1.4X B) + (3.3x C)+ (0.6 x D) +(1 X E) = Z score
The resulting answer can then be used to determine the financial quality of the company.
Originally, the scores were interpreted based on a scale developed by Mr. Altman:
Z > 2.99 — Safe Zone — There is no risk of the company suffering severe financial distress.
1.81 between 2.99 — Gray Zone — There is some risk of financial distress.
Z < 1.81 — Distress Zone — Dead man walking.
In an interview with the CFA Institute, Altman said that the absolute score model was no longer the best way to apply the Z-score model. Since he first developed the Z-score tool, the cost of debt has fallen, and debt financing is far more prevalent around the world.
He told the institute, "In order to modernize the model, we needed bond-rating equivalence of the scores, which changes constantly and adds on an updated nature to the interpretations of the scores."
He suggested that the average credit rating around the world was a B rating from the major agencies, and that equates to a ratio of about 1.6. An A rating works out to an F-score of about 4, while the much coveted and rarely awarded AAA credit rating requires an F-score of about five right now.
Let's take a quick look at what happens when we take out the trash: The universe of several thousand small-cap companies is narrowed down to less than 200 most of the time.
Near the bottom of a really bad market, you might get many more non-financial companies with high F and Z scores that trade at low multiples as a falling market leads to a larger pool of undervalued stocks, but most of the time, over the last 25 years or so the average has been less than 50 small companies that have strong financials.
Taking out the trash leads to an outperformance of 6.6 to 1 over the market index.
That's before we apply any of the more qualitative measures we will also use to narrow the universe of companies down to 25 or 30 stocks; I think they have the social and demographic tailwinds that can help them outperform the rest.
When it comes to financial stocks, we use a few different measures.
I consider the equity-to-assets ratio to be the most important. This is total assets divided by the total equity of the institution, which gives us some idea of how much leverage they are using to run the business.
Banks and insurance companies are leveraged by the very nature of the business, but there is such a thing as too much of a good thing. I have a strong preference for financial companies with an equity-to-asset ratio of more than 10. That's enough leverage to run the business but not enough to blow up the world like we saw back in 2008 when many of the biggest banks had equity-to-asset ratios of 5 or less.
Just using this simple measure to find the winners in financial stocks can also lead to some dramatic returns. A universe of financial companies with equity-to-asset ratios over ten that also trade below tangible book value returns more than 14 times the compounded results from the S&P 500.
That's before we look at things like loan portfolio quality, insurance underwriting losses, and other measures of quality used to evaluate financial stocks.
It is important to understand that most small stocks underperform the S&P 500 and other large-cap indexes. The outperformance of small stocks occurs when we do a good job of taking out the trash and then buying out of the universe of financially solid companies that can be purchased at bargain multiples of assets and earnings.
Sorting the Winners
Now, it is time to grab a cup of coffee and do some thinking about the companies that remain.
We want to know more about each of them. What they do, where they are located, who the management teams are, and the history of each company. We want to consider what can go wrong and what can go right for each company on the list. We want to discover everything we can and limit ourselves to those that are in great financial shape and have some economic, demographic, and social tailwinds in place that can help drive the stock higher in the years ahead.
The best way to evaluate the companies that remain is going to be a checklist.
You will also need access to the company's last 10K, annual report, annual proxy, and most recent 10K filed with the SEC, as well as the one from the previous year. I highly suggest using a laptop or tablet as opposed to printing everything out unless you love being buried in paper.
The first part of the checklist is the nine points of the Piotroski F-score. Completing the comparisons and calculations of these nine questions will give you more information about a given company than many mutual fund managers have before they make buy and sell decisions. This is a critical first step, a high-level overview of the company.
Once that is done, let's move on to the next part of our checklist.
1. What does this company make or provide its customers? This is going to knock out several companies right off the bat. If it makes CDs and DVDs, for instance, it probably does not have a bright future, even if it has excellent F and Z scores. That market has matured and begun to decline. Be specific and go in depth. It is not enough to know that a company makes semiconductors. You need to know what its semiconductors are used for and which industries will use them.
2. Who does this company sell to? This is an expansion of the first question, but you want to know who makes up the market. Does it sell to senior citizens? Millennials? Does it sell to auto manufacturers, or does it sell exclusively to the steel industry? Are its primary customers buggy whip manufacturers?
3. How does it sell its products and services? Is it a brick-and-mortar retailer? Does it sell online only? Does it have a direct sales force or use distributors?
4. Who are its competitors? Which companies sell the same goods or services? Is this company a David or a Goliath in the industry?
5. Where are its markets? Is it international or domestic only?
6. Is there room for geographic expansion? Can they expand to the next town, county, state, or even internationally to grow sales and earnings?
7. Are there any smaller companies in a similar business it can acquire to increase revenue and profit? Are these businesses in different geographic markets that give it instant expansion of the sales territory?
8. Who are its top executives? What are their backgrounds and experience?
9. What is the average age of the executive team members and board of directors? It may seem trivial, but this is actually a very important question. It has been my experience that a company with board members and executives nearing retirement is far more likely to be considering exit strategies like selling the company for the best possible price. Often, the insiders at smaller companies have a good deal of their net worth tied up in their company, and the easiest way to gain liquidity is via a sale. The best possible price is usually well above the current stock quote.
10. How much of a stake do officers and executives own? This is a big one for me. I like to see that the people running the company have the skin in the game. I want their goals on the upside to mirror mine, and I want them to feel the same financial pain I do if they screw up.
11. Have insiders been buying or selling shares? Sometimes, this isn't significant because insiders may be selling to meet a specific large financial need. However, when several are selling their shares at the same time, that can be a red flag. Optics and PR can play a role, but the majority of the time, there is only one reason for an insider to buy a significant amount of stock, and that's because they think the stock is going higher.
12. Is there an employee stock ownership plan? We see a lot of these with small banks and insurance companies. The knowledge that employees have skin in the game and the price of the stock will have a great deal of impact on the quality of their retirement tends to keep employees a little more focused and loyal.
13. What can go wrong? What mistakes can management make that will destroy the business? What is the likelihood they will do so?
14. How does management respond to difficulties? Pull up a long-term stock chart and look for times when the stock price took a sharp tumble. Now go to the SEC website and read the 10K for that year. What went wrong, and what did management do to fix the problem? Did the board step in and replace the managers who made the mistakes?
15. Does the business depend on commodity price levels for profit? This lesson was reinforced massively in 2013-2014. Stocks that seemed cheap were quickly exposed as the price of oil and other natural resources plunged. Earnings disappeared, and asset levels were written down to levels no one imagined. Companies that deal in natural resources are best purchased when shares seem cheap, and commodity prices are at a multi-year low.
16. Has the company made any acquisitions over the last ten years? Did the M&A activity add to the value of the business, or did they simply "de-worsify" the company? (This is a term invented by Peter Lynch to describe a company that expands into business lines that actually reduce returns and burn the cash generated by the profitable part of the business.)
For the next few questions, we will need long-term financial information. You could go back and compile it by hand using the last decade or so of 10K reports if you have an unlimited amount of time, but it's a lot more efficient to use financial sites on the web or Value Line and S&P reports to gather this data.
17. Does the company pay a dividend? How long has it paid it? Has it been rising or falling over the last decade?
18. Have the earnings before interest and taxes been growing over the past ten years? Is business steadily improving, or has it been two steps forward and three steps back for this business?
19. Are the annual EBIT results smooth or uneven in nature? It is OK if they are uneven as long as they are generally trending higher. Lumpier results are often preferable. Wall Street and institutional investors tend to overvalue even results and undervalue lumpier growth. You need to be sure you understand why they are lumpy.
20. How does the company use debt? Does it borrow money for expansion and then pay it off? Are debt levels generally higher or lower than they were five and ten years ago?
21. Are the earnings or EBIT numbers unusually large in the past year or two? Has there been some one-time event that makes the company look far more profitable than is actually the case?
22. Is the number of shares outstanding higher or lower than five and ten years ago? If it is higher, the company may be using dilutive equity offering to finance itself, and that destroys shareholder value. This may also be a sign of excessive stock-based compensation plans that subtract from the value of outside equity holders, something that you can sometimes find out about by reading the footnotes and proxy filings on executive compensations that companies release. (I told you this was a lot of detail work.)
23. Have revenues been growing over the past ten years? If not, why not?
24. Are reported earnings consistently higher than operating cash flows? If so, it is likely there are accounting shenanigans involved, and it's a huge red flag. Unless you can find an easily identifiable reason for this condition to exist, it is usually best to throw the idea of investing in the company into the trash pile.
25. Is tangible book value growing over time? Book value is the ultimate measure of growth. If the company is making money and management is reinvesting profits wisely, the net worth of the business should be increasing. If it is not, you need to know why before putting your money into the company.
26. Is the F-score rising or falling? A company that earns an F-score of 6 may appear to pass the trash test, but if the number was 9 two quarters ago, we need to know why the fundamentals of the company have deteriorated.
For the next two questions, we need to put on our futurist hat and think about where the world is going.
27. What social, economic, and demographic developments may provide tailwinds for this company? Will they benefit from the rise of robotics and Big Data? How will the rising role of drones impact this company? How does the aging of society affect its future? Will it benefit from the increased usage of renewable energy? Are there big-picture items that can help drive profits and growth rates higher than we can imagine in the future?
28. What can destroy this company? This is the most important question on the checklist. Is there a new product or technology on the horizon that can turn this into a buggy whip company? What could make this company obsolete/unnecessary in the future?
The original F-score calculation with these 28 questions gives you a powerful 37-point checklist to evaluate small-cap stocks. No company will have positive results on the entire checklist, but those that check off the majority of the list are going to be undervalued companies with strong management that are capable of delivering the type of extraordinary returns we are hoping to achieve.
It is somewhat time-consuming, but you will find that many companies are removed from consideration fairly early in the checklist process, so it is not as bad as it looks. You will also get a lot faster at checklist evaluation as time goes by.
Before we move away from the checklist, we have to talk about the two supplemental checklists that I use for financial stocks. There is one for banks and one for insurance companies, and I use them because these two industries have some unique characteristics and risk factors that need to be considered before investing.
Property and Casualty Insurance Companies
Insurance companies come with their own set of rules and, depending on the size and market they're in, can introduce both new risk factors and new opportunities.
The following checklist items are specific to Property and Casualty insurers and help me determine which ones are the strongest and most likely to make good investments. I've found Property and Casualty insurers, in particular, to be among the best candidates for investment.
Combined Ratio: The combined ratio is a measure of how well the company is underwriting policies and managing expenses. To calculate the ratio, add operating expenses and incurred losses and then divide by the earned premiums the company has reported. A ratio under 100 indicates the company is earning a profit from its daily operations before investment income is considered. A consistently high combined ratio is something of a red flag. Very few companies can keep the ratio under 100 every year, but being able to do so most of the time is a sign of strong management.
Reserve Accounts. Insurance companies set aside money each quarter to pay anticipated losses. Actuaries attempt to calculate the probability of losses and the amount of losses anticipated, and the money is set aside to pay claims. If a company is under reserve, there will be substantial reductions in earnings when losses in excess of reserves are incurred. Most companies include reserve and actual payout information in the 10K report filed each year with the SEC that will help determine how effectively the company has reserved for losses.
Investment Portfolio. Insurance companies have substantial investment accounts that they use to invest collected premiums. The premiums collected and not paid out in claims are called "float," and the returns on the float and reinvested profits are an important part of property and casualty insurance company earnings. Reviewing the 10K will help you determine how the company is investing its money and what type of return it's earning on those assets. Most companies have relatively conservative fixed-income accounts, but a few, like Berkshire Hathaway and Markel (MKL), have substantial equity holdings that have helped drive long-term returns.
Banks
Evaluating banks also has its own set of rules. Banks make their money by taking in deposits and lending to customers. It is important to track the quality and components of the loan portfolio to understand how much risk the bank is taking and how well paid it is for the risks. Growing losses in the loan portfolio could mean the institution is about to run into serious trouble.
1. Nonperforming loans are loans that are 90 days past due. They are either in default or very close to default. I track these closely. This is where any serious problems will first show up. I like this number to be under 2% of total loans, and I also consider the trends in nonperforming loans each quarter. I will also look at each classification of loans to see where the problems are developing.
2. Nonperforming assets. These are nonperforming loans plus properties acquired by foreclosure. I compare this to the total assets owned to find the NPA ratio. Again, I want to see a number under 2.5% and trending down.
3. Loan portfolio composition. Is the bank overloaded in any particular category? Are the riskier classifications, like construction and development or commercial and industrial loans, increasing faster than other types of loans? That could be a sign of management reaching for returns and adding risks it's not equipped to manage.
4. The efficiency ratio measures how well the bank is managed. The ratio is calculated by dividing the bank's noninterest expenses by its net income. Banks with lower ratios are making more than they are spending and controlling expenses in an efficient manner. Those with higher ratios are struggling to bring in enough income and need to do a better job of managing expenses. Banks that have higher efficiency ratios that trade at low valuations are more likely to seek a takeover or M&A partner.
No one company is going to look fantastic on every point on any of these checklists. What we are looking for here are companies that look good on most of the checklist points and that can be purchased at a bargain price.
Once we have used the checklists to identify those companies with the very best fundamentals and prospects, we can put together a portfolio that is capable of beating the market by a wide margin over time.
Standing on the Backs of Giants
Once we run the companies through the checklist process, there is one more factor we want to consider: We want to review the company's shareholder list to see which institutions own the stock.
While the larger institutions and hedge funds cannot invest in small stocks, there are some that specialize in small-cap deep-value investing, and it makes sense to track the buying and selling of those who have been successful in this segment of the market. There are also a handful of activist investors who track smaller stocks, and we want to follow them as well.
Tracking these investors can confirm our research. It can also be a valuable source of new ideas.
I read 13D and 13G filings every day to see if the more successful small-cap investors are buying stocks I own. I also use these filings, as well as the quarterly 13F filings that reveal the full holdings of money managers and hedge funds, as an additional source of ideas. My screening process is pretty thorough, but if I see that investors with an outstanding track record are buying a particular small-cap company, I am going to investigate further.
Smart money buying is not the end-all and be-all of investing, but it does act as a powerful confirmation factor and a potential source of profitable ideas.
Private equity funds are also must-follow sources of ideas, and they're a welcome presence on the shareholder lists of our stocks. They have the same focus on value and a very similar timeframe to me when they invest. Most of them do invest in public companies, and while some are not small-cap stocks, many are. There is also valuable information about potentially over- or undervalued sectors and asset classes to be found in private equity buying and selling.
I track Apollo Global, Leonard Green and Company, KKR, The Carlyle Group, and Blackstone every quarter to see what private equity firms are buying and selling right now.
As I said at the top, winning with a small cap deep value strategy is possible, but it is not easy and does take a fair amount of time.
Your first review of the company is going to take a long time, and you will get frustrated. Over time, you will get faster.
After decades of reviewing small-cap companies, I can go through a stack of companies in a day and rather quickly get down to those worth buying, and eventually, you will get there as well, given enough time. Of course, since I am doing all the work for myself every day anyway, I am happy to share the results and identify those small-cap, deep-value companies that I think will be outstanding long-term investments.