3 Criteria to Spot a Good Stock

As Peter Lynch, Warren Buffet, and others will tell you, a stock certificate is merely a piece of paper – but it represents an ownership stake in a business. Knowing this will go a long way to helping you understand how you should view investing.


Background Needed


Now, this article is not meant to be the be-all end-all in investing – I’m not qualified for that honor. However, it is something to get you thinking differently. Let me highlight something to show what I mean. If you were to buy a local business outright, and you were trying to value the business, how would you value it? of course you would answer me, “depends on the business.” Let’s say it is a well established business, either a popular pizzeria or a well-respected local IT shop.


You discover that the business cash flows $250,000 per year after salaries and expenses. And the business makes this money without day-to-day intervention of the owner, which is a good thing. Most buyers would value the business at 2.5-3.5x cash flow, or $625-825,000. With that said, think of the stock market, where BAD businesses often sell for over 10x’s cash flow and where people are willing to pay sometimes 100xs cash flow for the hope of some future growth.


And you rely  on management to run a pulic company; with a stock, you don’t even control how cash flow is used, what investments are chosen, who is hired – basically you’re paying MORE for a business with LESS control. So with that said, here are 3 criteria to start you out:


1. Management is aligned with, and thinks like owners


From what I have seen, most management takes care of themselves first, or at least their actions appear so. When they earn good cash flow, they often look to buy other companies at market peaks or they’re sucking 50% of net earnings in option grants, or they leave excessive amounts of cash on the balance sheet earning 2%. What they should be considering doing is making strategic acquisitions at market bottoms (like now), buying back stock (especially if return on equity or ROE is > 16%), or paying dividends. Typically, paying dividends is so dull that these Harvard MBA types that run companies spurn the idea and instead look for more “creative” ways to spend cash – this is unfortunate.


Look also for excessive stock options and pay – as I’ve joked about recently, we didn’t need to pay these high, Ivy-league salaries to blow up our biggest financial companies. These companies could have gotten someone with a high school diploma to do the same quality of “work” and saved some on the salaries. I remember once studying the merger documents of two tech companies- I was SO disgusted by the option pay that each CEO was getting, I threw the filing document out right there.


 2. Good Financials: The balance sheet, looks good and cash flow looks “free” and plentiful


Highly-indebted companies are to be avoided if possible. I’m sure there are exceptions, but some early “tuition” I paid to “Market University” was losing 100% of my investment in a cheese company growing at 50-70% year over year (YoY). That growth sounds good right? Well, short term debt was growing just as fast, as was accounts receivable. Eventually, the customers didn’t pay and I woke up with a bankrupt company – and with no warning I lost $1,308 dollars – all 100 shares were worthless! I was mesmerized by the growth and overlooked (on purpose) the balance sheet.


Cash flow – some companies, like Microsoft, generate tons of free cash flow – meaning cash flow after investing in R&D and certain other expenses. this cash flow is free for management to use as they see fit – and if they are aligned with the owners (you the shareholder) then they can pay dividends, buy back  stock, etc. (and Microsoft has done this in a big way). Some companies use almost all of their cash flow to reinvest in keeping revenue coming. If a company needs to reinvest most of its cash flow to just stay competitive, then this is useless in my eyes. The owners (you again) will never get anything from a company like this. Look at Oracle’s Statement of Cash Flows HERE. They are generating operating cash flow and apparently buying stock but their number of outstanding shares is still growing (see the number of outstanding shares on their balance sheet here – up over 20% from 2006-2007!).In my mind, this is not owner-friendly management of cash.


Bottom line on cash flow – some industries, once penetrated, require less cash flow investment to stay competitive and some require more. Technology companies can go either way (MSFT vs ORCL). You have to look – and if you’re too lazy then don’t be an investor (this is a common problem – average investors throw money at companies without knowing these things).


 3. There is a clear thesis of why the stock should appreciate


If you don’t have this then don’t bother. This could be for many reasons. For example, you have a slower-growing company, with revenue growth expected to be 9-10% annually, but the company is lowering costs, trades at a low multiple to cash flow, and is owner friendly (i.e.buying back shares). A company like this could theoretically buy back all its shares and go private in 10 years – not a bad thesis in my mind.


Another example – the company owns 30 stores and most of these stores are doing well in their market. Existing store sales continue to climb, and the company plans to open 5 new stores this year. Theoretically, if they open 5 new stores (16% more stores) and existing store sales grow 5%, this company could grow revenues 21% next year – not bad. If they are doing everything else well, you could have a company doubling its revenues (and profits- more if scaling) in 3 years or so.


However the company plans to execute, you should clearly see a probable path to an increasing business valuation. You can never be sure (all kinds of things can, and may go wrong), but you should have data that makes your thesis probable!


Being an educational site, I am not going to give you picks (I know you’re sad) – I hope you’re not that lazy! Go find companies in industries you understand that are owner friendly, have solid financials, and have a good reason that they will grow their business value. And let me know how you make out!

Chris Grande
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