Monday, November 27, 2006

My rules for investing

Here is my list of rules for buying stocks. These will probably evolve with time. I will refrain from investing in any company which fails ANY of these rules. If a company passes these tests then I will buy it if it well priced compared to my personal valuation models.

1) I understand the business reasonably well. I know where profits come from and what drives earnings growth.

2) The company has little to no risk of failure.

3) The company has stable postive earnings and decent earnings growth over long periods of time, say 10 years.

4) The company's earnings growth is sustainable. It's growth is fed by high returns on equity. ROE > 15, minimum, preferably much higher.

5) This high ROE is maintained by some apparent competitive advantage.

6) The company has low or no debt or at least high interest coverage for it's level of earnings volatility. This should be reflected in low leverage and high ROA and ROIC. Shows strong financial strength.

7) The company produces free cash flow and/or dividends.

8) The company is well managed. Management hold shares in the comany and act rationaly as owners.

9) The company returns excess cash to shareholders though dividends or buybacks. Exceptions are when company can reinvest in the business as very high ROIC.

10) The company has a good long term outlook. There is no chance of becoming obsolete by new technology or fundamental changes is the world economy. It is poised to benefit from important megatrends of our time: ie globalization, demographics. Macro ideas may enter here but should not dominate other factors.

11) The company is not burdened by organized labor or unfunded pension liabilities or any other off balance sheet items
including major lawsuits.

12) The company's earnings are not heavily regulated by the government.

13) Insiders are buying or some Superinvestor is buying or I am just VERY confident about the stock.

14) The company can be purchased at a good price (see "Stock Valuation" post).