I'm still trying to introduce the ideas behind value investing, so these 6 steps are very general. In future posts I will go into more detail on each and every step, so don't worry.
Big picture first, then details. Remember, in the most basic sense we are trying to by anything something that is worth $1 for $0.66. It can be stocks, corporate debt, etc. This list is mostly directed at stocks (equities), but some tweaking can help with other securities.
Enough blabbing, onto the list:
Step 1: Identify Potential/Create a List of Potentially Undervalued Stocks
- Look at ‘daily/weekly low’ lists in Wall Street Journal, Investor’s Business Daily, Financial Times, other newspapers, internet sources such as Barron’s.
- Financially distressed/bankrupt securities (note, this takes more extensive knowledge)
- Other special situations such as spin-offs (what's a spin-off?)
Step 2: Evaluate the Balance Sheet/Foundation (look for red flags)
- The balance sheet shows the financial position/solvency of a company
- Gives an idea of actual worth, how much it owes, and what resources it has going forward
- Basically the same form filled in for a loan
- Make sure it’s not overburdened with debt
- Make sure has enough capital to stay in business during bad times
Step 3: Evaluating Earnings Power/Prospects (lifeblood of company)
- Use “normal”/adjusted earnings for all these calculations – not simply last years net income
- Adjusted means you remove non cash items (e.g. depreciation), non-recurring/extraordinary items (e.g. large one time write-off), etc
- When we say adjusted earnings, we basically mean free cash flow (money that is available to shareholders basically)
Step 4: Come Up With Questions to Understand Competitive Position & Growth Prospects
- I'm going to do a detailed post on this soon, so for now I'll leave it at that
Step 5: Step 5: Get Info Through the “Scuttlebutt” Method (from Phil Fisher)
- "Scuttlebutt" is basically Fisher's way for saying you need to ask important questions to customers, suppliers, employees (& ex-employees), management, competitors, and anyone else who understands the company/industry and may have insights
- One of Fisher’s favourite questions for top executives: "What do you consider to be the most important long-range problem facing your company?"
"Why Buffett Loves Investing in Insurance Companies" (everything from auto insurance (GEICO was a dear of his) to MASSIVE reinsurance (reinsurance = insurance that is purchased by an insurance company (insurer) from another insurance company (re-insurer)) deals)
"Understanding Student Loans and a Basic Analysis of Various Debt Instruments Available to You" (I see too many students on campus with a student loan of more than $100,000! The worst part is they don't know the details of that debt ... if ignorance is bliss, then bliss is expensive!)