Tim du Toit

Presents...
How to decrease the time you
research investments, make
less mistakes and increase
your returns in any type
market
31 Proven checklist items, questions and ratios that will increase your returns and
virtually eliminate investment mistakes in recessions, depressions and booms.
EuroShareLab
Table of Contents
ntroduction..........................................................................................................3
!E"E#$L...........................................................................................................%
s the dilution lower than 3&' ......................................................................%
s mana(ement)s shareholdin( * 1+&'.......................................................%
,oes the company have an enormous moat'............................................%
s the stock screamin( -cheap.'...................................................................%
s it a low risk business'................................................................................%
s there hi(h uncertainty'.............................................................................../
0hat are the 1uture (rowth prospects o1 the business'............................/
s it in my circle o1 competence'.................................................................../
s it a (ood business'...................................................................................../
s the company in a bubble industry or has there been a hu(e industry
tailwind'............................................................................................................/
2as the industry pro1ited 1rom a re(ulatory tailwind' ................................3
4$"$!E4E"5..................................................................................................3
0hat incentives does mana(ement have'..................................................3
2ow hi(h are the salaries o1 mana(ement'................................................3
,oes mana(ement make a solid impression' ...........................................3
s there heavy insider buyin( or sellin('......................................................3
"674E S5$5E4E"5......................................................................................8
s 1ree cash 1low per share hi(her than dividends paid'...........................8
$re there net share buybacks'.....................................................................8
,oes the company (enerate hi(h returns on capital' ..............................8
,oes the company pro1itably reinvest retained pro1its'.............................8
$re pre9ta: mar(ins hi(her than 1/&' .......................................................8
s there (rowth in earnin(s per share'.........................................................;
6$S2 <L70 S5$5E4E"5..............................................................................;
2ow capital intensive is the business'.........................................................;
s operatin( cash 1low hi(her than earnin(s per share' ...........................;
0here is 1ree cash 1low invested'................................................................;
=$L$"6E S2EE5..............................................................................................>
s total debt to equity less than 3/&'..........................................................>
s total debt less than book value' ..............................................................>
s lon( term debt less than ? : workin( capital' ........................................>
s the current asset ratio (reater than 1./' ................................................>
s the quick ratio (reater than 1' .................................................................>
s the $ltman @ Score * 3'..........................................................................1+
0hat is the 1low ratio A!ood B 1.?/, =ad * 3C'.........................................1+
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Introduction
0hat does your investment decision check9list look like' ,o you even have
one'
6heck9lists have been used with (reat success in the aviation industry since
their introduction in the Second 0orld 0ar by the D.S. $rmy $ir 6orps a1ter a
star aviator crashed a =918 bomber durin( its demonstration 1li(ht.
6heck9lists work best in a comple: environment where the per1ormin( o1 certain
steps is critical. n 1lyin( it is taken as a (iven that hi(hly trained pilots work
throu(h check9list 1or virtually every eventuality.
An aeroplane is a complex entity, and I want to arue, so is investin!
0hen evaluatin( a company there are so many 1actors that are beyond our
control. 2owever, throu(h empirical research, we know what increases the
probability o1 us makin( pro1itable investment decisions.
0hat is important is that we 1ocus on what we can control in our research and
analysis.
$s part o1 my evaluation process, work throu(h the 1ollowin( check9list. t
1orces me to be methodical, and to evaluate and analyse all items on the list.
have put this check9list to(ether over a period o1 more than ?+ years and o1ten
make chan(es to it as (ain new insi(ht or learn somethin( valuable.
2owever, do not have a 1ormula that i1 a company 1ails in terms o1 various
points on the check9list do not consider it worthwhile investment.
The check"list #ust ives me an indication of what problem areas are in the
company that may re$uire further research and analysis%
ur(e you to spend a 1ew minutes to read throu(h the list and then 1ormulate
your own check9list. t will de1initely make you a better investor.
$lso please let me know i1 you have any additional points should add to the list
by sendin( me an e9mail at tdutoitEeurosharelab.com
Fours in investin(
5im du 5oit
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&'(')A*
s the dilution lower than 3&'
AA,iluted number o1 shares in issue G actual shares in issueC H actual number o1
shares in issueC
Some companies hand out really e:cessive amount o1 options to mana(ement
and that dilutes the returns o1 e:istin( shareholders. 5he optimal situation is
where mana(ement spends its own money to buy shares in the company as
that would ali(n their interests per1ectly with shareholders, but that is
un1ortunately very seldom the case.
look at this number Iust to (et an idea o1 what the dilutions in the company are,
but there is really no hard or 1ast rule here. 1 it is more than 3& usually
investi(ate 1urther.
s mana(ement)s shareholdin( * 1+&'
like to see a substantial commitment by mana(ement in terms o1 shareholdin(
when invest. Should mana(ement not have a substantial percenta(e
shareholdin(, or at least a substantial amount o1 money invested in the
company, it will make me think twice be1ore investin(.
,oes the company have an enormous moat'
5his is another question can only have come about as a result o1 readin( the
writin(s o1 0arren =u11et. Should a business not have a moat, or the moat is
deterioratin(, as in the case o1 newspaper companies at the moment, will be
care1ul be1ore investin(.
s the stock screamin( -cheap.'
5his is usually an easy question to answer because there are a 1ew basic
valuation measures that look at, includin( the 1ollowin(J
K price to earnin(s ratio
K price to book ratio
K dividend yield
K price to 1ree cash 1low
K price to sales ratio
Lust by e:aminin( these indicators you can usually quickly decide i1 the
companies are screamin( -cheap.. Should this be the case usually overlook a
1ew other thin(s such as lower mana(ement percenta(e shareholdin( and one9
sided compensation arran(ements.
s it a low risk business'
5his is Iust a question ask mysel1 to determine the nature o1 the business o1
the company. 7bviously i1 it is a hi(h risk business will invest less than, 1or
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e:ample, a utility where the business is very stable and low risk. 5his may also
be one o1 the reasons why the company)s share price is ine:pensive, but at
least askin( the question makes me more aware o1 the company)s business
risk.
s there hi(h uncertainty'
5his item can relate either to the company or the industry it operates in. t)s a
similar question to the one be1ore and it may seem completely redundant but it
de1initely is not. Dsually hi(her uncertainty means the company will be
ine:pensive.
$n e:ample o1 a hi(h uncertainty situation was the home buildin( companies in
$merica shortly a1ter the property bubble burst. 5he companies all appeared
cheap compared with past earnin(s but i1 you consider the uncertainty around
the number o1 houses to be built in the ne:t 1ew years it would probably not be a
wise investment.
0hat are the 1uture (rowth prospects o1 the business'
ask this question to (ive me an idea o1 where the company, as well as its
industry, is movin(. 1 it)s a low or no (rowth industry, am not averse to buyin(
but usually have a look to make sure that no (rowth proIections are included in
my investment decision.
s it in my circle o1 competence'
5his question could only have come 1rom 0arren =u11et. use it to determine i1
really know enou(h about the business the company is in so that have a
reasonable possibility o1 analysin( the company and makin( a sound
investment decision.
1 my answer to that question is no, may use this opportunity to (et to know a
new industry in order be able to invest in it in 1uture.
s it a (ood business'
use this question to make a quick Iud(ement as to whether it is a hi(hly
pro1itable business with low amounts o1 debt and hi(h mar(ins. Should this not
be the case have to make a decision i1 am (oin( to invest based on other
metrics, such as a low price to book value.
s the company in a bubble industry or has there been a hu(e
industry tailwind'
5his question is used to determine i1 the current and past 1ew years earnin(s
my not be in1lated. Should this be the case, normal pro1its will be lower and the
company will be overvalued in spite o1 appearin( attractive.
$ (ood e:ample will be the steel companies in ?++;. 2avin( pro1ited 1rom the
resource boom pro1its may not look the same (oin( 1orward.
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2as the industry pro1ited 1rom a re(ulatory tailwind'
=e care1ul o1 industries that bene1ited 1rom re(ulatory protection that may
disappear. 5he best e:ample was the airline industry in the DS$ that was quite
stable and pro1itable be1ore 7pen Skies a(reements in 1>8> or the brokera(e
business in London be1ore the =i( =an( dere(ulation o1 1inancial markets.
+A(A&'+'(T
0hat incentives does mana(ement have'
5his is Iust to (et a 1eel 1or how mana(ement is most likely to run the company.
$s human behavior is (reatly in1luenced by incentives this (ives me an idea as
to how the company will be mana(ed.
<or e:ample i1 mana(ement keeps on makin( acquisitions to make the
company as lar(e as possible )m usually care1ul as siMe does not mean a hi(h
return to shareholdersN it probably means less dividends as more cash will be
used 1or 1urther acquisitions.
2ow hi(h are the salaries o1 mana(ement'
usually have a quick look to compare the salaries o1 mana(ement with the siMe
o1 the company, and with the salaries o1 peer companies. 1 salaries are
e:cessive usually take a hard look at the company as it has to be e:ceptionally
cheap 1or me to invest in a company where mana(ement takes them bulk o1 the
income 1or themselves in terms o1 e:cessively hi(h salaries.
usually look at this indicator alon( with the percenta(e o1 shareholdin(
mana(ement under the company. <or e:ample, lar(e cash salaries with a low
percenta(e shareholdin( in the company would make me very uncom1ortable.
,oes mana(ement make a solid impression'
A7perators, capital allocators, inte(rityC
5his question doesn)t really have a de1initive answer in terms o1 the numbers G
it is based more on a 1eelin( (et a1ter readin( a 1ew yearOs annual reports.
0hat try to do is (et an idea i1 mana(ement 1ollows up on what they promised,
or i1 they Iust mention a new set o1 (oals in each set o1 annual reports. 5his is a
subIective impression you (et a1ter readin( about the company and its
mana(ement.
s there heavy insider buyin( or sellin('
5his (ives me an idea o1 the amount o1 insider transactions in the company.
7bviously heavy buyin( at the same time as )m thinkin( o1 investin( will be a
positiveN heavy insider sellin( will make me more care1ul o1 investin(.
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I(C,+' -TAT'+'(T
s 1ree cash 1low per share hi(her than dividends paid'
use this item to determine i1 the dividend the company pays is sustainable.
Should 1ree cash 1low per share be less than the dividend per share, and pro1its
don)t recover soon, the company will most likely have to reduce its dividend or
eliminate it completely.
$re there net share buybacks'
"et share buybacks mean that a company is buyin( back more shares than
what it is issuin(. n other words, the number o1 shares outstandin( is
decreasin(.
added this item to my check9list a1ter readin( a research study that 1ound that
companies that have net share buybacks in one year substantially outper1orm
the market in the 1ollowin( year, and also over two or three years. tOs a de1inite
plus in my evaluation.
,oes the company (enerate hi(h returns on capital'
APre9ta: pro1its H Atotal capital P lon(9term debtCC * 1/&
am attracted to companies that (enerate a hi(h return on capital.
Should this not be the case )m usually care1ul be1ore investin(, or the company
has to be e:tremely cheap.
,oes the company pro1itably reinvest retained pro1its'
5his an important question to ask, especially i1 the company does not return any
cash to its shareholders. n order to answer this question usually look at the
amount o1 pro1its reinvested in the business by mana(ement every year and
then compare the yearly operatin( pro1it mar(in and the net pro1it mar(in to
make sure they are not deterioratin(.
Should there be a trend where mana(ement keeps on investin( in the business
but mar(ins continue to (o down )m very care1ul be1ore investin(.
$re pre9ta: mar(ins hi(her than 1/&'
APro1its be1ore ta: H total salesC
like buyin( companies which are hi(hly pro1itable and this is one o1 the metrics
use to make sure that this is the case.
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s there (rowth in earnin(s per share'
use this ratio, even thou(h it may sound simplistic, to see i1 the company)s
pro1its are (rowin( year by year on a per share basis.
Should the company (row by acquirin( other companies all the time, and
especially by issuin( shares, but in spite o1 it (ettin( bi((er its earnin(s per
share may actually be decreasin( because o1 the amount o1 new shares they
issue to buy the companies.
CA-H .*,/ -TAT'+'(T
2ow capital intensive is the business'
5his is a question that comes back to the amount o1 1ree cash 1low a business
(enerates. 5he hi(her the capital intensity o1 the business the more capital has
to be invested as it (rows and the lower the amount o1 1ree cash 1low the
company (enerates. usually try to 1ind companies that (enerate a lar(e
amount o1 1ree cash 1low but will occasionally consider buyin( into a capital
intensive industry i1 it is cheap enou(h.
s operatin( cash 1low hi(her than earnin(s per share'
5his item is to make sure that the company is not Iust makin( accountin( pro1its
but cash pro1its. added this item a1ter the Enron bankruptcy, as it was one o1
the ways you could determine that somethin( was 1ishy.
$s soon as accountin( earnin(s are substantially hi(her than cash earnin(s,
especially over multiple 1inancial years, it deserves 1urther investi(ation.
1 a company is (rowin( or investin( a substantial amount o1 money in workin(
capital, cash earnin(s are o1ten less than accountin( earnin(s. 5his is,
however, not a problem as you can see where the cash 1low (oes.
0here is 1ree cash 1low invested'
K Share buybacks
K ,ividends
K #einvested
K #7E Q #76E
K ncremental =R (rowth
$nswerin( this question allows me to clari1y where the company invested
money. usually compare this to mana(ementOs comments ri(hts in the annual
report. ,oin( so usually quickly allows me to determine i1 mana(ementOs deeds
equal their actions.
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0A*A(C' -H''T
s total debt to equity less than 3/&'
am very conservative in terms o1 balance sheet risk and do not like total debt
to be more than 3/& o1 equity.
sometime make e:ceptions when investin( in utility type businesses, but
normally look 1or companies that (enerate a hi(h amount o1 1ree cash 1low and
there1ore, e:cept i1 they)ve recently make an acquisition, usually have no or
very little debt on the balance sheet.
Fou can easily increase this number to /+& or even 33&, and that would also
be 1ineN Iust pre1er a lower number.
s total debt less than book value'
AS6urrent liabilities P total debtTHtotal equityC
5his is another debt measure use in conIunction with the one above. 5his
measure also includes current liabilities, and is there1ore a wider measure o1 the
company)s liabilities.
1 the number rises above 1, have a look at the siMe o1 each component. 1
current liabilities are substantial look at accounts payable to determine why it
1orms such a lar(e part o1 the company)s liabilities.
#emember, all creditors have to be paid at some point.
s lon( term debt less than ? : workin( capital'
ALon( term debtHA6urrent assets G 6urrent liabilitiesC
5his is also a measure o1 a company)s liquidity, which think comes 1rom
=enIamin !raham.
Should lon( term debt be more than twice workin( capital, it should warrant
some investi(atin( as the company)s 1inancial situation may not be very sound.
s the current asset ratio (reater than 1./'
A6urrent assets H current liabilitiesC
5his item is used to check i1 the company has more than short9term assets to
cover its short9term liabilities.
s the quick ratio (reater than 1'
AS6urrent assets G inventoryT H 6urrent liabilitiesC
5his is also a measurement o1 the company)s liquidity and is more restrictive
than the current asset ratio above. 5his ratio determines i1 the company has
enou(h short9term assets to meet its short9term liabilities assumin( it is unable
to sell any o1 its inventory.
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s the $ltman @ Score * 3'
5he $ltman @ score is a number that is calculated as e:plained below and is
used to determine the likelihood the company will e:perience 1inancial distress.
like to see a ratio above three 1or the companies invest in, as am
conservative 9 as can also be seen in the low debt to equity ratio mentioned
above.
5he @9score is a combination o1 1ive wei(hted business ratios and can also be
used to predict bankruptcy. n a series o1 tests coverin( three di11erent time
periods over 31 years Aup until 1>>>C, the model was 1ound to be ;+9>+&
accurate in predictin( bankruptcy one year prior to the event, with a error rate o1
1/9?+&.
The 1"score is calculated as follows2
@9score U 1.?51 P 1.%5? P 3.353 P .35% P .>>>5/.
51 U 0orkin( 6apital H 5otal $ssets.
5? U #etained Earnin(s H 5otal $ssets.
53 U Earnin(s =e1ore nterest and 5a:es H 5otal $ssets.
5% U 4arket Ralue o1 Equity H =ook Ralue o1 5otal Liabilities.
5/ U SalesH 5otal $ssets.
and is interpreted as follows2
@9score * ?.>> U Sa1e
1.; B @9score B ?.>> U 4iddle or (rey
@9score B 1.;+ U ,istress
SourceJ 0ikipedia
0hat is the 1low ratio A!ood B 1.?/, =ad * 3C'
A6urrent $ssets 9 A6ash P Short9term nvestmentsCCHA6urrent Liabilities 9 Short9
term ,ebtC
5his ratio comes 1rom a (ood 1riend o1 mine, @eke $shton, who used to write 1or
the 1ool.com in the DS and now has his own 1und mana(ement company.
5he 1low ratio can be e:plained as 1ollowsJ
6ash and short9term investments are the ultimate (ood current assets. 5o
isolate the bad current assets, you subtract cash and short9term investments
1rom the total current assets. =ad current assets primarily consist o1J accounts
receivable and inventory. $ccounts receivable represent sales 1or which the
company hasn)t received payment. 5he lon(er it takes to collect on them, the
less valuable those ori(inal sales become to the company. nventory represents
(oods waitin( to be sold, but like accounts receivable, the lon(er those (oods
have to wait be1ore they (et sold, the less valuable they are to the company.
do the same with current liabilities. 5he most common are accounts payable,
which are simply (oods and services the company has received but hasn)t yet
paid 1or. !ood current liabilities are those that don)t accrue interest. Each day
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that the company can put o11 payin( these accounts without bein( assessed an
interest penalty is another day that they can keep that cash earnin( interest.
,ividin( the bad current assets by the (ood current liabilities (ives us the 1low
ratio. 5he lower the 1low ratio, the better the business is at ma:imisin( the value
o1 its cash 1low.
$ low 1low ratio tells us that the company has a li(ht business model and H or
e:cellent 1inancial mana(ement. $lso, a low ratio means the company may also
have power1ul 1inancial levera(e due to leadership in the industry.
$ risin( 1low ratio shows a deterioration o1 these qualities. 1 the 1low ratio (ets
up over 3.+, itOs best to avoid the company as 1ar as possible.
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