My Dividend Investing Checklist
The Importance of Checklists:
In 1935, the US Army held a flight competition to find the next generation long range bomber. Boeing’s “flying fortress” outperformed its competitors on all conceiveable metrics, and the competition was considered a mere formality.
A small crowd assembled to watch the competition. As the flying fortress took to the sky, it began to turn, then stalled, then crashed in a huge explosion. An investigation revealed that the crash had been pilot error – the new plane was simply to difficult for the pilot (the most decorated test pilot in the US Army) to fly. The army nonetheless ordered a few Boeing planes – and Army pilots were tasked with figuring out how to fly it.
The simple approach – creating a flight checklist – saw pilots subsequently fly 1.8m miles in the flying fortress without a single accident.
Investment Checklists:
I first came across the idea of an investment checklist from Mohnish Pabrai, and then subsequently via Guy Spiers both of who spoke glowingly about Atul Gawande and his book, the Checklist Manifesto. Mohnish Pabrai was interviewed for that book, as he has developed an extensive investment checklist for his own personal use. Unfortunately, Mr Pabrai didn’t publish his checklist, stating that the reader was more likely to benefit from a checklist developed by themselves. Having developed my investment checklist some five years ago, I whole-heartedly agree. By building a checklist—a standardized set of questions you must answer before you commit to any investment decision—you can reduce the risk of making costly errors.
I developed my checklist because I had a propensity to make the same mistake over and over. In particular, I often had trouble identifying cyclical peaks in earnings for companies that are cyclical or commodity linked. While I dealt with commodities by simply ceasing to invest in commodity linked stocks, cyclical stocks were often a little trickier to identify. Sydney Airports, for example, is an excellent example of a stock that has in my opinion benefitted from the cycle of lower interest rates. This does not mean that I automatically disqualify Sydney Airports from investment, but it does help me to focus on what the company’s profile may look like if interest rates start moving back up. Similarly, a number of highly leveraged REITs are benefitting from a low cost of debt. I suspect that some of these companies may have difficulty if interest rates ever rise, making long term investment in those stocks are risky proposition.
My Dividend Investing Checklist:
My checklist focuses on four main areas – areas that Mohnish Pabrai believes are the largest source or errors made by investors. These questions are aimed at trying to eliminate mistakes, rather than uncovering new investments. Broadly, these areas encompass valuation, balance sheets (or leverage), management and competitive advantage.
- Valuation:
- Valuation is one area where I am reasonably disciplined. By focusing on dividends, dividend growth investors have a “true north”. This is one area where I have yet to make a huge mistake (although I’m certain I have one in my future). A company can be valued based on dividend yield, dividend growth expectations and sustainability of the dividend
- Is the dividend yield satisfactory?
- Is dividend growth likely?
- Does the combination of dividend growth and yield look likely to deliver greater than 10% returns?
- Is the dividend sustainable, based on quality of earnings, payout ratios and cashflows?
- Valuation is one area where I am reasonably disciplined. By focusing on dividends, dividend growth investors have a “true north”. This is one area where I have yet to make a huge mistake (although I’m certain I have one in my future). A company can be valued based on dividend yield, dividend growth expectations and sustainability of the dividend
- Balance Sheet and Leverage:
- This is an area that I am constantly concerned about. I have a tendency to believe that the level of debt is justified by earnings, when history has shown me that these type of companies is where I make most of my investing mistakes. I check to see if the following ratios are adequate:
- Debt to Equity
- Current Ratio
- Interest Coverage
- This is an area that I am constantly concerned about. I have a tendency to believe that the level of debt is justified by earnings, when history has shown me that these type of companies is where I make most of my investing mistakes. I check to see if the following ratios are adequate:
- Management:
- Warren Buffet said that you should pick businesses that any idiot can run – I’d prefer to have great management in charge of my businesses to turbocharge my results. This is also where I consider the capital allocation policies of management.
- Do insiders have significant skin in the game?
- Are management incentives aligned with investor incentives?
- Are insiders buying or selling stock?
- Does the company have a sensisble capital allocation policy?
- Has management historically allocated capital in a sensible manner (including in previous capacities?)
- Warren Buffet said that you should pick businesses that any idiot can run – I’d prefer to have great management in charge of my businesses to turbocharge my results. This is also where I consider the capital allocation policies of management.
- Competitive Advantage:
- By far the hardest part of the checklist, as this involves a number of value judgements. This is the place where you can fall in love with a stock – try to be as rational about this area as you possibly can.
- Is the business in a cyclical industry?
- Is the company benefitting from cyclical change in underlying drivers?
- Are current earnings representative of long term earnings power?
- Can you explain how the business makes money? Does the company benefit its customers?
- Is the ROE acceptable?
- Is the company in an attractive industry?
- By far the hardest part of the checklist, as this involves a number of value judgements. This is the place where you can fall in love with a stock – try to be as rational about this area as you possibly can.
The last question I ask is a very basic one, but it is probably the most important of the group. I simply ask myself: “If the stock falls, would I buy more?” If the answer is not an unequivocal yes, the investment is not likely to be suitable for my goals.
Conclusion:
I use my checklist to make sure I have covered the basics of investment, and to stop me from making the same mistakes over and over again. It certainly isn’t meant to be exhaustive and there are a number of other things that I analyse before making investments, but I always go through this checklist as the last thing I do before committing my hard won capital to any ideas. I’ve found it beneficial to my results and I think you might too.