DIY Stock Watchlist Guide
If you're investing on your own, you should create a watchlist of companies to follow. The reason for this is that there are great companies out there that may not be trading at prices you find compelling. Once you have your watchlist, you can do the following:
Wait for a price you feel gives you a large margin of safety,
Then pounce on the opportunity.
How do you go about creating this list, and when do you know is the right time to pile money into these great companies?
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I think Li Lu summed this up beautifully in this Q&A:
"You must understand yourself relatively well and then you can be picky in your choices. Once you understand a company, you can just sit and wait until an opportunity comes when the price gives you sufficient margin of safety. At that point, you won’t lose money even if you’re wrong. This is when you can go all-in. This is why you should focus your research on things that you can understand well and understand clearly. And since you will only be choosing a few companies, you might as well choose the very best ones. Of course, you can also choose the smallest companies or those whose price is already cheap. If you understand them well and there is sufficient margin of safety, you will not lose money. In short, you want to invest in certainty and avoid uncertainty. When price can give you certainty, then price becomes the most important consideration. When your own knowledge, ability and judgement can give you certainty – especially when you have been researching truly exceptional companies – then you don’t need to constantly change your watchlist every few years. You can just keep going and let the company's own compounding do the work for you."
I gleaned a lot of information from this short quote.
He mentions the margin of safety (MOS) many times.
You must understand yourself well, and know what you can and can't understand.
Price and certainty are correlated. The right price can give you the certainty that you won't lose money.
Don't waste your time trying to understand a bunch of companies.
Research a few great companies and follow them closely.
This is what he's done for decades on his way to extraordinary market gains. This is what I'm understanding more and more for myself as well. You only need to follow a few very good companies that will be around 10+ years from now. The goal is to understand the economics of a business so well you can roughly forecast its future fundamentals. Then you value it, and wait for the price to come down where you meet your rate of return. Once it reaches that price, pile money in!
He makes it sound easy, and perhaps it gets easier the more you do it. It takes a lot of work, but it's worth it if you want to succeed at investing. To summarize, you must be able to:
Lay the groundwork to try to understand your circle of competence,
Learn about the great companies you're going to follow,
Be patient as the price fluctuates (and hope it comes down to your MOS).
Here is how I go about does these things:
Understanding Your Circle of Competence
Charlie Munger says you need to be able to understand the company that you're looking at. This gives some room for adding companies into your circle of competence. If you've been reading for hours every day for 80+ years you're going to understand a lot more than someone who barely reads. The key is that you should be able to understand. This means you will need to put time in the future to improve your understanding.
Not being able to understand means you don't think you are capable or want to understand it. This might mean you are bored when researching, or have no desire to learn more. This is ok. Feel free to move onto something that stimulates you.
The toughest company to understand that I own is Micron. I researched for many hours about the company economics and industry. Although I have a solid understanding of the business I still don't know the exact ways their products work. For that, I'd need to be an engineer and I'm not. I understand the industry well enough and can predict with certainty where it will be in a few year's time. For me, that's enough to understand something and invest.
I remember looking at Raytheon, as it's owned by many great investors (I know this using Dataroma). When I started looking into their products, I decided I don't care to put the time and effort into understanding it. So I moved on with my life.
At a bare minimum, you should understand:
- What the company does
- Why they are successful
- What impact management has
- About their industry and competitors
- If they have durable competitive advantages
I’m not going to go into making a checklist, as mine is currently at 100+ points. But you should break each of the components down into segments. Use your checklist to identify areas you need to learn more about. Remove the grey areas. Once you feel you have great insights into all areas of your checklist, you should have a high degree of confidence in what you know about the company.
Learn How To Identify Great Companies and Follow Them Closely
Identifying great companies requires a few important qualities:
1. Excellent management
2. High returns on invested capital (ROIC)
3. Reinvestment opportunities
These are the three stools that Chuck Akre is always discussing. He's broken down finding quality companies into its simplest form. Sure you can go much deeper than this in your research and analysis. It will all boil down to the three qualities above.
Management should be talented and have integrity. A long history of success is a must. Other things to look for in great management is high insider ownership. Is the founder of the company involved? What's the culture like? Do employees like management or are they scared of them? Is management likely to treat shareholders well? Find answers to these questions and you'll understand if management is aligned with shareholders.
The issue with certain companies is that the best management team possible can't fix a broken ship. So we want a company that has great economics, which gives it a moat. This moat will show up in its returns on invested capital (ROIC). Great companies generate profits. If you increase their capital base, they should be able to maintain that rate. You'll want to look for companies that:
Have high 10-15% + and sustainable ROIC
Require little to no debt to operate and grow
Have a strong base rate. This should not be fluctuating negatively.
Great companies have reinvestment opportunities. The reason this is important is that we want to hold these companies for longer time periods. In order for them to keep growing, they must be able to increase profits. Some companies do not have reinvestment opportunities. A company I own, InMode, is a good example of this. Their cash pile keeps growing and it's been tough for them to find ways to deploy it.
We'd prefer companies to reinvest this money rather than return it to shareholders. If a company has 20% ROIC, that means they are earning 20% on the money they retain. But if they can't redeploy that capital into the company, there won't be growth. Companies like Constellation and Topicus are great at redeploying capital at high rates. Since they are so successful at this, there is no reason for buybacks or dividends (although Constellation has done dividends in the past).
Determine Your Margin Of Safety (MOS) and Be Patient
This is where many investors lack of discipline comes into play. When you get “shiny toy syndrome” it can be easy to hit the buy button regardless of price. You will want to resist this urge.
It doesn't matter how high quality a business is, issues will arise to sabotage your thesis. Yes, high quality companies generally go through less issues than lower quality comparisons. But you should always have some margin of safety when purchasing a company.
Let's look at an example with a thought experiment. We are looking at a company called "Zeus and Co." We project it can grow earnings at 15% for the next 5 years. It's currently trading at 35x earnings, and is earning $1.00 per share right now. So it's trading at $35. If it continues growing at this rate, in 5 years earnings will be $2.00. If it trades at the same multiple it’ll be $70.
The analysis above assumes that everything goes perfectly. It also assumes the market gives it the same multiple. Things don't always go perfectly, so we want to buy at a price that will let us make money even if everything doesn't go perfectly.
If we want a 50% margin of safety here is what we’d do: we discount the company to our desired rate of return. I aim for 15%. So if we discount $70 in 5 years by 15% to the present, we will want to buy it at $35. It's current price. But I also want a 50% margin of safety in case things don't go as planned. So I'll shave 50% off $35, which gives $17.50.
So I'll wait for something to happen such as a down quarter, market sell-off, or some short-term event to bring the stock price down. If it reaches $17.5 or lower, then I can buy it. Let's look at a few outcomes that could happen:
The stock grows at only 10%. In this case EPS will be $1.61. If this happens you can also assume the PE multiple goes down. Let's say it goes down to 20. So the price would be $32.20.
The stock's terminal PE multiple decreases. Perhaps the fundamentals begin deteriorating or some bear report comes out. We assume it keeps growing earnings at 15%. So EPS will be $2.00, but the PE will be 22. So the price after 5 years is $44.
The company's fundamentals fully deteriorate and it grows at 3%. In this case EPS will be $1.16. PE would be super low as well, let's say 12. This gives us a $13.92 exit price.
Our original thesis happens. $2.00 EPS with a 35x earnings multiple.
Our forecasted is exceeded and earnings grow at 20%. EPS would be $2.50 and the market loves the company even more and gives it a 40 PE. This makes our exit price $100.00.
You can see how our rates of return will change based on the outcome. The better the outcome, the better the returns.
You can see from this that our downside protection is higher when we buy with a margin of safety. In the large margin of safety price, we have a very low probability of losing money, and if we lose, it’s not very much. If we have no margin of safety we have more outcomes that cause us to lose money.
On top of the decreased risk you get higher rates of return if the initial thesis plays out. You can choose your own rates of return and margins of safety. You could make the argument that a higher quality company has a lower probability of downside events happening. Therefore you could use a lower MOS. This is largely an individual thing, you know yourself better than anyone else, so you have to set your MOS at your own levels of comfort.
To create your watchlist, you have to do a few things. Understand the company you are investing in. Make sure it’s a high quality company (or, you invest in other types, make sure it meets your guidelines). Then evaluate the company and set your margin of safety price. You’ll need to do some maintenance to make sure the fundamentals of the company are still intact. Then you wait for the price to come down to your desired entry. Then buy.
This is a simple process to explain, but not easy to execute. Staying disciplined and sticking with your plan will lead to great results. If your strategy doesn’t work, you can look at your inputs and where you are making mistakes. Get to work.
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