If you do not use a checklist when investing you are basically ignoring one of the simplest and most effective ways to improve your investment returns.

Its a strong statement but allow me to explain.

Some time ago I stumbled onto an article in The New Yorker magazine called The Checklist written by Atul Gawande a multi talented surgeon who is also the author of a interesting book I am reading called Complications: A Surgeon’s Notes on an Imperfect Science.

The article is quite long but it boils down to that in spite of strong evidence to the contrary highly trained people think it’s below them to use check-lists.

They think they know what to do and working through a check-list is an insult to them.

Check-lists work best in a complex environment where the performing of certain steps is critical. In flying it is taken as a given that highly trained pilots work through check-list for virtually every eventuality.

An aeroplane is a complex entity, so are medical procedures and I want to argue so is investing.

When evaluating a company there are so many factors that are beyond our control. We however, through empirical research know what to look for in an investment to increase the probability of us making profitable investment decisions.

What is important is that we focus on what we can control in our research and analysis.

Over more than 20 years of investment experience I have put together the following check-list that I work through for every investment I make.

I hope you find it of value.

* Operating cash flow higher than earnings per share
* Free Cash Flow/Share higher than dividends paid
* Debt to equity below 35%
* Debt less than book value
* LT debt less than 2 times working capital
* Pre-tax margins higher than 15%
* FCF Margin higher than 10%
* Current asset ratio greater than 1.5
* Quick ratio greater than 1
* Growth in EPS
* Management shareholding (> 10%)
* Altman Z Score > 3
* Substantial Dilution?
* Flow ratio (Good < 1.25, Bad > 3)
* Management incentives?
* Are the salaries too high?
* Bargaining power of suppliers?
* Is there heavy insider buying?
* Is there heavy insider selling?
* Net share buybacks?
* Is it a low risk business?
* Is there high uncertainty?
* Is it in my circle of competence?
* Is it a good business?
* Do I like the management? (Operators, capital allocators, integrity)
* Is the stock screaming cheap?
* How capital intensive is the business?
* High Profitability
* High Return on Capital
* Enormous moat
* Profitable reinvestment
* Future growth
* Net share buybacks?
* Strong cash flow
* What has management done with the cash?
* Where is Free Cash Flow invested?
* Share Buybacks
* Dividends
* Reinvested
* ROE & ROCE
* Incremental BV growth

I also have an analysis spreadsheet for companies I have come across using the Magic Formula from Joel Greenblatt. For these companies I use these additional check-list items:

* Magic formula values any outliers
* Bubble industry last 7 years
* Does the cash belong to the company
* EBIT / Assets > 20%

As mentioned I use the checklist to evaluate every company I am thinking of investing in and often make changes as I gain new insights or learn something new.

I do not have a formula that if a company fails X amount of points on the check-list I do not consider it.

The check-list however gives me an indication of what problem areas the company has and where I have to do further analysis.

Feel free to use the above points in your analysis process and let me know if you have any items I can add to the list.

Tim du Toit is editor and founder of Eurosharelab.

On his website he reveals what more than 20 years of equity investment have taught him – sometimes at considerable cost.

To discover how you can avoid costly mistakes and enjoy greater profits, sign up for his free newsletter “Investing that makes sense” at http://www.eurosharelab.com

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