Why Valuation Is Just a Small Part of Any Buy Decision

Many readers must undoubtedly be familiar with Investment checklists. Famed investors such as Charlie Munger and Mohnish Pabrai have used them to structure their buy decisions. This article will explain my checklist structure so the readers can apply the underlying mental model to their buy decisions.

In trying to come up with the structure, I faced the challenge of deciding what the most important checklist items should be. After years of refining, I am currently at a point where I have just seven checklist items –Â not too many and yet just enough for me to help decide whether I should buy a stock or NOT. I call this my 7FC (7 Factor Checklist) model of investing that has helped me beat the market in six out of the last eight years.

Notice below that valuation is just one of the seven checklist items. Hence the title of this article emphasizes the fact that, while valuation is important, there is a lot more to the buy decision.

In the following paragraphs I discuss all the checklist items in the 7FC model and apply them to two items in my portfolio –Â Wells Fargo (WFC, Financial) where I am sitting on 100% gains and SandRidge Energy (SD, Financial) where I am sitting on a 90% loss.

1. Valuation – Range -5 to 5 – This checklist item is perhaps the most straightforward and yet the trickiest. Straightforward because you can get a DCF from any good calculator (I prefer the one on GuruFocus) that does the calculation for you. Trickiest since you have to think about RISKS to the DCF calculated value and factor it in. Case in point is SD, where a year ago the DCF was showing it to be a great value. After the oil price case, not so much.

Notice I have assigned a range of -5 to 5 for this item. This range lets me assess whether the stock is richly valued (negative range) or is a bargain (positive range). To illustrate, I rate SD as a zero and WFC as a 2 on this scale.

You might ask how can SD be zero (and not -5) if the company is carrying such a huge debt and might even go bankrupt. Well, read on as I capture leverage as another checklist item.

2. Competitive Advantage (Moat) – Range of 0 to 5 – This item captures whether a business has a moat, hopefully a stable or growing one. There can be several drivers of such a moat. In fact, SD and WFC are examples of two different kinds of moats that a company can have. Despite its troubles, SD has been driving down well costs to a point where it is ahead of most of its competitors. Hence it has a moat of lower costs. On the other hand, WFC's moat is in its scale (cross- and up-sell of services) and its brand (by far the best one on the West Coast.)

For these reasons, I have assigned a 2 to SD and a 3 to WFC for this item.

3. Management – Range of -5 to 5 – This is perhaps one of the most important criteria of a "buy" decision in my mind. The best of businesses can be destroyed by bad management. Similarly, there are countless cases of bad businesses that have been turned around by great management (check out the turnaround of Post Holdings (POST) that is currently in progress.)

This is one criterion that has saved my bacon several times. And it still might do so in the case of SD, a stock that the management might bring back from the brink of extinction. In fact, I had bought into SD after the previous management regime was replaced by the current one. One thing of note, I do NOT invest in a business where I know that the top management has a dubious record, however good the valuation looks.

On this item, I assign a 3 to SD and a 4 to WFC

4. Leverage – Range of -5 to 5 – Like the "management" check list item, this is one that can make or break the decision for me. But this is also an area whose importance in my checklist has gone up as I have recieved my fair share of battle scars (mostly volatility) in the stock market. Even today, I am not sure whether I have fully internalized the importance of it.

Case in point is SD, which went from a great to horrible investment in the last few months. Only because the earlier management saddled it with a debt load that has become an anchor as oil prices have plummeted (something that not many, much less me, would have factored in).

On this item, I assign -5 to SD and 4 to WFC.

5. Circle of Competence – Range 0 to 5 – This item refers to how well I know the underlying business and its drivers. In some businesses, like hi-tech, I have a natural advantage since I live and breathe it. On others, I have found two good proxies that help me understand the business:

• Research, research, research –Â I follow selected good businesses (I maintain a list and regularly refine it) and over time develop a good sense of how those businesses rank on these checklist items. These are the businesses that go in my "wanna buy" list, and it is not unusual for me to initiate investments months (or even years) after a particular stock has appeared on my radar.
• Guru buying –Â If several esteemed (I maintain a list and regularly refine it) investors are buying a stock, I feel better about investing in it. But I never blindly follow the Gurus. More often their activity is a starting point for me to add the stock to my "wanna buy" list.

Given the amount of research I have done in SD and WFC, I have assigned a 2 (out of 5) to both SD and WFC.

6. Macro Trends – Range of -5 to 5 – Unlike many of the value investors I admire, I do not decouple my buy decision from where the economy or the industry (for the stock being considered) is going. Many times this is a matter of timing where I might identify a good investment but just wait for a slightly more opportune time to invest. Case in point is where I identified FireEye (FEYE, Financial) (in my circle of competence) several months ago but waited for it to come down from its lofty valuation just after the IPO (when there is a maximum buzz/hype about such stocks).

Given the carnage in the oil market, I have assigned a -4 to SD. And given the prospect of increased interest rates, I have assigned a 1 to WFC.

7. Catalyst – Range of 0 to 5 – To be fair, I buy stocks for long holding periods. As such, I am not that interested in short-term catalysts, although it never hurts. Many a time the catalyst can be longer term and recurring, as with stock buybacks. Or the catalyst could be the prospect of changes bought by new in management, as in the case of VEREIT (VER, Financial). Also notice that sometimes macro trends are themselves catalysts for a stock, as in the case of WFC. In those cases, I tend to split the magnitude of the rating between "Macro Trends" and "Catalyst" checklist items.

Since I do not see any catalyst for SD on the horizon, I have assigned it a 0. For WFC, the macro trend of rising interest rates will also act as a catalyst. Hence I have assigned it a 2.

Summary

If we summarize the ratings of SD and WFC, here is how it looks:

This analysis tells me that WFC is still a good candidate to buy. While SD's ratings have changed quite a bit, notice that a significant oil price change coupled with time (paying down debt) can move it quickly from "bad" to "good" idea, which is why I bought it in the first place.

As a final comment, let me point out that, while I did not go into how I come up with values for any given criteria, the values are calculated using proprietary models that I have developed and refined over time. But for a reader of this website, even getting the approximate values should help with the "Buy" decision.