The Five Rules for Successful Stock Investing 12

The 10-Minute Test

With literally thousands of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren't.

Does the firm pass a minimum quality hurdle? Avoiding the junk that litters the investment landscape is the first step in our 10-minute test. Companies with miniscule market capitalizations and firms that trade on the bulletin boards (or pink sheets) are the first ones to rule out. Also avoid foreign firms that don't file regular financials with the SEC [...]. Finally, recent initial public offerings (IPOs) are usually not worth your time. Companies sell shares to the public only when they think they're getting a high price, so IPOs are rarely bargains. Moreover, most IPOs are young, unseasoned firms with short track records. The big exception to this rule is firms that are spun off from larger parent companies.

Has the company ever made an operating profit? This test sounds simple, but it'll keep you out of a lot of trouble. Very often, companies that are still in the money-losing stage sound the most exciting [...] Unfortunately, stocks like this will also blow up your portfolio more often than not. They usually have only a single product or service in the pipeline, and the eventual viability of the product or service will make or break the company.

Does the company generate consistent cash flow from operations? Fast-growing firms can sometimes report profits before they generate cash – but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are returns on equity consistently above 10 percent, with reasonable leverage? Use 10 percent as a minimum hurdle. If a nonfinancial firm can't post ROEs over 10 percent for four years out of every five, for example, odds are good that it's not worth your time. For financial firms, raise your ROE bar to 12 percent.

Is earnings growth consistent or erratic? The best companies post reasonably consistent growth rates. If a firm's earnings bounce all over the place, it's either in an extremely volatile industry or it's regularly getting shellacked by competitors.

How clean is the balance sheet? Firms with a lot of debt require extra care because their capital structures are often very complicated.

Does the firm generate free cash flow? [...] Generally, you should prefer firms that create free cash to ones that don't and firms that create more free cash to ones that create less. [...] The one exception – and it's a big one – is that it's fine for a firm to be generating negative free cash flow if it's investing that cash wisely in projects that are likely to pay off well in the future.

How much "other" is there? Companies can hide many bad decisions in supposedly one-time charges, so if a firm is already questionable on some other front and has a history of taking big charges, take a pass.

Has the number of shares outstanding increased markedly over the past several years? If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. The former is a red flag because most acquisitions fail, and the latter is not something you want to see because it means that your ownership stake in the firm is slowly shrinking as employees exercise their options. [...] However, if the number of shares is actually shrinking, the company potentially gets a big gold star. Firms that buy back many shares are returning excess cash to shareholders, which is generally a responsible thing to do.

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