How Checklists Can Help Investors

April 12 2012 

It is easy to drown in the flood of information available in the financial markets. There's always one more report to read, one more press release to peruse or one more chart to interpret. In such an environment, it's easy to get pulled off course; information intended to help you, can actually make it difficult to maintain a consistent investment process.

Unfortunately, the market rewards disciplined investing and often quickly punishes emotional, distracted or disorganized approaches. What's more, it's easy to forget discipline when things are going especially well or especially bad. And then there's just human nature – humans are fallible creatures and even the best find it difficult to remember or replicate what worked three or four years ago.

SEE: Stock-Picking Strategies 

Accordingly, investors should seek out ways to stay disciplined and methodical when it comes to researching new ideas, maintaining an existing portfolio and exiting positions. One of the best ways to achieve this is the use of checklists. Just as airline and military pilots have used checklists for decades to eliminate avoidable accidents and produce better results, so too can investors use checklists to develop better and more consistent investment behaviors. 

The Advantages of ChecklistsWords like "disciplined" and "methodical" are going to show up a few times in this article, and for good reason. A methodical and disciplined approach means that investors are considering the full range of the possibilities and risks, practicing careful due diligence and performing the detailed research that often accompanies long-term investment success. To that end, step-by-step checklists help foster, support and reinforce that step-by-step approach.

Checklists also help investors avoid lazy mistakes or short-cuts. Many investors, particularly value investors, claim that there is a wealth of information in the details and footnotes of filings like 10-Ks. That's true, but the fact remains that investors often forget to go through every step and read all of that material. They certainly may mean well, and they may even think they have done it, but it's all too easy to forget in a hectic and busy time. In other words, a checklist ensures than an investor always does what he or she intends to do. 

Checklists are also advantageous in that they leave a decision-making trail that can be modified and corrected with time. If an investment didn't work out, the investor can often see what went wrong and that may point to a necessary change in the process. Perhaps that investor ignored large insider sales or perhaps the investor failed to investigate what new products were coming out from rivals. Whatever the case may be, it can be a new item to add to the list. Just as airlines are constantly updating pilot checklists on the basis of experience (good and bad), so too should investors.

On the flip side, investors may also learn that they are being too strict or demanding; investors who see too many stocks succeed outside of their standards may need to revisit and revise those standards. If an investor can identify what works in the market, they can compare the qualities and characteristics of those stocks to the standards demanded by their checklists and see if they match appropriately.

Emotions are often the enemy of successful investors, and checklists can help sap the emotion from investment decisions. If nothing else, the methodical process of going through a checklist introduces a bit of tedium to offset those emotions and can allow a cooler head to prevail. The routine and ritual of going through a checklist can help preserve gains or avoid chasing bad ideas by not allowing investors to get carried away with momentum or hot stories.

The Disadvantages of ChecklistsWhile checklists are useful tools and this is a pro-checklist article, fairness demands that some of the downsides and disadvantages of checklists be presented as well.

For starters, checklists can feed a "paralysis by analysis" - the idea that there's always just one more piece of information to find before an investment decision can be made. This is especially true in cases where checklists have become too long or too thorough over time.
Checklists may also provide a false sense of security. Checklists are a consummate example of "garbage in, garbage out" and if investors build checklists on the basis of trivial or incorrect views of the market, the resulting investment performance will be lacking.

Lastly, checklists can be emotionally painful. It can ding the ego or pride to realize that you cannot do it all and need to rely on refreshers. Likewise, some investors love the rush that comes with investing on whim and emotion, and checklists can feel like straightjackets. Moreover, checklists eliminate some of the excuses that investors may like to use to explain losses – a consistent and methodical approach doesn't really allow for investors blaming "shorts," hedge funds or other fictional evil-doers for their losses.

Steps to Build a More Useful ChecklistAs there are so many different valid investment strategies out there, it is beyond the scope of a single article to offer the range of appropriate checklist permutations. Instead, there are some more general philosophies and approaches that can help investors create usable checklists for their own particular approach.

Above all, it is important to identify the key steps in the process and the key opportunities for a serious error. A fundamentals-based value investor, for instance, has to consider those financial footnotes, but likely has little reason to worry about chart patterns. Relying on technical analysis, though, may have to include a number of confirming or contradictory signals before coming to a final decision on a stock, while not worrying much (if at all) about the details of the company's off-balance sheet financing.

Checklists must also be brief. These are reminders and guides, not how-to manuals. Anything beyond a single page is likely to be too unwieldy to be practical, and investors are well-advised to create separate lists for separate tasks (like buying, evaluating current holdings and selling).

Physically using the checklist also seems to make a difference; printing it out and actually checking boxes seems to feed a different psychological process than just referring to a list on a screen. This, after all, is the major difference between a real checklist and the "mental checklist" that most investors claim to use. The investor has to make sure that their process demands that they

go through each step and leaves a record of doing so.

Last and not least, checklists need to be consistently evaluated and revised. When something goes wrong, identify the cause and evaluate the checklist to see if it needs revision. When something goes right, the same rules apply. Not all mistakes are preventable, but it is important to identify those that are and make sure they do not reoccur.

The Bottom LineChecklists are tools, not panaceas. If an investor can identify the aspects of an investment that indicate a possibility to outperform the market, it behooves them to make sure that they carefully evaluate every potential investment for those aspects and stay away from investments that do not have them. There is nothing sexy about checklists and most investors will find them to be tedious at first. As time goes on, though, and potential mistakes are avoided in lieu of real winners, diligent checklist-users are likely to find that this is a relatively simple and cheap means of boosting returns. 

Read more: http://www.investopedia.com/articles/basics/12/Investors-Should-Check-Out-Checklists.asp?partner=sfgate#ixzz1tPhOR0zP

Benjamin Graham and his 9 commandments of value investing

GRAHAM'S MAXIMS ON INVESTING

Janet Lowe, in her biography of Ben Graham, notes that while his lectures were based upon practical examples, he had a series of maxims that he emphasized on investing. Because these maxims can be viewed as the equivalent of the 10 commandments of value investing, they are worth revisiting:

1. Be an investor, not a speculator. Graham believed that investors bought companies for the long term, but speculators looked for short-term profits.

2. Know the asking price. Even the best company can be a poor investment at the wrong (too high) price.

3. Rake the market for bargains. Markets make mistakes.

4. Stay disciplined and buy the formula:
E (2g + 8.5) (T.Bond rate/Y)
where E = Earnings per share, g = Expected growth rate in earnings, Y is the yield on AAA-rated corporate bonds, and 8.5 is the appropriate multiple for a firm with no growth.

For example, consider a stock with $2 in earnings in 2002 and 10 percent growth rate when the Treasury bond rate was 5 percent and the AAA bond rate was 6 percent. The formula would have yielded the following price:
Price = $2.00 (2 (10)+8.5)* (5/6) = $47.5

If the stock traded at less than this price, you would buy the stock.

5. Regard corporate figures with suspicion (advice that carries resonance in the aftermath of recent accounting scandals).

6. Diversify. Do not bet it all on one or a few stocks.

7. When in doubt, stick to quality.


8. Defend your shareholder’s rights. This topic was another issue on which Graham was ahead of his time. He was one of the first advocates of strong corporate governance.

9. Be patient. This follows directly from the first maxim.

It was Ben Graham who created the figure of Mr. Market, which was later much referenced by Warren Buffett. As described by Mr. Graham, Mr. Market was a manic-depressive who did not mind being ignored and was there to serve and not to lead you. Investors, he argued, could take advantage of Mr. Market’s volatile disposition to make money.



http://media.wiley.com/product_data/excerpt/32/04713450/0471345032.pdf

Benjamin Graham: The Father of Screening

Many value investors claim to trace their antecedents to Ben Graham and to use the book on security analysis that he co-authored with David Dodd in 1934 as their investment bible. But who was Ben Graham, and what were his views on investing? Did he invent screening, and do his screens still work?

Graham’s Screens 

Ben Graham started life as a financial analyst and later was part of an investment partnership on Wall Street. While he was successful on both counts, his reputation was made in the classroom. He taught at Columbia and the New York Institute of Finance for more than three decades and during that period developed a loyal following among his students. In fact, much of Mr. Graham’s fame comes from the success enjoyed by his students in the market.

It was in the first edition of Security Analysis that Ben Graham put his mind to converting his views on markets to specific screens that could be used to find undervalued stocks. While the numbers in the screens did change slightly from edition to edition, they preserved their original form and are as follows:

1. Earnings to price ratio that is double the AAA bond yield
2. PE of the stock has to be less than 40 percent of the average PE for all stocks over the past five years
3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
4. Price < Two-thirds of Tangible Book Value1
5. Price < Two-thirds of  Net Current Asset Value (NCAV), where net current asset value is defined as liquid current assets including cash minus current liabilities
6. Debt-Equity Ratio (Book Value) has to be less than one
7. Current Assets > Twice Current Liabilities
8. Debt < Twice Net Current Assets
9. Historical Growth in EPS (over last 10 years) > 7%
10. No more than two years of declining earnings over the previous 10 years


Tangible book value is computed by subtracting the value of intangible assets, such as goodwill, from the total book value.


Any stock that passes all 10 screens, Graham argued, would make a worthwhile investment. It is worth noting that while there have been a number of screens that have been developed by practitioners since these first appeared, many of them are derived from or are subsets of these original screens.

The Performance 

How well do Ben Graham’s screens work when it comes to picking stocks? 

• Henry Oppenheimer studied the portfolios obtained from these screens from 1974 to 1981 and concluded that you could have made an annual return well in excess of the market. 
• As we will see later in this section, academics have tested individual screens—low PE ratios and high dividend yields to name two—in recent years and have found that they indeed yield portfolios that deliver higher returns. 
• Mark Hulbert, who evaluates the performance of investment newsletters, found newsletters that espoused to follow Graham did much better than other newsletters.

http://media.wiley.com/product_data/excerpt/32/04713450/0471345032.pdf

Book Value: Theory Vs. Reality

Book Value: Theory Vs. Reality
by Andrew Beattie (Contact Author Biography)

Earnings, debt and assets are the building blocks of any public company's financial statements. For the purpose of disclosure, companies break these three elements into more refined figures for investors to examine. Investors can calculate valuation ratios from these to make it easier to compare companies. Among these, the book value and the price-to-book ratio (P/B ratio) are staples for value investors. But does book value deserve all the fanfare? Read on to find out.

What Is Book Value?

Book value is a measure of all of a company's assets: stocks, bonds, inventory, manufacturing equipment, real estate, etc. In theory, book value should include everything down to the pencils and staples used by employees, but for simplicity's sake companies generally only include large assets that are easily quantified. (For more information, check out Value By The Book.)

Companies with lots of machinery, like railroads, or lots of financial instruments, like banks, tend to have large book values. In contrast, video game companies, fashion designers or trading firms may have little or no book value because they are only as good as the people who work there.

Book value is not very useful in the latter case, but for companies with solid assets it's often the No.1 figure for investors.

A simple calculation dividing the company's current stock price by its stated book value per share gives you the P/B ratio. If a P/B ratio is less than one, the shares are selling for less than the value of the company's assets assets. This means that, in the worst-case scenario of bankruptcy, the company's assets will be sold off and the investor will still make a profit. Failing bankruptcy, other investors would ideally see that the book value was worth more than the stock and also buy in, pushing the price up to match the book value. That said, this approach has many flaws that can trap a careless investor.

Value Play or Value Trap?

If it's obvious that a company is trading for less than its book value, you have to ask yourself why other investors haven't noticed and pushed the price back to book value or even higher. The P/B ratio is an easy calculation, and it's published in stock summaries on any major stock research website. The answer could be that the market is unfairly battering the company, but it's equally probable that the stated book value does not represent the real value of the assets. Companies account for their assets in different ways in different industries, and sometimes even within the same industry. This muddles book value, creating as many value traps as value opportunities. (Find out how to avoid getting sucked in by a deceiving bargain stock in Value Traps: Bargain Hunters Beware!)

Deceptive Depreciation

You need to know how aggressively a company has been depreciating its assets. This involves going back through several years of financial statements. If quality assets have been depreciated faster than the drop in their true market value, you've found a hidden value that may help hold up the stock price in the future. If assets are being depreciated slower than the drop in market value, then the book value will be above the true value, creating a value trap for investors who only glance at the P/B ratio. (Appreciate the different methods used to describe how book value is "used up"; read Valuing Depreciation With Straight-Line Or Double-Declining Methods.)

Manufacturing companies offer a good example of how depreciation can affect book value. These companies have to pay huge amounts of money for their equipment, but the resale value for equipment usually goes down faster than a company is required to depreciate it under accounting rules. As the equipment becomes outdated, it moves closer to being worthless. With book value, it doesn't matter what companies paid for the equipment - it matters what they can sell it for. If the book value is based largely on equipment rather than something that doesn't rapidly depreciate (oil, land, etc), it's vital that you look beyond the ratio and into the components. Even when the assets are financial in nature and not prone to depreciation manipulation, the mark-to-market (MTM) rules can lead to overstated book values in bull markets and understated values in bear markets. (Read more about this accounting rule in Mark-To-Market Mayhem.)

Loans, Liens and Lies

An investor looking to make a book value play has to be aware of any claims on the assets, especially if the company is a bankruptcy candidate. Usually, links between assets and debts are clear, but this information can sometimes be played down or hidden in the footnotes. Like a person securing a car loan using his house as collateral, a company might use valuable assets to secure loans when it is struggling financially. In this case, the value of the assets should be reduced by the size of any secured loans tied to them. This is especially important in bankruptcy candidates because the book value may be the only thing going for the company, so you can't expect strong earnings to bail out the stock price when the book value turns out to be inflated. (Footnotes to the financial statements contain very important information, but reading them takes skill. Check out An Investor's Checklist To Financial Footnotes for more insight.)

Huge, Old and Ugly

Critics of book value are quick to point out that finding genuine book value plays has become difficult in the heavily analyzed U.S. stock market. Oddly enough, this has been a constant refrain heard since the 1950s, yet value investors still continue to find book value plays. The companies that have hidden values share some characteristics:

• They are old. Old companies have usually had enough time for assets like real estate to appreciate substantially.
  
• They are big. Big companies with international operations, and thus with international assets, can create book value through growth in overseas land prices or other foreign assets.
  
• They are ugly. A third class of book value buys are the ugly companies that do something dirty or boring. The value of wood, gravel and oil go up with inflation, but many investors overlook these asset plays because the companies don't have the dazzle and flash of growth stocks.

Cashing In

Even if you've found a company that has true hidden value without any claims on it, you have to wait for the market to come to the same conclusion before you can sell for a profit. Corporate raiders or activist shareholders with large holdings can speed up the process, but an investor can't always depend on inside help. For this reason, buying purely on book value can actually result in a loss - even when you're right. If a company is selling 15% below book value, but it takes several years for the price to catch up, then you might have been better off with a 5% bond. The lower-risk bond would have similar results over the same period of time. Ideally, the price difference will be noticed much more quickly, but there is too much uncertainty in guessing the time it will take the market to realize a book value mistake, and that has to be factored in as a risk. (Learn more in Could Your Company Be A Target For Activist Investors? Or read about activist shareholder Carl Icahn in Can You Invest Like Carl Icahn?)

The Good News

Book value shopping is no easier than other types of investing, it just involves a different type of research. The best strategy is to make book value one part of what you look for. You shouldn't judge a book by its cover and you shouldn't judge a company by the cover it puts on its book value. In theory, a low price-to-book-value ratio means you have a cushion against poor performance. In practice it is much less certain. Outdated equipment may still add to book value, whereas appreciation in property may not be included. If you are going to invest based on book value, you have to find out the real state of those assets.

That said, looking deeper into book value will give you a better understanding of the company. In some cases, a company will use excess earnings to update equipment rather than pay out dividends or expand operations. While this dip in earnings may drop the value of the company in the short term, it creates long-term book value because the company's equipment is worth more and the costs have already been discounted. On the other hand, if a company with outdated equipment has consistently put off repairs, those repairs will eat into profits at some future date. This tells you something about book value as well as the character of the company and its management. You won't get this information from the P/B ratio, but it is one of the main benefits from digging into book value numbers, and is well worth the time. (For more information, check out Investment Valuation Ratios: Price/Book Value Ratio.)

by Andrew Beattie, (Contact Author Biography)

Andrew Beattie is a freelance writer and self-educated investor. He worked for Investopedia as an editor and staff writer before moving to Japan in 2003. Andrew still lives in Japan with his wife, Rie. Since leaving Investopedia, he has continued to study and write about the financial world's tics and charms. Although his interests have been necessarily broad while learning and writing at the same time, perennial favorites include economic history, index funds, Warren Buffett and personal finance. He may also be the only financial writer who can claim to have read "The Encyclopedia of Business and Finance" cover to cover.



http://www.investopedia.com/articles/fundamental-analysis/09/book-value-basics.asp


Also read: Nets and net net

Ben Graham Checklist for Finding Undervalued Stocks

In addition to identifying and quantifying important value components, Graham left us with an assortment of general stock selection rules. He created a number of checklists at different times in his career to serve different investment objectives and portfolio strategies. The checklists review different aspects of a company's financial strength, intrinsic value, and the realtionship with price.

Here is a
Ben Graham Checklist for Finding Undervalued Stocks

Criterias

Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.

Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.

Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.


If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.

If you're income oriented, Graham recommended paying special attention to items 1 through 7.

If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.

If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.

Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.

The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.

Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html


Reference: 20.11.2008 - KLSE MARKET PE