Stock picking criteria

Choosing winners is hard. So I came up with a stock picking checklist based on my past mistakes to see if I can improve my stock picking skills.

My strategy involves picking two categories of stocks: “Compounders” and “Deep value”.

“Compounders” are stocks which can increase their earnings over the long term. Holding such stocks over the long term can be highly profitable.  

1. A proven track record of growth. Winners win. I’ll be looking for companies operating in industries experiencing secular growth. Ideally, these are companies which have compounded revenue at least 10% per year over the last 5 years. I foolishly categorized TripAdvisor as a compounder in 2019 when the company’s revenue growth was sluggish in 2018-19.
2. Moats. Internet platforms benefiting from network effects and high switching costs will be ideal. The strongest compounders benefit from multiple moats such as network effects, switching costs and economies of scale. TripAdvisor had network effects but no switching costs so the company’s user growth plateaued when Google started prioritizing its own travel sites for search results. TripAdvisor is now trying to make its product more sticky by introducing a subscription service offering discounts to attractions and hotels.
3. Smaller companies. Smaller companies (eg. market cap below USD10 billion) have a better chance of being 10 baggers because such companies are still considered too illiquid by most funds and ETFs. I picked MasterCard in 2020 thinking it had a long growth runway with 80% of global transactions still done via cash but their performance has trailed some of the big winners in my portfolio probably because the company is already one of the world’s largest companies.
4. Founder-leaders with integrity. Founder-CEOs with skin in the game who own at least 10% of the company are likely to be more motivated to grow the company than professional managers. The product development speed of Datadog, a company led by two founder-leaders has been amazing with Datadog introducing up to 8 products in a single quarter. For US companies, I’ll look for companies with high CEO ratings on Glassdoor.

“Deep value” stocks are stocks trading at a low multiple of their profit, cash flow or book value. Buying cheap stocks is well known for generating great long term returns which is an approach adopted by famous investors such as Benjamin Graham and Warren Buffett.

1. Strong balance sheet, preferably with no debt. Companies with no debt are less likely to face financial difficulties when the going gets tough. In early 2020, Singapore was hit by the global pandemic and I was worried that Kingsmen wouldn’t survive the year in a zero sales scenario. My concern about their weak balance sheet led me to sell the stock resulting in a near 50% loss.
2. Limited revenue concentration. Some companies are cheap because they depend on a certain customer or employee to generate most of their sales. A company where their largest customer or employee does not make up more than 10% of revenue will be ideal. Singapore O&G had poor share price performance in 2018-20 probably because the company is dependent on 3 doctors for 30% of their net profit.
3. Sustainable dividends. Choosing cheap stocks which pay a sustainable dividend ensures that a return is possible from cheap stocks while waiting for a catalyst to unfold. The dividend should be sustained by current earnings and free cash flow. Ideally, the dividend should make up only 50-60% of free cash flow so management has enough cash to reinvest in the business. For example, HRNet doesn’t have a fixed dividend policy but they typically pay out 50% of their earnings.

Do you have a different view on picking compounders or cheap stocks? Let me know what you think!