Pilots don’t take off without completing a checklist. Surgeons don’t operate if they haven’t completed a pre-operative checklist. The power of checklists is that they make it much easier to deliver successful results repeatedly.
As these examples show, checklists aren’t just for beginners. That’s true in investment as well. Many of the world’s most successful investors won’t consider buying a stock unless it passes a set of checks.
Today I want to share with you three simple tests you can do before you buy any shares in 2019. I believe that following these steps should help you avoid big losses and increase your chance of beating the market over long periods.
As a general rule, I won’t buy shares that don’t pay a dividend. There are two main reasons for this. The first is that I think dividends are a good indicator of management discipline and of how much spare cash the company is generating.
Another advantage is that reinvested dividends can give a big boost to your returns. A 4% dividend yield reinvested over 10 years will add 48% to your original investment, on top of any capital gains.
The biggest risk with dividends is that they can be cut. The simplest way to test whether a dividend is affordable is to compare it with earnings per share. I usually look for earnings per share that are at least 50% higher than the dividend per share, preferably more.
Even if you’re looking for good value income stocks, I think it’s important to look for companies that are growing.
As a rule of thumb, I would avoid companies with falling sales or profits. I’d aim to invest in companies where sales and profits are rising ahead of inflation. If a company isn’t growing, then quite often its value will gradually fall, along with its share price.
3. Spare cash
Free cash flow may sound technical, but it’s not really. It’s the money left over each year after a company has met all of its obligations. These include all operating costs, tax and interest payments.
This surplus cash can be used for investment in new growth opportunities, for debt repayments, or for dividends.
Most investors agree that the best dividends are those which are covered by a company’s free cash flow. This is because they are affordable without using debt or previous savings.
Bonus tip: Debt
Perhaps the simplest way to stay out of trouble on the stock market is to avoid companies with too much debt. The reason for this is that when a heavily-indebted company runs into problems, shareholders always lose out. That’s because debt is ‘senior’ to equity — lenders must be repaid before shareholders get anything.
A rule of thumb I use for my own investments is to avoid any company whose net debt is more than four times its annual profits. This isn’t appropriate for all businesses, but if your focus is on profitable, growing and dividend-paying stocks, I think this should be a useful guideline.
A sure thing?
This simple checklist won’t guarantee that you pick winners.
But I think it should reduce the number of losers in your portfolio. And that’s one of the biggest secrets of successful investing — if you avoid big losses, then your profits should take care of themselves.
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