I've updated my checklist, concatenating some questions, and rephrasing the most important one.
Out goes: 'What could stop the company achieving its strategy?'; in comes: 'Is the company's profitability dependent on things unlikely to change?'
It's essentially the same question from a different perspective. A long-term investor must be confident his investment will endure.
Thinking about where the profitability of the business comes from first, part of the second version of the question, guides you where to look for potential susceptibilities.
If the profitability of Goodwin's refractory engineering businesses depends on jewellers continuing to cast jewellery, the business may face challenges sometime in the future (maybe a long time), because a new technology, laser sintering (3D printing), may develop to the point it is better.
This checklist aims to identify companies to invest in for the long term, stable, trustworthy firms in other words. A checklist for turnarounds or high-growth companies would ask different questions.
For each question I've included in italics where I most often find the answer, and an explanation of the kind of information I need to answer 'yes' or 'no'. There is another answer, 'maybe', which I often use. When I fill out each answer, I first give my verdict, and then list the reasons or factors that lead to it.
Maybe one day I'll find a company that satisfies all 10 criteria, but the checklist is not definitive because I'm not all-knowing. What I'm really looking for are 'nos'. If I can't live with the 'nos', I'm out.*
Is it clear how the business makes money?
Strategic report in the annual report, company websites, other similar companies
Yes: I can explain in my own words.
No: Stop! There's no point in progressing further.
Is the accounting straightforward?
Financial statements and notes to the accounts, from the annual report
Yes: I can adequately understand it.
No: It includes items I can't yet rationalise, such as large defined pension obligations worth more than the company and hedge accounting.
Is the company mainly self-financing?
Share Sleuth spreadsheet (derived from financial statements in annual reports)
Yes: The value of borrowings plus capitalised operating lease payments is under half the value of the capital required to operate the business.
No: Borrowings etc. are higher.
Is the company profitable in cash terms as well as accounting terms?
Share Sleuth spreadsheet
Yes: The company has earned positive free cash flow (operating cash flow less capital expenditure), preferably over six years or more. The higher the better as long as investment is not compromised.
No: Free cash flow is relative low.
Is the company consistently profitable?
Share Sleuth spreadsheet. Occasionally, and provisionally, commercial data sources, principally SharePad
Yes: The company hasn't lost money for a long time, at least six years. Ideally return on capital will always be above 8-10 per cent.
No: The company has experienced losses, or periods of low returns.
Is the company's profitability dependent on things unlikely to change?
Strategic report in the annual report, knowledge of other companies and industries
Yes: It's likely that its main products or services will still be in demand in 10 years' time.
No: The company faces new competitive threats.
Is the company forthright about strategy, and setbacks?
Executive statements and strategic report in the annual report, news released via the stock market and direct communication with management.
Yes: In its annual reports, stock market announcements, and private communications, the company does not appear to obfuscate or hold significant information back.
No: Management is tight-lipped or worse.
Does the company's strategy differentiate it from rivals?
Strategic report in the annual report, other companies' reports
Yes: I can identify elements of what it does that are unusual, valuable and possibly unique.
No: It's a recruitment consultancy (that's only partially a joke).
Is current management responsible for past success?
Directors' biographies in the annual report
Yes: Directors have worked for the company long enough to deserve a share of the glory, or, less significantly, they have bathed themselves in glory elsewhere.
No: Management is inexperienced.
Do management incentives and shareholdings encourage long-term thinking?
Remuneration report in the annual report
Yes: Directors own significant shareholdings. Bonus and share option schemes are modest, tied to profitability targets rather than profit growth, and reward performance over periods of five years or more.
No: Directors are guns for hire. They may be motivated by large bonuses and free shareholdings to manipulate earnings in the short term at the expense of long-term investment.
*You may be wondering why there's no checklist item on valuation. That's because valuation is handled in the Share Sleuth spreadsheet.
Because I have similar expectations for companies in the Share Sleuth spreadsheet I apply the same valuation thresholds to them automatically.
An earnings yield of 8 per cent is unambiguously cheap, preferably normalised using average return on capital over at least six years. An earnings yield of 5 per cent is probably dear. Anything between is probably worth watching, or holding.
The spreadsheet gives on overall opinion on a company's business risk and valuation, whether it is a good business at a cheap price. I take the business risks from the checklist. Too many 'nos' and the business risk lights up red.