Never Again Ask, “What in the World Was I Thinking?”

When investing in the stock market, I usually keep one thought in my head: in a few years from now, I never want to ask myself, “What in the world was I thinking?”

During the leverage boom of 2007, I got on a dividend kick and invested a small amount in a media company. The company paid a 15% dividend yield (very attractive) yet I didn’t concern myself too much that it was leveraged at a level historically unprecedented (this should cause any investor to run for the hills).

Needless to say, when the economy turned, the company could no longer meet its interest payment obligations. The dividend was slashed, and the company nearly went bankrupt.

Fortunately, I only invested a small amount of money and learned a lesson for a lifetime: if a company is leveraged at irresponsible levels unforeseen in the industry, do not invest!

Seems simple enough, but I’m sure investors will get burned by this again in the future. Now I look back and ask, “What in the world was I thinking?”

This is just one example, but over time I have learned from some of my own mistakes and reading about those of others. I don’t necessarily know how to pick the absolute best investments; however, I think by following some simple steps, I will generally avoid the worst ones.

Using past experiences, I have developed an investing strategy which I believe is defensive and logical. If you are looking for a strategy to triple your money in one year, please stop reading now. However, if you’re looking for a disciplined and transparent approach to achieve success over the long term, please continue on.

The two broad steps involve a screening process followed by a business diligence process. Below I have listed my steps to looking at domestic equities.

First step: Screening

– Companies should have historically produced large amounts of EBITDA from minimal capital expenditures (“capex”). Further, I do my best to estimate (or speak with the company to gather) the breakdown of maintenance vs. growth capex. If capex happens to be a large % of EBITDA because of growth investments, and the growth investments that I get comfortable with are producing great amounts of EBITDA in future years, that will be attractive.

– Companies should have a large amount of net cash (cash minus debt). This allows them to withstand recessionary environments and gives management flexibility.

– Management should be returning cash to shareholders through share repurchases or dividends. Simply speaking, acquisitions are historically unsuccessful. Companies would usually be better off returning cash directly to shareholders.

– Companies should trade at relatively low EBITDA multiples for their industries. Further, unlevered cash flow yield ((EBITDA-Maintenance Capex-Taxes) / Enterprise Value)) should be a high percentage. I don’t generally include working capital changes because historically changes in working capital are unpredictable on an annual basis, generally net out to even over past years (if this is nowhere near true, will dig in to this), and thus in the future should even out to zero over a long period of time unless there is a company specific issue that makes them relevant to valuation. Also, I am not so concerned about interest since most companies targeted using this strategy have a large amount of net cash and should have little to no debt.

– The company should have an Enterprise Value between $50MM and $5Bn with little to no research coverage. Historically speaking, smaller cap companies generally have greatest returns.

Second Step: Use a thorough yet common sense approach to diligence, “Is this a good business?”

– Confirm that this is a viable business model. How does the company make money? What are the revenue streams?

– Make sure there isn’t a specific/obvious reason the company trades at a low multiple.

– Make sure that the company’s EBITDA and cash flow are sustainable. Could the EBITDA materially decrease or get cut in half in a year? Does revenue come from long term contracts, a proprietary product, or some other sustainable competitive advantage?

– Are there barriers to entry to this industry? What is the makeup of the industry? How difficult is it to get new customers?

– What is the customer breakdown? Does the company depend heavily on only a few customers or a highly diversified base?

– Make sure logically this is a stable business and historical numbers prove so.

If a company can pass through Step 1 and I can get comfortable with the company in regards to Step 2, I believe I’ll have an interesting investment opportunity.

If a few years down the road I can say I invested in a company because it produced significant EBITDA from minimal capital expenditures, had a safe balance sheet with a large amount of net cash relative to its market cap, had a management team that responsibly returned cash to shareholders through dividends/share buybacks, produced a high free cash flow yield, and had a viable business model, I believe I will be a happier and wealthier investor.

Jason Neider is a contributor to Wall St. Cheat Sheet and can be reached at jason.neider@gmail.com