The Successful Investor’s Checklist – Part 2

Hello, and welcome to Part 2 of the successful investor’s checklist! If you would like to start with Part 1, click here.

Here’s a brief recap: Stepping into the share market can be as daunting as walking up to the longest buffet spread you have ever seen. The number of companies listed in Singapore is fast approaching 800. Needless to say, it would be tough for any Foolish investor to study all companies in great detail.

Narrowing it down to a few

To narrow down this long list of companies, Pat Dorsey, author of the Five Rules for Successful Stock Investing, offered up a 10 minute test in his book to separate the companies which are worth a detailed examination from the ones which aren’t.

Do note that the criteria in the test are to be treated as rules of thumb, as there will be exceptions to each guideline. That said, Dorsey believes that these guidelines may eliminate poor investments more often than not.

Let’s move ahead with the next three criteria.

4. Good returns on equity (ROE)

The next criterion involves something more specific: a Return on Equity which is above 10% with the firm employing reasonable leverage. Dorsey prefers a company to achieve a ROE of at least 10% for four out of every five years – in other words, he would want consistency in a company’s performance. He also would like to see a company employ leverage that is in line with its industry norms. For a higher quality result, Dorsey suggests that investors can look for firms that use minimal leverage and yet can earn a ROE of at least 15% with some consistency.

One local company which may fit the bill here would be popular curry puff maker Old Chang Kee Ltd (SGX: 5ML). The company has generated an ROE exceeding 15% for the past five years while employing little leverage (the company has mostly carried substantially more cash than debt). You can catch up with Old Chang Kee here and here.

Meanwhile, one exception to this ROE-criterion would be cyclical companies. Take diamond systems provider Sarine Technologies Ltd (SGX: U77) for instance. The firm demonstrated a stupendous ROE of more than 30% from 2010 to 2014. However, its ROE sank below 6% in 2008 and 2009 during the Great Financial Crisis. This was due to the cyclical nature of its business which can be sensitive to trends in consumer spending.

Despite that, Sarine has been a winner over the long term. So, it goes to show that cyclical companies can still make for great long-term investments even if they have ROEs that can swing wildly. You can read more about Sarine here.

5. Consistency in earnings growth 

The test here is to observe the consistency of a company’s historical earnings growth. Dorsey believes that superior companies exhibit reasonably consistent growth rates; erratic earnings may signify a company belonging to volatile industries or being caught up in a highly competitive environment.

For this test, Vicom Ltd (SGX: V01) might be a good candidate to study given its steady growth over the past ten years. Over the decade from 2003 to 2013, the vehicle inspection and test outfit has expanded its earnings by more than 13% on a compounded annual basis. You may dive deeper into Vicom’s business here and here.

6. A clean balance sheet

It may not surprise the Foolish investor that Dorsey also prefers companies to have clean balance sheets. Preferably, that would be balance sheets that have no debt. If there is debt, Dorsey prefers non-bank firms that have a financial leverage ratio below 4, or a debt to equity ratio below 1.

Generally, less debt is desired, as any borrowings would bring into question the stability of the business. Furthermore, companies with debt require the private investor to understand the types of borrowings taken, as well as to track the trend of debt as a percentage of total assets.

A good place to start for this criterion could be a company like ARA Asset Management Ltd (SGX: D1R). As my Foolish colleague Ser Jing has pointed out, the real estate fund management outfit has largely kept its debt levels in check while still growing its earnings over the long term. A large part of ARA Asset Management’s revenue is also recurring, which adds to the stability of the company’s business to finance its own growth.

Remember: All these criteria can only help you narrow down the field as more research should be done beyond this. Like what you see so far? Click here to read Part 3.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.Motley Fool Singapore contributor Chin Hui Leong owns shares in ARA Asset Management Limited.