The Successful Investor’s Checklist – Part 3

Welcome to Part 3 of the successful investor’s checklist! If you would like to start with Part 1, click here. The link to Part 2 is 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 get cracking with the final three criteria!

7. Free cash flow generation

Right off the bat, Dorsey refers to free cash flow as the holy grail of successful investments. Generally, companies will be in a good position if it is able to generate more cash than it needs for its future expansion. Furthermore, if said company is able to re-invest its free cash flow with a high return on equity (ROE), that would be a powerful one-two punch.

At the local front, healthcare provider Raffles Medical Group Ltd. (SGX: R01) would be a candidate that meets this criteria. As you can see from the chart below, the company’s financial track record – especially in generating free cash flow – has been enviable. You can catch up on the business of Raffles Medical here as well.

Raffles Medical's financials

Source: S&P Capital IQ

Free cash flow is not the be all and end all, of course. There may be companies which exhibit negative free cash flow but yet have been re-investing all of its operating cash flows into highly profitable opportunities for the future – such companies might make for great investments too.

But that said, the desirable combination for Dorsey here would be the presence of free cash flow and a good solid ROE.

8. Occurence of “other” charges

In this check, Dorsey suggests that the private investor should take a quick look at the frequency of one time charges made by the company. He believes that these charges may be instruments used by management teams to hide bad decisions.

To be sure, no management team is immune from bad decisions – after all, no one is perfect. However, if there is a consistent trend of “bad decisions” – and a clue to that may be the frequent occurrences of “other” charges on the financial statements –  then we should sit up and take notice. After all, we could certainly live without a litany of bad decisions made by management teams of companies we own.

9. Share count dilution

On the final note, Dorsey recommends that we look at the number of new shares being issued by the company. New share issues could be used to fund acquisitions and/or organic growth.

Both may be good things for investors if it leads to material future per-share increases in important metrics like profits and free cash flow, but it’s worth pointing out that Dorsey is not a big fan of acquisitions as he believes that most acquisitions tend to fail.

At the local front, the share count of Global Yellow Pages Limited (SGX: Y07) has multiplied by about eight times over the past decade. This dilution in share count may have contributed to the dismal performance of the company’s shares – over that timeframe, Global Yellow Pages has seen its share price decrease by more than 90%.

On the other hand, if you can find a local company that has been decreasing its share count over the long-term, Dorsey might just give it a big gold star. A decreasing share count might mean that the existing shareholders would be getting a bigger slice of the business-pie of a company.

Foolish summary

We have come to the end of this series. As a gentle reminder: All these criteria can only help you narrow down the field as more research should be done beyond this.

In any case, if all nine checks are done well, Dorsey expects us to take only about 10 minutes to quickly sieve through a company and decide if it’s worth a deeper look.

That little amount of effort (just 10 minutes!) needed to work the criteria could prove to be helpful for Foolish investors in focusing their efforts more efficiently. Also, it may just increase our chances in obtaining successful invsting results. Read more about investing and get more investing tips and tricks, FREESign up here to The Motley Fool Singapore’s weekly investing newsletter, Take Stock Singapore.

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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 doesn’t own shares in any companies mentioned.