3 Simple Indicators Of Potentially Good Investments

Credit: Simon Cunningham

Benjamin Graham is a seminal figure in the world of investing and has contributed widely to the field with many of his timeless ideas such as “Mr. Market” and the margin of safety.

Graham also left behind a series of formulas and investing checklists that can help investors simplify the investing process. One of them is a 10-step checklist. In my own personal investing activities, I have adjusted Graham’s 10-step checklist into a simpler 3-step checklist to reflect how I think about investing. The adjusted checklist is shown below:

  1. Sustainable profitability, preferably over the last 10 years, with a minimum history of five years
  2. A maximum debt to equity ratio of 1
  3. An earnings yield that’s at least twice the yield of an AAA-rated bond

Let’s run through the importance of each step.

For the first, the key word is “sustainable.” When we invest, we are laying out our cash today with the expectation that more cash will return in the future. The odds of this happening can be high if the company we invest in is able to continue making money in the future, perhaps even growing its profit.

By focusing on companies that have produced sustainable profits historically, I can have more confidence that these companies could deliver similar business performances in the future.

I look for sustainable profits from companies that deliver products and/or services that are simple and/or fulfil a need. Some firms in Singapore’s stock market that I think fit the bill are Singapore Telecommunications Limited (SGX: Z74), Raffles Medical Group Ltd (SGX: R01), and Singapore Exchange Limited  (SGX: S68).

SingTel is Singapore’s largest telecommunications company and it’s fulfilling a need – the need for telecommunications services among people. Meanwhile, Raffles Medical provides healthcare services – that’s also a need – through its hospital (Raffles Hospital in Singapore) and its network of medical centres and clinics in Singapore, China, Hong Kong, Japan, and more. The third company, Singapore Exchange, is the sole stock market operator in Singapore.

Moving on to the second step in my investing checklist – a maximum debt to equity ratio of 1 – it is a simple calculation of dividing the total borrowings of a company by its equity. These figures are easily found in a company’s balance sheet.

The idea behind this ratio is to find companies with lower debt levels. Having low debt allows a company to better withstand shocks to its business and to survive for the long-term. It thus provides investors with an element of safety.

Lastly, we have the third-step in my investing checklist.

Here’s a quick explanation of the technical terms: (1) The earnings yield is the inverse of a company’s price-to-earnings (PE) ratio and so, it can be found by dividing a firm’s earnings per share with its share price; and (2) An AAA-rated bond is supposedly the safest bond an investor can get his or her hands on – the AAA rating is the highest rating in the scale used by credit rating agencies.

The rational for having a company’s earnings yield come in higher than the yield of an AAA-rated bond is that investors in stocks should demand a higher return for the higher risk undertaken given that equities are higher risk when compared to bonds.

Now, why are equities considered higher risk? This is because bonds are usually secured by the assets of a company. Furthermore, in the event that a company is liquidated, bond investors are the first to be paid, with the equity investors being handed the leftovers – if there is any.

As an illustration of how the third step in my check-list works, if an AAA bond is yielding 4%, I’d demand at least an 8% earnings yield (or PE of 12.5 or lower) for the stocks I’m looking at.

Foolish takeaway

By using the simple 3-step investing checklist above, I believe I’m able to identify worthwhile candidates for further research as the companies that filter through will have three important business characteristics: (1) sustainable profits, (2) low financial risk, and (3) a reasonable valuation. But, I should stress again that the checklist is not meant to pick investing targets – it’s merely meant to prune the field of stocks into a more manageable number for a deeper study.

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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 Lawrence Nga doesn’t own shares in any companies mentioned.