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Checklists are a great way to make sure you haven’t missed anything obvious about a stock
Thursday 29 Oct 2020 Author: Martin Gamble

In investing, the more positive factors you have working in your favour, the better the likely results.

For this reason with every potential investment it is worth totting up winning factors in a checklist.

In this article we reveal three fundamental indicators which have proven their worth over the years and could provide a low risk way of tipping the investment odds in your favour.

The power of the checklist

Famed side-kick of Warren Buffett, Charlie Munger once wrote, ‘no wise pilot, no matter how great his talent and experience, fails to use his checklist’. Checklists were popularised by Atul Gawande in his book, The Checklist Manifesto. They provide simple reminders for things that everyone knows they should do, but which in practice are often missed.

Seek out rising revisions

When analysts revise their earnings forecasts upwards it is usually a positive sign that the company is performing better than expected. Shares with rising revisions tend to outperform other shares.

The reason is based on behavioural dynamics which can be neatly summed up as ‘bad news travel fast, but good news travel slowly’. It can take a number of weeks for improving earnings estimates to be priced into share prices, allowing the savvy investor an opportunity
to profit.

We screened for companies receiving larger than average revisions over the last month using Stockopedia.

Bike and car Accessories Company Halfords (HFD) has been a major beneficiary of the pandemic with increased demand for bicycles as more people decided it was safer to cycle to work rather than take public transport. Demand was also influenced by government schemes that help finance bike purchases.

The fact that Halfords is still receiving some of the highest upgrades across the UK market months after the start of the pandemic suggests analysts are still behind the improved fundamentals.

One surprising name on the list is parcels company previously struggling DX Group (DX.:AIM), perhaps confirming that the company’s turnaround plans are gaining traction. First-half results showed a return to profitability and the company is now debt free.

The firm said the parcels market continues to grow strongly providing it with opportunities to increase volumes and expand margins.

Director buying is a positive signal

Director buying can send a powerful signal to other investors and like earnings revisions the news can travel slowly, allowing alert investors to get on-board.

There is supporting academic evidence with studies showing that buying shares with heavy director buying can be rewarding.

The Shares website is a good source of director dealing information while every Thursday we report on the most significant deals over the prior week. Click on the tools tab, then director deals-analysis tab before selecting the most significant deals from the drop-down menu.

Non-executive director Andy Bird at educational publisher Pearson (PSON) purchased £2.5 million worth of shares at 495p on 29 September. Fashion company Superdry (SDRY) founder Julian Dunkerton purchased £1.1 million worth of shares at 135p on 21 September.

The biggest purchase by value over the last three-months was made by Ryanair (RYA) chief executive Michael O’Leary who participated in the firm’s £400 million rights issue by spending €16 million buying shares.

Look for firms paying down debt

By reducing debts a greater proportion of a company’s cash flow is available for the benefit of shareholders. Assuming nothing else changes, profits rise as debt interest falls. This also de-risks the business from a balance sheet perspective, creating a win-win.

Kipling cakes maker Premier Foods (PFD) offers a good example, net debt has been reduced by a fifth over the last five years, halving interest costs and resulting in free cash flow improving by a whopping 129%.

Another is specialist social care and education services group CareTech Holdings (CTH:AIM) which is in the process of reducing the debt it took on to purchase competitor Cambian for £372 million in 2018.

At the recent (21 October) pre-close trading update the company said strong cash conversion had reduced net debt by £18.5 million in the six months to 30 September. It reiterated it was on target to reduce the net debt-to-EBITDA (earnings before interest, taxes, depreciation and amortisation) ratio to below three-times for the year ending 30 September 2021.

According to broker WH Ireland forecasts, net debt will fall by £18.5 million over the next two-years to £250 million which represents 2.5 times 2022 forecast EBITDA.

PUTTING IT ALL TOGETHER

If you find a stock which has one or, even better, multiple of these factors in its favour it could represent an interesting opportunity.

After all should a company be in a position where it is reducing its debt, enjoying earnings upgrades and directors are loading up on stock this is likely to be a pretty powerful catalyst for outperformance.

However, you also need to balance these positive factors with any negatives and risks that you identify too to ensure you are getting a full perspective on the investment case.

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