With the turn of my blog into its second year, I first started to publicly present the performance of my stock ideas that are exclusive to my Premium / Premium PLUS members. As it stands, on average my picks have been beating the market. Now, I also want to explain more in-depth the recipe behind how I pick those ideas – my analysis approach. I am transparent in what I do. Here’s my concept I developed over the years.

Summary and key takeaways from today’s Weekly
– In this weekly, I am explaining my analysis process – a 7-step checklist with my mission-critical points.
– It not only helps me to find my best ideas, but also to sort out others while learning a lot.
– As of now, my picks on average have left the S&P500 and the MSCI World behind them.

As I don’t want to make any mystery or big secret out of it, this Weekly serves to explain my personal analysis approach of how I select my best stock ideas for my Premium and Premium PLUS members. I hope that this also helps free readers to understand what I am doing. Even if you decide not to become a member, but you take home some valuable input, my work is done.

It took me more than a decade and many costly mistakes to arrive where I am now.

But finally, I can say that the experience I gained proved to be very valuable. I am fully convinced that every serious investor must be ready to do mistakes and to learn from them. What should not be done is to blame others like “the market”, “the central banks” or even any strange conspiracy or manipulating forces.

Either you know what you are doing or not. The other possible outcome is, either you have luck or not. However, using luck as a “strategy” is a way to fail.

The former approach is clearly my favorite.

Having and using (!) a checklist like a pilot before take-off, is a proven system.

My seven step checklist effectively is a filter to sort out and dismiss those ideas that are not attractive enough, which can be due to different reasons. It can be just one big flop or a bundle of several no-gos. It can also be an okay-ish outcome, but without fully convincing me. Often I even look into a company and then decide to take a step back to monitor it further over the next weeks or months.

Some ideas are only currently not good enough due to a too rich valuation and thus put on the back burner, while others (the majority) are completely dismissed, because for example the underlying company has a way too high debt load or a weak, wasteful capital allocation.

Only if I am really convinced, not trying to sell something to myself I do not stand fully behind, then I make the decision to write a research report. Not seldomly, I am watching the developments over many quarters and only then decide to strike.

Self-explanatory, I am fully aware that there is no such thing like a “perfect stock”.

While it would be great to find it, I am realistic. There are always pros and cons and possible improvements. First and foremost, I am trying to filter out the big no-go’s. If I don’t find anything that bad and the overall result is good (as said, with here and there some room for improvements), a possible candidate is the result.

After this rather mechanic work-off, I am doing one final thing, though. This is something that I really learnt to cherish, because it has shown me often that I am on the right track. Also, so far the results speak for themselves.

By the way, a dismissed stock is not automatically a waste of time, because I often learn something new while analyzing and from time to time I can use these results for a weekly to present my learnings to my readers.

Now, let’s have a look at my seven mission-critical points.

The performance of my best stock ideas proves that my concept works.

Since I have started this blog and my memberships, the average total return of my closed ideas is +19.6%, comfortably beating the S&P500 and the iShares MSCI World ETF.

I am also ahead “live”, looking at all my active and closed ideas.

As of writing this weekly, the average of all my ideas has an almost 3 pp. higher return than the S&P500 and even close to 4 pp. than the iShares MSCI World ETF over the last twelve months.

You can beat the market!

If you struggle to find high-quality stocks, consider becoming a Premium or Premium PLUS Member, to receive my exclusive research reports with my best and market-beating stock ideas.

My not so secret analysis approach unveiled

Around 2011 (i.e. already more than ten years ago, how time flies…) I became interested in stocks. Back then, I was studying industrial engineering, without having had anything to do with stocks before. Interest-bearing deposits at my bank were my only “investments”, besides investing in my own education.

Already then, I was skeptical about the public pension system, though.

I did not think it was reliable. Frankly, I did not even expect to receive a penny of the promised pension. As I also don’t like to be dependent on others, especially the public hand, it was time for me. Therefore, I decided to take my destiny into my own hands. 

I started investing.

To be more precise, after a fellow student and friend until today was buying stocks under the desk while in lecture. This was the igniting spark.

Well, I thought I was investing.

You can imagine that over the past twelve plus years I have made many, if not almost all, of the mistakes an equity investor can make.

I started buying my first stocks (Commerzbank, Daimler and Deutsche Bank – but hey, I sold them all for small profits and even tucked in my first dividends 🙂 ) without even understanding what exactly I was buying.*

* Commerzbank (ISIN: DE000CBK1001, Ticker: CBK), Daimler is today Mercedes-Benz Group (ISIN: DE0007100000, Ticker: MBG), Deutsche Bank (ISIN: DE0005140008, Ticker: DBK)

And this is the key – not understanding what I was doing.

Without having had any first-hand experience, I cannot blame my younger self today.

What I mean by that is that I never thought about the underlying businesses of my “investments”. Today, I consider this approach “investing blindly” or “buy and hope investing” to be what they are – gambles, not investments.

Betting on luck shall not be the main driver.

This is likely why I made many mistakes that cost me money. Real, hard earned money. As if this (not performing picks or selling winners too early) wasn’t enough, I became a victim of the doom-sayers and crash prophets (often without track records in investing) that all the time see the next crash of at least 50% coming – which, however, seldom comes!

And when it comes, it does not happen in a single day. Plus, you can prepare for it by

• picking defensive businesses
• stop reinvesting your dividends to pile up some cash
• buy more uncorrelated special situations
• think about investing in sectors that benefit economically

Some stocks even benefit from a crash like the company that every new subscriber to my free newsletter receives a report about.

Maybe you have made similar experiences that held you back?

But the good news is, I learnt from my mistakes. Instead of blaming others for my failures, I tried to figure out what went wrong and why. You have to be willing to learn and grow as an investor.

And you have to understand one thing: As an equity investor, you are participating in the economy by holding productive assets (some more, others less).

You need to have a positive and optimistic mindset, not a depressive or negative one. If you add rational decisions instead of emotional ones, you’re already half way there.

Many companies make it through good and bad.

This inspired me to start my blog Financial Engineering, where I started to write down my knowledge and experiences for other like-minded readers and investors.

I developed my own investment and research process to find the best stock ideas – not the most risky (I don’t believe in the saying that higher returns only come with higher risks), but those to achieve the best expected risk-adjusted returns. Or in other words, you should know what you’re doing.

Here are my 7 mission-critical checkpoints that lead me to by best stock ideas:

1. understand the business model
2. check management’s background
3. convince myself that capital allocation is attractive and in the best interest of shareholders
4. make sure the financials are strong and that debt won’t be an issue
5. is there any potential / catalyst on the horizon or is this a dead fish?
6. determine the intrinsic value and make sure there’s a decent margin of safety between the current stock price and true underlying value of the business to limit the downside
7. risk management: what could go wrong?
   even more important: is there a risk that could destroy the company, no matter how likely?

Before we have a closer look at each point:

Did you know – it is no secret – that around 80% of retail investors never make money with stocks at all, despite stocks only going up in the long run? There are several reason, from acting too often to buying high and selling low, instead of the other way around, making macro bets or trying to time the market.

Did you also know that an estimated 90% of professional, over-paid fund managers never beat the average market?

Here’s how I am doing my analysis, step by step, though somewhat simplified:

First, the business model.

I could make it ultra-short and just say “if you don’t know what the business you’re investing in is doing, you don’t know what YOU are doing”.

While this sums it up well, I would like to add a few things.

My goal is to always be able to explain in plain language to someone who is not familiar with the industry or underlying business what the company is actually doing and how it is generating its sales.

Obviously, in this regard I am highly inspired and influenced by Peter Lynch.

It also shows me whether I have understood the business. What also happens here and there is that I either do not feel comfortable enough with the business model or that I do not fully understand it, having difficulties to explain it straight.

I learnt to fold in such cases. There are enough other rocks to be turnt around!

You really need to understand what the business is doing. To be able to answer this question, I go through the latest annual report and one or two investor presentations. Usually, at least one from a capital markets day or called something like “investor presentation” that differs from the earnings results presentations (if available).

While the annual report is more “dry” and official, it is interesting to see for a first impression how the management pitches the business itself with its presentations. Those other than from earnings releases regularly are longer, giving more background information and – if applicable – longer term goals or at least more context about the industry and certain developments.

What is also helpful is to do the same with material from competitors.

How do you want to know for example which company is the lowest cost producer if you don’t compare many of them? I would not have been able to write my free weeklies and certainly not the exclusive research reports for my members about the offshore energy industry as well as the lowest cost producers or silver miners.

Not only could you find with more research even a stronger and more interesting business than previously thought. Also, some competitors show whole sector-wide overviews, for example cost-curves, growth rates of the industry or where certain companies are positioned using different figures or metrics like

• market share
• debt load
• margins
• growth rates
• and so on.

It is not necessary at this stage, but sometimes it also helps to go through the latest earnings call transcript, because there you can receive information about the state of the industry or longer-term trends.

Usually, due to having only 24 hours gross like everyone else, I am first doing a quick and dirty rush through the above, scanning for no-go’s.

Should I find an interesting development without big flaws, then I check the next points and return at a later stage to do a deep dive.

Second, check management’s background

This point 2 goes hand in hand with the following point 3 (covered on one page in my research reports), as management is responsible for a proper management of shareholder’s money.

But conceptually, I am looking at two separate sub-topics, hence two parts.

Here, I am asking questions like:

• is there a founder at work? are there several founders?
• is the founder maybe chairman of the board, after having been CEO for a long time?
• are there apparatchiks at the steering wheel?
• how about skin in the game, i.e. does management and especially the CEO hold significant stock positions?
• how about insider transactions?
• does management receive stocks or stock options?
• what about fluctuation? are there frequent changes in key personnel?
• is it already clear that a key person will retire soon?
• what has management achieved in the past?
• has management already proven itself by steering the company through a crisis, being it economical, industry-specific or company-individual?

One could ask more questions and depending on the case there are certainly more. But these are the most important ones I check every time.

I clearly prefer founder-leg businesses compared to typical managers or even worse government-installed leadership. For example, I published a report for my Premium PLUS members about a company where the leadership formerly was working for a big state-owned enterprise, but left to create its own company.

Guess which has better operating leverage?

But I have also published a report for all members about a majority state-owned enterprise with a not so good history. But there are other outside drivers and the business itself has too good economics (production costs and reserves) to pass on it, though management is of course a higher risk factor here.

In 10 out of my 15 reports in total, management is of highest quality, meaning either a founder-figure or at least tied closely to the company in other ways and often having signifiant ownership.

Third, shareholder-friendly capital management

This is one of the toughest disciplines, if not THE toughest.

It requires much skill and talent to “smell” things – you have to have a nose for it. I think this is hard to learn, if at all. Either it is given to you by nature or not.

You can even have a founder that has no clue about a proper capital allocation, e.g. buying back stock constantly at high valuations. To the contrary, it is also possible to be invested in a state-controlled enterprise and receive fat dividends (though the primary motivation are clearly not outside shareholders).

You should also be cautious when a founder or founding families have very high ownership. Dividends could be rather payouts to them, but not necessarily the best use of capital from the perspective of the business.

Under capital allocation, I understand the most effective use of financial means that goes hand in hand with the interests of all shareholders.

Typically, management can do the following with shareholder’s money, assuming it generates positive free cash flows:

• invest back in the business for growth
• making an acquisition
• repay debt
• pay dividends
• repurchase stock
• keep and increase cash

It is all a question of where the highest strategic value can be found and where investments give you the highest return on your investment.

For example, due to high interest rates, it can make sense for a company to delever quickly, instead of buying back its stock.

Generally, I want to get a feeling for where management’s priorities are.

What I don’t like are serial acquirers that generate lots of goodwill (premia paid to net asset values, i.e. risk for overpaying). Likewise, I don’t like to see companies that pay more in dividends than they earn in free cash flows, just to appease shareholders and to keep up a series of some years. The latter is typical behavior by someone who is short-sighted and does not want to be the one who ends a series.

^{source: Gerd Altmann on Pixabay}

Forth, sound financials

As I am more or less on a mission in this regard, preaching day in and day out, a company must have under all circumstances at least sound or even better strong financials.

Even an otherwise strong business can be knocked off its feat when there’s too much debt in play.

Many CEOs, managers and other pundits thought that interest rates would not rise anymore during their lifetimes – how quickly things can change!

Is there anything better than being able to operate from a position of financial strength than being pushed into the corner due to being over-indebted? A business without debt, but positive cash flows, cannot go bankrupt.

What sounds obvious, gets forgotten or over-looked easily.

And debt is not debt. Some very aggressive folks even used debt with variable interest rates to save a few bips in the short-term. They started to feel higher interest rates immediately. Then of course, I am checking the maturity of debt. Are bigger walls approaching or is there enough breathing room?

All in all, I always prefer to have less debt or even net cash.

Besides debt, I am interested in sales development and growth rates, margin trends and comparisons to peers as well as capital / investment intensity and free cash flow generation. I also differentiate between growth capital and sustaining capital.

I am also looking at capital return figures and cost structures.

Fifth and sixth, outlook, potential, catalysts and valuation

This fifth topic is in tandem with the consequence sixth point in my reports which I call “valuation and what to expect”. I need organic upside potential or an external catalyst to kick the stock higher.

This can be an undervaluation or it can be a spin-off. It can also be a massive industry-wide improvement in a cyclical business environment. Think of rising commodity prices.

If for example the valuation is too rich and the company is barely growing without anything meaningful enough on the horizon to move the needle – why invest? I am not interested in dead fish, priced for perfection.

If you do (or let me do) some research, there’s always something undervalued!

Though there is no one-size-fits-all approach here, I try to determine the true, i.e. the intrinsic value of every business. Sometimes, I am doing just discounted cash flow analysis. I can also look at historical valuation figures, which for example can make more sense with cyclical businesses.

What I am currently doing with oil companies for example is to look at the capital expenditures of the companies. Since the last high in 2013 / 2014, there has been no huge interest in investing, just what is necessary. Shareholder payouts have a higher priority.

That’s why I think that oil is still one of the most interesting sectors.

No matter the business or the tool, in all cases do I need to make sure that there is a sufficient enough margin of safety.

This is absolutely necessary to limit the downside.

I want to be surprised to the upside, not to the downside.

Seventh and last: risk management

This is somewhat tricky, but very important.

Of course, I first think of potential risks myself. Some are self-explanatory. Others are typical for a cyclical industry. There’s also potential for becoming obsolete, should certain developments occur.

With experience and years hours spent on such topics, you get better at it.

Try to destroy your own investment thesis.

A good starting point here is to read the ultra-dry risk section of a company’s annual report. Sometimes, they can be 30–40 pages long.

You should play some devil’s advocate here.

Not only do you receive precious information about potential risks, but sometimes there are more valuable pieces like a high customer or supplier concentration where some companies even name their top customers or suppliers directly and openly. Or competitors are named.

Regulatory and / or political influence are two other topics to think about.

While many risks are more of theoretical nature, others occur more often. For example, if a company warns about natural disasters potentially affecting the operating environment, you should check where the company is operating, whether it is diversified over several locations and think about how likely such a thing is?

One last point I want to put on the table is the likelihood vs. the potential implication of a risk.

While you can have a likely occurring risk with low damage for the business, what you don’t want to have is a negative once-in-a-lifetime event that completely blows up your thesis and investment.

It is worth it to think twice at this point to make sure to not gamble on binary outcomes.

Now you have seen how complex such an analysis process can be.

With time, one gets better at it.

Some things have to be felt or smelt, others can be found even without looking for them on purpose. Others are dry and systematic checking.

It took me many years and trial and errors to create this checklist for myself with which I feel comfortable and without over-analyzing. Yes, this is also possible! As an outsider, I will never have access to the same information that management has. Thus, I have to Pareto my way through all the available information.

That's why risk management is so important, yet underrated.

Maybe, because it is boring…

My most sophisticated readers turn into Premium or Premium PLUS Members and receive my best stock ideas where I strictly apply my research process that – as it stands – is even beating the market.

By letting me do the work, my members get not only ideas they might not have thought about in the first place. They also save valuable time and benefit from my efforts.

Yes, my closed ideas, but also all my ideas (active and closed) are ahead of the S&P500 and the iShares MSCI World ETF which I think are good benchmarks, because many follow them.

I frequently update on my performance numbers, so stay tuned.

If you want to part of a small, exclusive group – namely those who care for their investments – achieving not only positive, but even market-beating returns, you should seriously check out my memberships.

My performance numbers prove that my concept works!

Conclusion

In this weekly, I am explaining my analysis process – a 7-step checklist with my mission-critical points.

It not only helps me to find my best ideas, but also to sort out others while learning a lot.

As of now, my picks on average have left the S&P500 and the MSCI World behind them.

By becoming a Premium or Premium PLUS Member, you get instant access to all my already published research reports as well as several updates.

Likewise, you qualify for eight, respectively three more exclusive reports with my best investment ideas plus updates on the featured businesses over the next twelve months.

Premium PLUS Members also get access to all Premium publications.