“No wise pilot, no matter how great his talent and experience, fails to use his checklist.” — Charlie Munger
Allow me to highlight the importance of having a checklist before I share with you my checklist for small cap stocks.
Let's say you're in the market for a new home. You approach a real estate agent with a simple request to purchase a property. But, when asked about your specific preferences, such as budget, size, and location, you draw a blank and admit to having no idea what you're looking for.
While this scenario may seem unlikely, it's safe to say that most homebuyers have at least some basic criteria in mind before beginning their search.
Similarly, a checklist is important to guide where and what to look for. Checklist helps you stay focused, avoid hasty decisions, and make informed choices.
“We are not built for discipline, we are built for novelty and excitement, not for careful attention to detail. Discipline is something we have to work at.” — Atul Gawande
1. Market Cap <$300M
I generally prefer a market cap of less than $300 million. Because these companies are not yet well-known to most investors and there is usually no institutional ownership. I feel this is an opportunity for me to get a share of the company before it manifests in the investment universe.
2. Revenue Growth - ideally more than 20%
I want to see a track record of revenue growth for at least a few quarters or years. Consistent growth is an indication of increasing market share and demand for the company's products or services.
3. High Gross Margins
A high gross margin indicates that the company is able to maintain a healthy profit after accounting for the cost of goods sold. High gross margins can be an indication of a competitive advantage or a unique value proposition that allows the company to charge premium prices.
4. Healthy Balance Sheet
A strong balance sheet, with enough cash and little to no debt, can ensure that the company can weather economic downturns and take advantage of growth opportunities.
5. Positive Operating Cash Flow
I only invest in companies after they have started generating cash from its core operations. This can be an indication of sustainable growth and financial stability.
6. Insider Ownership - more than 20%.
I don't want the CEO to run the company solely for a salary. I want the person who is running the company to be fully committed to its success. I want our interests to be aligned. A high level of insider ownership can also be an indication of confidence in the company's future prospects.
I prefer companies trading not more than 5 times its Gross Profit. Many investors base their valuations on EBITDA or EBIT or models like discounted cash flow but I think less than 5x Gross Profit provides a better margin of safety.
8, Easy to Understand Business
I am open to say no to any investment if I have difficulty understanding the company and its business model. A straightforward and easy-to-understand business is all I want.