Bookworm: A ten minute filter for better quality investments
When it comes to individual shares, avoiding big losers is every bit as important as finding winners. This quick test could make that easier.
Today’s insight comes from Pat Dorsey’s book The Five Rules for Successful Stock Investing.
The book is something of a rarity in regards to how much effort is put in to making the ideas easy to apply instead of reading once and moving on from them. This is especially true for the section of the book that I’m going to explore today.
The ten minute test
For a bit of context, Dorsey wrote this book while he was Director of Stock Analysis at Morningstar.
After walking through a complete process for researching and valuing a company, Dorsey provides what he calls a “ten minute test” to eliminate companies unlikely to be a good fit for Morningstar’s method of investing.
With the caveat that there will be exceptions to every ‘rule’ on his list of checks, Dorsey presents it with a bold claim:
“Apply the following tests to any stock that you think might be a worthwhile investment, and you should be able to decide in 10 minutes whether it warrants much of your time”.
Gone straight away
Dorsey first excludes companies with “miniscule” market capitalisations and companies that only just went public.
“Companies sell shares to the public when they think they’re getting a high price, so IPOs are rarely bargains” says Dorsey. “Most are young, unseasoned firms with short track records”.
By excluding unproven IPOs, Dorsey is simply playing the odds. For every WiseTech (ASX: WTC) there are dozens of new issues that end up worthless. Of course, those that are valuable will make themselves clear over time and may pass this test at a later stage.
It’s important to note that Dorsey makes an exception for established companies that come to market after being spun-off from their parent company. And speaking of spin-offs, it’s time to introduce the example I’ll use for the rest of this article.
Endeavour Group (ASX: EDV) is Australia’s biggest liquor retailer thanks to its BWS and Dan Murphy’s branded stores. Endeavour was spun off by Woolworths (WOW) in 2021 and also owns a large hotels and gaming business. How will it stand up to Dorsey’s ten minute test?
Cash flow and profitability tests
Dorsey suggests testing a company’s ability to generate profits and positive cash flow from several angles.
The first test, one which a lot of companies still fall foul of, is whether the company has ever made an operating profit. As accounting and cash profits aren’t the same thing, Dorsey also advises you to seek out companies with “consistent cash flow from operations” and the ability to generate free cash flow.
Operating profit measures what is left once you subtract the company’s cost of doing business from its revenue (leaving out other expenses like tax and interest payments). Endeavour made over $1 billion in operating profit in fiscal 2024. It passes this test easily.
Let’s look at free cash flow next. This measures the cash generated by a business over and above it’s operating costs and normal investment needs. In theory this cash can be used for shareholder returns (dividends or buybacks), debt paydown, acquisitions or further investments in the business.
A quick and dirty way to calculate free cash flow is to start with operating cash flow and subtract investments in tangible assets (usually listed as plant, property and equipment) and intangible assets like software. Here are those numbers for Endeavour since its IPO:
Figure 1: Endeavour ‘free cash flow’ fiscal 2021-2024 in AUD millions. Source: Pitchbook
You can see from these numbers that Endeavour’s business has consistently generated free cash flow, and that it has also consistently recorded positive operating cash flows. Of course, if you were to take a closer look at the company you would want to understand the reason for any major fluctuations.
It’s safe to say for now, though, that Endeavour passes Dorsey’s minimum bar the cash flow and profitability front. Let’s see how it stacks up to an even sterner test of quality.
Quality tests
In his quest to help readers avoid poorer quality companies, Dorsey also advises them to seek companies with consistent earnings growth and satisfactory returns on equity.
Endeavour’s operating profits have ticked up each year since it went public and its net profits have generally followed suit. It passes Dorsey’s test here, but we would also want to understand how this relates to what we have already seen is a lumpier cash flow record.
I also noted that fiscal 2024 was a 53 week trading year for Endeavor, which gives their headline profit numbers a rather unfair boost versus last year. To be fair, the annual report makes this very clear and also provides numbers adjusted for a 52 week year.
Returns on equity measures the percentage of shareholder’s equity (an accounting concept mostly made up of earnings held back from previous years) that a company can turned into profits each year. Dorsey wants to see a minimum of 10% per year for non-financials and at least 12% for financials.
High levels of leverage juice returns on equity because equity is small relative to all of the (debt funded) resources at a company’s disposal. For that reason, Dorsey wants these high returns to be evident without excessive leverage being used.
Figure 2: Endeavour return on equity and debt-to-assets. Source: Pitchbook
Endeavour has reliably cranked out return on equities in the mid-teens. What’s more, its total debt relative to its total assets (one measure of leverage) doesn’t seem excessive for a company getting most of its earnings from staple goods that aren’t as fragile to economic cycles. I think it’s a pass here too.
Balance sheet tests
Dorsey also warns investors away from the perils of investing in companies with risky or complex balance sheets. He suggests taking a deeper look at this early stage of your research process “if a non-bank firm has a financial leverage ratio of above 4 or a debt-to-equity ratio of over 1”.
Seeing as Endeavour had a debt-to-equity ratio of around 1.5 by the end of fiscal 2024, I needed to put it through several additional questions posed by Dorsey.
- Is the firm a stable business? I would say yes. Most of the profits come from everyday goods that people aren’t likely to cut back on majorly in a poor economy. As we’ve seen, the company has consistently generated excess cash from its operations.
- Has debt been going down or up as a percentage of assets? Debt has risen on a debt to equity basis and you’d want to understand why. But it has stayed rather flat relative to Endeavour’s annual operating cash flows and on a debt-to-assets basis.
- Do you understand the debt? Looking at the ‘Borrowings’ section of Endeavour’s 2024 annual report shows me that its debt was almost entirely in syndicated bank loans with maturities ranging from 2026 to 2031. Seems pretty vanilla to me.
Other quick checks
In his noble pursuit of steering investors away from clinkers, Dorsey also suggests excluding companies that consistently seem to hide behind constant restructuring charges or “one-off” expenses that they blame bad results on. He also asks the reader to think thrice before buying a serial share issuer, as this dliutes per-share value.
I didn’t see much “other” in the annual reports I read and noted that Endeavour’s total number of shares outstanding after fiscal 2024 is largely unchanged from 2021.
An important reminder
It seems that Endeavour passes Dorsey’s list of initial checks on a potential investment candidate. But it’s important to remember that these checks are only supposed to satisfy a very narrow purpose: eliminating lower quality investments from consideration.
Just because a stock passes this test doesn’t make it a buy. For one, consider that the questions asked here were mostly quantitative rather than qualitative. To borrow a phrase from my old colleague Steve Clapham, you also need to know what the numbers mean, not just what they are.
One bonus of this method is that it can shine a light on areas you might want to focus doubly hard on in your further research.
There are several other things you’d need to consider before investing. For example, this list doesn’t broach the topic of valuation. Nor does it consider how a company might fit into your portfolio in terms of diversification, or how suitable it is for your goals and personality.
Make the ten minute test your own
If you’ve been reading our investing content for any length of time, you’ll know that we encourage defining a ‘big picture’ investing strategy before considering any individual investments. Doing so means that any decision you make is deliberate and part of a plan rather than an impulsive one.
A big part of this is setting your investment criteria – qualities an investment needs to have in order to make it into your list. Why not combine these criteria with Dorsey’s ten minute test as a starting point in your investment research process?
You can learn more about setting your investment criteria in Mark LaMonica's four-step guide to defining an investing strategy.
