What is your favourite investing book of all time?

For me, The Five Rules For Successful Stock Investing is an often overlooked contender. I like this book because it is written in straightforward language and offers a method based on a solid investing philosophy.

It is a book dripping with Morningstar DNA. After all, it was written by our former director of stock analysis, Pat Dorsey, while he was here. But don’t think it’s a biased choice on my behalf. I viewed this book as a fantastic guide to investing long before I started working here.

A highlight of the book is the ‘ten minute test’ towards the end. This series of checks encapsulates some of the rules taught in the book and makes it easier for the reader to put what they have learned into action.

It’s easy to go from book to book without applying what you have learned. But if you don’t apply something, can you really say you’ve learned it?

The ten minute test

The aim of this test is not to decide whether you will invest in the company.

The idea is to quickly eliminate unsuitable candidates before you waste too much time researching them. Stocks that pass this test might be worthy of a deeper analysis in the context of your investment goals.

The ten minute test features the following 9 questions:

  • Does the firm pass a minimum quality hurdle?
  • Has the company ever made an operating profit?
  • Does the company generate consistent cash flow from operations
  • Are returns on equity consistently above 10% with reasonable leverage
  • Is earnings growth consistent or erratic
  • How clean is the balance sheet?

To give you an example of how it works, I am going to apply these questions to ASX-listed Bapcor (ASX: BAP). I will use financial data from Morningstar and the research of our Bapcor analyst Angus Hewitt.

In case you aren't familiar with Bapcor, it sells replacement vehicle parts to trade and retail customers. Through its Burson segment, Bapcor is Australia’s second biggest trade parts supplier with around 180 locations across the country.

Meanwhile, its AutoPro and Autobarn brands give it roughly 12% of Australia’s retail parts business. This makes it Australia’s third biggest retail parts player, ahead of several far smaller businesses.

Let’s see if it passes the ten minute test.

Does the firm pass a minimum quality hurdle?

The aim of this step is to eliminate more speculative companies and areas of the market where everyday investors are less likely to score good returns.

This isn’t to say that enterprising investors can’t unearth gems here. But as a rule of thumb, the book suggests that readers steer away from tiny market caps, companies that don’t file regular financials, and recent IPOs (except for some spin-offs).

Bapcor has a market value of $1.7bn and has been public since 2014. It clearly passes this hurdle.

Has the company ever made an operating profit?

This step filters for proven companies rather than more speculative buys. Bapcor is very much a proven and profitable operation. Morningstar’s financials show me that the company has made an operating profit every single year since 2014. It passes this check too.

Does the company generate consistent cash flow from operations?

This step is related to the previous one but recognises that a company can report an accounting profit while still bleeding cash.

The idea of looking for positive operating cash flow reduces the likelihood that, in the absence of positive cash flows, the company will need to raise cash to fund its operations. This would dilute the ownership share of existing shareholders.

Bapcor also passes this test. Net operating cash flows have been positive every year since 2014. However, it’s worth noting that Bapcor did raise equity funding in April 2020 amidst the uncertainty of Covid-19. The firm raised $230 million, a move our Bapcor analyst Angus Hewitt views as overly conservative in hindsight but helpful for the firm’s debt metrics.

Are returns on equity consistently above 10% with reasonable leverage?

Return on equity shows the return that management are getting on shareholder funds invested back into the business. The reason Dorsey’s test calls for reasonable leverage is that high levels of debt can make this number look more attractive.

Bapcor passes the return on equity hurdle, but it is close. Its average return on equity for the past 5 years is 11.25%. It has dipped below the 10% level in each of the past two years but has also spent a fair bit of time in the low teens.

These returns haven’t been juiced by using lots of debt. By the end of 2023, Bapcor’s net debt was just 1.5x its annual earnings before interest, taxes and depreciation.

Is earnings growth consistent or erratic?

Consistent earnings growth suggests that a company is in a steady industry with growth potential and that the firm is faring reasonably well versus the competition.

Bapcor’s operating and post-tax profits fell in 2023 but the longer-term picture is encouraging. From 2016 to 2023, Bapcor’s net profit grew at a steady clip from $43.6m to $106.5m. While some years had bigger rises than others (and profits fell in 2020 and 2023), there weren’t any wild swings.

In assigning the company an Uncertainty rating of Medium, Hewitt noted that most of Bapcor’s revenue is non-discretionary. Said differently, customers face the choice of buying replacement parts for their vehicle or not being able to repair and use it.

How clean is the balance sheet?

Debt to equity compares a firm’s total assets to the amount of shareholders equity (which is calculated by subtracting liabilities from assets). The higher this number, the more debt has been used to fund the company’s asset base.

As a rule of thumb, Dorsey says that non-financial firms with debt to equity of over 4 warrants further questioning. In that case, Dorsey would want to know if the amount of debt carried is suitable given the nature of the business and if it keeps growing.

Bapcor’s leverage is under 2x and, as we saw earlier, it’s net debt is roughly 1.5x its annual cash flow from operations. Hewitt thinks Bapcor’s level of debt is reasonable compared to the company’s earnings and the reliable nature of its core replacement parts business.

Does the firm generate free cash flow?

Free cash flow is calculated by subtracting capital expenditure (investments in the business) from operating cash flow. Positive free cash flow shows that a company is making enough money to self-fund its growth with money left over for shareholders.

Bapcor has generated positive free cash flow in the vast majority of its years as a public companies. Two notable exceptions were 2016 and 2017, which both featured large acquisitions.

How much “other” is there?

This step seeks to eliminate companies with financials that are complicated and the use of one-off charges. Bapcor’s earnings before and after extraordinary items have been exactly the same for the past few years. I don’t think there is a great deal to be concerned about here at first glance.

In a deeper analysis, I would want to get a grasp of how aggressive the accounting used is on grounds like revenue recognition, asset lives, etc.

Has the number of shares outstanding increased over the past several years?

Bapcor’s number of shares outstanding rose from 281 million in 2018 to 341 million today, an increase of around 20%.

The vast majority of this stems from the capital raise at the height of Covid uncertainty in April 2020, and the number of shares has not risen since then. Looking back further, you can see a couple of bumps in shares outstanding that further research shows were issued to fund acquisitions.

Given that 2020’s capital raise is understandable in the circumstances, I did not write off Bapcor on this measure. I would, however, be interested in knowing how any future acquisitions would likely be funded.

Next steps

I think the value of this ten minute check is that it doesn’t take long, has clear guiderails and brings up some questions to answer in your future research. For example, why profits weaker last year and how future acquisitions are likely to be funded.

In my opinion, Bapcor passes the ten minute test. Therefore I might consider giving it a closer examination. Further steps in your research might include:

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