Making hay all of this data can be mind numbing at times. If you believe everything you hear, there are always thousands of great stocks to own at any given time. Of course, you know that simply isn’t true — especially if you have ever taken a stock tip from your neighbor.

So what can you do to sift through all the garbage and hype that you come across — so at the end of the day you are left with a short list of great investment opportunities?

There are three tests you can put any stock through before you invest in it. 99% won’t pass at least one of these tests. Those are the ones not worth investing in — or at the very least, they are better left for someone else. But on occasion, you’ll find a company or two that does pass all three tests. Those are the ones you should consider owning in your portfolio.

Test #1: Circle of Competence

Charlie Munger, Warren Buffett’s sarcastically brilliant sidekick at Berkshire Hathaway, once said, “The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.”

As human beings, there is no way we can possibly know everything about every company in every industry. It simply isn’t possible. Yet when it comes to making an investment decision, so many people forget this. They think they can properly value an ethanol plant just as well as a startup biotech company or a software business.

Inevitably, they can’t. People make false assumptions (or no assumptions whatsoever) about a business they don’t know a thing about. And when the business goes out of favor or the stock price falls, they are left wondering what happened.

For instance, think back to the 1990s for a second. How many people understood Enron’s business model? Did you really understand energy derivatives? Or how many could sit down and explain to me how Celera Genomics was able to sequence the human genome?

Probably not many.

When it comes to investing, you are much better off narrowing your focus to companies you can wrap your hands and mind around. If energy derivatives aren’t something you understand, how can you expect to properly assess whether Enron is a good company? You can’t.

With that said, take a look at your portfolio right now. Look at the businesses you own. Being 100% honest, how many of those businesses do you really understand? If you had to explain the business model to a 10-year-old, could you?

If you couldn’t, you might be better off not owning that stock. As Warren Buffett said in his 1998 annual meeting, “I don’t want to play in a game where the other guy has an advantage…The fact that there’ll be a lot of money made by someone in cocoa beans doesn’t bother me really. There’s going to be a lot of money made by someone in cocoa beans. But I don’t know anything about ’em. There are a whole lot of areas I don’t know anything about. So more power to ’em.”

In order to pass test No. 1, you have to understand the business. It must be within your area of competence or expertise. If it’s not, walk away.

Test #2: Margin of Safety

I had to laugh last week. After the Dow Jones shed off 140 and 120 points on Thursday and Friday, I saw several articles published the following Monday proclaiming the market was ripe for “bargain hunters.”

Most people don’t have a clue what a bargain is. They think they are getting a good deal when they are really overpaying. After all, just because a stock falls from $10 to $5 doesn’t mean it is a bargain — especially if its intrinsic value is only $3 a share.

A company’s intrinsic value is a bit tricky to understand. But essentially, if you make an assumption about how much cash a company is likely to make from now until eternity and discount that to the present, you come up with a number. In theory, that number is the true value of the company.

For instance, let’s look at one of the hottest small-cap stocks in recent memory, TASER Intl., Inc. (TASR:NASDAQ). From 2002-2004, TASER’s cash flow from operations went from negative $0.8 million a year to $30.3 million to the good. And during that time, its stock price rose from $1.13 to $32 a share. Of course, nothing rises forever. And for a brief time in 2004, TASR corrected all the way down to $11.88 a share.

Was it a bargain at $11.88? Everyone sure thought so at the time. But the numbers said something different.

Between 2002-2004, TASR grew at a triple-digit rate — which is not sustainable for very long. But what if you assumed the stun gun company could grow 10% a year for the next 10 years (dating back to 2004)? And at the end of those 10 years, you could sell your shares outright for 20 times earnings plus cash on hand. Sound reasonable?

After crunching the numbers (using a 10% discount rate), I determined TASR would be worth $825 million by the end of 2013. With 97 million shares outstanding at the time, its intrinsic value was $8.50 a share. In other words, even after falling from $32 to $11.88, TASR was still overvalued. There was no margin of safety — meaning you could not buy the company for less than its intrinsic value.

Not surprisingly, TASR trades for $9.61 today — 19% less than its low in 2004. And it still isn’t worth that much!

The great investors (think Buffett, Munger, Whitman, Greenblatt, Templeton, etc.) insist on buying good companies for less than they are worth. So if there is no margin of safety, they don’t write a check. Neither should you.

Test #3: Time

One of the most frustrating complaints I see day in and day out from readers is that they can’t understand why a stock I recommended two months ago isn’t up 300% already.

Crikey! I don’t even know how to respond to those complaints. It’s unbelievable, unrealistic and utterly amazing. Over the last 80 years, the stock market is up about 9% a year. Warren Buffett, the most prolific investor of our age, has averaged a robust 16% a year since 1990. Yet some people expect to make 300% in a few months? Come on!

It is next to impossible to “time the market” or make a lot of money in a short amount of time. It has been proven that those who simply buy and hold beat short-term traders (who hold for between a month and a year) 99.8% of the time.

So before you ever put your money in a stock, ask yourself if it is a business you don’t mind owning for two, five, even 10 years. Does the thought of holding a stock that long scare you? Is there a good chance the business won’t be around that long?

If the answer is yes, you may want to reconsider your investment idea. Sounds like the stock is highly speculative — and may not deliver those remarkable gains you hope for.

Final Thoughts

At the end of the day, investing is a difficult task. You have so many choices. You are bombarded with so many different ideas. And there are a ton of traps waiting for you around every corner. But if you do nothing more than pass each stock idea through these three tests, you will not only avoid many of the pitfalls, you will see far better results — over time.

What more can you really ask for?

Good investing,

James
May 18, 2006

Three Tests for Great Investing was originally featured in the Penny Sleuth.