The stock market is a very crowded place. There are nearly 4,000 publicly-traded companies within the United States alone, and we’re adding another 100 – 150 every year.

That is a lot of companies to choose from! With thousands of investment options available, how can investors possibly make informed decisions about important topics — such as the upside potential, the risk levels, and the larger-market opportunities? And then after doing that research, how should we decide which ones are worthy of pulling the trigger on and actually starting a position?

The key is having a fine-tuned investing process. Developing a methodical way to separate the wheat from the chaff will help you find the most lucrative stock market opportunities, which will also most closely align with your personal investing style and goals.

Motley Fool senior writer Brian Feroldi encourages the use of an investing watchlist, an investing journal, and an investing checklist as necessary tools to find those most promising opportunities.

In an exclusive interview with 7investing, Brian describes how his investing process incorporates a quality checklist to numerically score companies and then progress them to his official watchlist. He assigns each company he is interested in with a score that ranges from -44 (the worst possible) to +100 (the best possible). His ultimate goal is to find “high quality, low risk compounding machines” that will serve him well as long-term investments.

Brian also explains why keeping an investing journal is so important to improve one’s process over time. He reveals two companies — one large and well-known and another that’s more under-the-radar — which scored extremely highly on his checklist.

Interview timestamps:

01:20 – Why and how to use an investing watchlist
05:00 – The benefits of an investing journal
07:30 – How to improve as an investor over time
08:45 – How to find the most attractive companies
09:30 – What to avoid
10:30 – Brian’s ‘quality checklist’ scoring system
16:30 – Two of Brian’s highest-scoring companies
22:40 – Key takeaways for individual investors

Here is a link to see all of the companies currently on Brian’s watchlist!

Publicly-traded companies mentioned in this interview include Adobe, Alphabet, and Simulation Plus. 7investing’s advisors and/or guests may have positions in the companies that are mentioned.

This interview was originally recorded on August 20, 2020 and was first published on August 27, 2020.

Transcript

Simon Erickson:

Hi everyone! 7investing founder and CEO Simon Erickson here and I’m excited to talk today about investing process. Because there’s thousands of companies to pick from in the stock market every single day. So how do we figure out which ones to actually size up and take a position in?

I’m fortunate to be joined by my guest this afternoon. Brian Feroldi is a senior writer at the Motley Fool. He covers technology and he covers healthcare. He’s also a Tesla bull and a solar panel enthusiast. Many different titles, Brian.

You’re also a good friend of mine, a former colleague of mine as well. Thanks very much for chatting with 7investing!

Brian Feroldi:

Unabashed Tesla cheerleader here! Yes, I’m thrilled to be here today.

Simon Erickson:

Yes, indeed. And, you know, Brian, you know, we’re talking about your a methodical investor, you’re a systematic investor too. And we’re talking about thousands of companies to pick from. Thousands of different stocks that are publicly traded out there.

I’d like to split this conversation up into three different segments where we talk about an investing watch list, and investing journal, and then also an investing checklist.

And let’s start with the first of those three things. Because the watch list is probably the most well-known here for people that are watching this podcast. How do you think about building and investing watch list and and why do we do this in the first place?

Brian Feroldi:

Yeah, I think that most people, most people listening, I mean they’re investors. So there’s no doubt in my mind that almost all of them have developed a watch list, and I certainly use watch lists. I mean, how else do you know what you’re interested in what you want to buy? Whenever I come across a company that interests me, I have a process that I go through, as we’ll get into. But whenever a company scores really well and really interests me, the first thing I do is throw it on my watch list because I’m not necessarily going to buy that company instantaneously, but I’m at least going to start tracking it.

Maybe I’m not thrilled with the valuation at the time, maybe I have questions about the company’s competitive advantage. Maybe I just don’t understand the story of the management team. Myself, keeping a watch list of ideas is incredibly useful. Because Simon, we know the market is volatile.

And occasionally great businesses get whacked for short term reasons. And if you have, if you can find a high quality business that’s trading at an attractive price that’s opportunity and the way that you find those is by keeping a watch list.

Simon Erickson:

And specifically, how do you find what is interesting on a watch list? I mean, you’ve got thousands of different choices. We’ve got high quality tech companies that have been around for decades. We’ve got retail companies. We’ve got hot penny stocks that are out there right now. How do you go about building a watch list?

Brian Feroldi:

Well, the watch list is mostly informed by my checklist. So whenever I come across any company, and the good thing about being online these days is it’s incredibly easy to find interesting companies to invest in.

So whenever I come across a potential investment idea, the first thing I do is I run it through my quality checklist. I am personally only interested in investing in high quality, low risk compounding machines. That’s my style of investing. I’m not interested in high risk. I’m not interested in cyclical companies. I’m not interested in finding cheap companies. I want to find the highest quality, longest growing, best run companies that I can. And I want to fill my portfolio with them. So how do you separate, given that there’s thousands of companies for us to choose from?

Something that I struggled with in years past was what do I buy there I have way more ideas than I do money. And trying to keep all the factors in my head that I like in a business became basically impossible. I’d be trying to say, “well, should I buy this one, or should I buy this one? Well I like this company’s growth rate, but I don’t like his management team. I like this other company’s insider ownership.

But maybe it has more competition.” And trying to keep all that in my head just became impossible. Finally, I got smart enough to actually write these things down and create a checklist that that weighed the factors that I am most interested in.

And subtracted points for the factors that I am least interested in. And that just gave me a systematic approach to take a stock rank it on a quality scale based on the things that I’m most interested in, and then focus my capital in in my best ideas.

Simon Erickson:

And we’ll double click on that checklist, a little bit  in a couple of minutes here. Because I think it’s really important and you’ve got a really great framework for going through every one of those.

And we’d also like to look at some of your favorite ideas right now some of the companies that are ranked really highly on that checklist.

But before we get into that, I’d also like to touch on the second thing we mentioned, which is an investing journal.

And I think that most people probably have, you know, some concept of a watch list. Or certain companies that they’re looking for out there.

But like you just mentioned, it’s really important, unless you’ve got a photographic or audiographic memory, to start writing these things down that you see out there so you can reference them later. How do you approach an investing journal?

Brian Feroldi:

Yeah, a journal is something that I heard that idea that I borrowed from many other investors that I super respect. And when I first heard it, I thought, “Boy, that’s going to slow me down. I don’t really like writing. I don’t really like going slow.”

But I’ve come to really respect to the power of keeping an investing journal. So my process now is whenever I’m about to buy a stock,

I force myself to go into my investing journal, write down the date, write down the company, write down the current valuation, and write down my current thinking of the company, why, given all the stocks out there, am I interested in that particular company? What am I bullish about? What am I bearish about?

What concerns do I have, and what would cause me to re evaluate my thesis? That’s going to sound like a whole cumbersome process, but I believe that doing so forces you to slow down. Forces you to really think things through. And most importantly, gives you a reference point in the future to look back on where you’re thinking went awry.

We all have bought in stinker stocks. I’ve certainly bought plenty of them. And I’ve learned the best lessons by losing money. I buy a company that I think is essentially bulletproof and the market laughs and the market says otherwise. And I lose a bunch of money.

By having a journal. I can go back in time and see why I was so enthusiastic about that company, what assumptions I made, what I got wrong. And then I can inform my future personal decisions and make changes to my process to make myself a better investor. So I would really recommend to everybody that takes investing seriously just start a journal. You will learn so much about yourself.

Simon Erickson:

And hold you accountable for your previous decisions. Something that you can refine that process over time.

Brian Feroldi:

Yes, exactly. And that’s the whole point, is it’s okay to make mistakes in the market. And even the best investors make still make tons of mistakes. But if you have a journal, you can go back and examine your own thinking style and say, “here’s the mistake that I made. How can I make sure I don’t make that mistake again.”

So if you don’t have a way to document that, record it, and see what you’re actually thinking at the time, you are very likely to keep making the same mistakes over and over again.

Simon Erickson:

Yeah, great point. Brian. You mentioned earlier, “high quality, low risk, compounding machines” are the companies that you’re looking for.

How has your process as an investor changed? You said that you know you make fewer mistakes over time. What’s something that, or a couple of things, that you’ve actually found yourself making fewer mistakes of, as you mature as an investor?

Brian Feroldi:

Well, I think my investing style has changed dramatically. When I first started out, I had no idea what I was doing. I bought garbage. I bought penny stocks.

That didn’t work out. So then I switched immediately to high dividend yield stocks. That didn’t work out. So I switched my process again and again. And every time I made a mistake or every time I lost money,

I was learning lessons along the way. I did get a couple of good investments in there. And then after connecting with a ton of other people, other smart investors,

And just through and consuming as much content as I possibly could, my process slowly evolved over time. And lo and behold, my results got a heck of a lot better. But a few years ago, I had so many stocks that I was tracking and so much to keep keep track of. I just wrote it down. I wrote a board post on The Motley Fool, and I said, “here are the characteristics that I find most appealing in an investment.”

You know I want a wide and expanding economic moat; competitive advantage. I want companies with organic growth potential meaning they’re not acquiring other businesses. They’re growing through their own homegrown products or services.

I want a high gross margin. I want a strong balance sheet. I want profits. I want free cash flow. I want optionality or the company that has the ability to have multiple futures. I want companies that can raise prices. Invested management teams. High levels of insider ownership. Recurring revenue. Etc, etc, etc. So I just made a list of like 15 things that I said yes, if a company has all of these things, I’m in. Like I’m really interested.

At the same time I made another list that says, all right, what do I want to avoid? What if I see is like almost, not necessarily a thesis buster, but it’s unattractive to me.

Number one, no moat. You don’t have a competitive advantage. I don’t care how great you are. I’m not interested just period.

To me a moat is a must if you’re going to make any investment. I don’t like companies that rely on one or two customers for the bulk of their sales.

That means that one bad relationship or one decision by another company could ruin this investment thesis. I don’t like companies that lose money for long periods of time and will do so for the next five years.

I don’t like certain industries. I don’t like companies that don’t have recurring revenue. I don’t like extreme levels of stock based compensation. Etc. Etc, etc. So I will make a list of all the things that I want in investment and I made a list of all the things I don’t want.

And then through trial and error and peer review and feedback from tons of people, I created a system that scores companies on a zero to 100 point scale based on the factors.

Based on factors that I think are most appealing. Once I have a score. I then subtract points based on things that I don’t want to invest in.

The process is always, you know, the system isn’t perfect. It’s always a work in process. It’s not going to find every home run investment.

But I think that going through this process is super valuable and it greatly increases my accuracy rate so that I dramatically lower my chances of buying companies that are just gonna blow up my portfolio.

Simon Erickson:

Yeah, that’s excellent Brian. We’ll also link to the checklist criteria that you mentioned there too. But we’ll put your framework that you have on there as well.

As you were describing it, it kind of makes me think of the whole idea of “conscious competence.”

And it kind of has four phases. You go through as you’re learning about being an investor. None of us starts as a really wonderful investor, you got to learn things over time. It’s kind of like playing golf.

When you first start playing golf, you hit it and it you know shanks off to the right over the trees. You have no idea what happened. You are “incompetence and completely unconscious of it” at the same time. You have no idea why it’s going the way that it is.

And then after you know doing that for a second. For a while, you reach the second phase where you actually are aware of the fact that you’re hitting it the wrong way. It’s still going off and you know you’re you’re hitting it over to the trees. But at least you’re starting to say “Oh well, I think I’m doing something wrong here, and I’m aware of that.”

The third phase is you start focusing on the competence. You are “conscious of your competence.” You have to hold the golf club a certain way in order to hit that shot straight out of a tee box. And the fourth phase is “unconscious competence.” Where you don’t even pay attention to it anymore. You’re just Tiger Woods and you hit it the same way every time.

Like when you think about it that way, it’s the same thing with investing. With a process. You keep refining it, you realize the holes in your process, you improve them over time. And it improves your hit rate, like you were just mentioning.

Brian, let’s jump into the checklist. Part of this is the third part of the conversation. I see that you’ve moved also from the Harry Potter background to Charlie Munger in the background there. And Warren Buffett, yes, on the other side. Getting some other good investors along there with you (for anyone who’s able to see the video of this).

But let’s dig into the checklist that you have there. You know, you mentioned a couple things that you’re looking for. You want to have companies that have moats. You don’t want to have companies who aren’t too tied to just a couple of customers.

But checklist, you’ve developed a very quantitative framework for finding the highest quality companies out there. How do you approach this checklist that you have?

Brian Feroldi:

Sure. So as I said, it’s a system that is based on a score of zero to 100 and I really liked the idea of starting with 100 points because it forces you to really think through and rank them.

Based on the factors that you think are most important. So for example, I think that the Moat is the most important factor to invest to any investment. So I gave it 20 points out of the hundred 20 points are dedicated just to the moat.

And the next most important thing in my opinion, is the potential of a business, the ability to for it to grow for a long period of times. I give 18 to that. Financials are 17. Relationship with the customers are 10. The management, the culture are 14. The stock itself is 11 points. And the company specific factors, as I call it, is 10. What I liked about sticking to exactly 100 points is that every time I added a point to one section, I had to subtract it from another.

So it really made me whenever I wanted to make any sort of change to it, I had to really want it. So I agonized when I was coming out with how to allocate these points.

I just think that the constraint of starting with exactly 100 really makes you think hard about truly what do you matter.

Because if it was previously it was just a point system that added up. And when you do that, it’s easy to just keep adding and adding things. And every time you add something that dilutes the value of everything else.

So that’s my system as it exists today. And then once I get that score for the business. Again I go through my thesis busting checklist and none of these on their own completely evaluate the thesis, except for accounting irregularities, I kind of made that as a emergency automatic elimination. But I just subtract points. If I see customer concentration or if the stock based compensation is really high or if they have a lot of business done in foreign markets. So a really great company can still get through and be and be a worthy of an investment, even if it has some of these, but they can’t have too many points subtracted. Otherwise, it’s just eliminated from contention.

Simon Erickson: And do larger companies necessarily score higher on your checklist, because most they have time to grow into that? They get larger, the larger market shares where they’re playing. Is it easier for a big company to score higher than a small company?

Brian Feroldi:

Overall, I would say, yes. Though that’s not on purpose. That’s not by design. There are lots many, many high quality very high quality, small companies. However, in general, how does a company go from small to big? Well, it’s got to be doing something right. It usually has to have a moat. It usually has to have financial resilience. It used to have a very diversified customer base. So this isn’t necessarily designed to get me into larger companies. But given the metrics that I score on, I would say that a large company has a better chance of scoring well than a small one does.

Simon Erickson: But not always. Okay. Brian and let’s go through a couple of specific companies that have scored well on your checklist.

Go ahead and start me out with one company that is a larger and maybe more familiar company that did quite well on your checklist.

Brian Feroldi: Sure. So one company that I hold in extremely high regard is Adobe. Adobe Systems. So I think most people know them as the software maker behind products like Photoshop, Acrobat, Premier. They also have a very large and growing business in that caters to the needs of businesses. Can help them with things like marketing. Adobe has made several acquisitions in recent times, to grow that side of the business as well. And Adobe was a company that I’ve known about for years, Simon. Years. And I never paid attention to it. And that was just completely my own flaw. But once I finally ran it through my checklist, it got one of the highest scores I’ve ever seen.

And when you really dig into the details of this company, Adobe is a financial powerhouse. It’s numbers are our jaw dropping. I think it has a wide moat. I think it has a lot of potential even ahead of it. It has 100% recurring revenue.

It’s got pricing power. And amazingly, the thing that really jumped out to me this is a this is a big company, but it’s also run by a CEO that has been there for years, decades.

Even and it gets amazing reviews from employees. So this company does a tremendous job of taking care of all of its stakeholders and employees and suppliers. It’s environmentally friendly, if you’re into ESG investing. The financials are are amazing and it’s extremely low risk. So when I ran it through my system, Adobe scored 86 out of a possible 100. And for a sense of scale, the highest score I’ve ever given is 88 and that was with Google. So this is right up there with basically one of the highest quality businesses I’ve ever found.

And I wouldn’t have known that Adobe was so awesome unless I would have run it through the system in the first place. So yeah, Adobe is a company that I think is a compounding machine and I’ve owned it for years and I plan on owning it for many, many more.

Simon Erickson:

And that recurring revenue piece so key, right. They’ve executed so well on this transition to cloud. They had those recognizable software titles, the Photoshop Premier, the PDF viewer, that kind of stuff. That they’ve really moved to the subscription model and it’s done incredibly well for their margins over time. So excellent management execution. I would assume that was scoring pretty highly on the model for that one as well.

Brian Feroldi:

Yeah, exactly. One of my research methods that I do is I always go to glassdoor.com and I want to see, you know, employees that give the company four stars out of five. That means that they’re going to have an edge with retaining top talent and recruiting top talent. And at the same time, the CEO was regarded as one of the highest rated CEOs in the world.

I mean, that’s incredible considering this company is competing for talent in Silicon Valley. We know that the competition there to retain and attract high quality engineers is extremely competitive. So you have to have a great energized workforce, if you’re going to attract the best and the brightest for your business.

Simon Erickson:

Absolutely. Okay, Adobe. Adobe is a common name and we know Adobe. We know it’s an awesome company. Definitely a financial powerhouse, Brian. What’s a company that scores really high in your checklist that we might not have heard about before?

Brian Feroldi:

Yeah, well, Simon. Have you ever heard of a $1 billion company called Simulation Plus? Ticker symbol “SLP”?

Simon Erickson:

I have not. In fact, we talked about this five minutes before we started recording this episode. And I told Brian the same thing. No, I’ve never heard of this company before. So this is new to me also.

Brian Feroldi:

All right. Well Simulation Plus is a software company based out of California. And they develop a range of software that helps biotechnology companies to simulate how drug molecules will interact in the body. The idea here is that you can take their software and plug a molecule into it and the software will predict whether or not there’s toxicity in the human body. So they have a plethora of tools that help biotechnology researchers to find and develop drugs faster.

That is a brilliant market because it takes 10s or even hundreds of millions of dollars to go from start to finish with any drug and if this software can predict with any level of accuracy whether a drug might be toxic in the human body, it allows researchers to kill ideas way before they spend money down the road on clinical trials.

Simulation Plus has been doing this for decades. It’s still run by its co founder, they’ve made a couple of acquisitions in their markets to build out their product offering. And because they’ve been doing this for so long, they use machine learning to make their software better and better and better over time. So this company while it seems like it’s in a very niche niche application, it’s a backdoor way to play the biotech industry. And it’s profitable. So again, this is a company that I took, top to bottom, through my checklist. I’d never heard of it before and it’s still a small cap. It’s a billion dollar company.

But this company scored an 81 on my list. And again, anything over 80 is exceptional. So Simulation Plus is a company I would have probably looked past. But once I put it through here, boy, was I impressed.

Simon Erickson:

Yeah, sounds like a really good one. 81 points on the checklist! That’s great. And yeah, of course, in biotech everything is front loaded, right? Those clinical trials, anything that you can do to reduce costs or improve the time to market of any kind of drug that you develop and then commercialize is a huge win for those drugmakers.

Brian, putting putting this all together, we talked about the watch list, we talked about the journal, we talked about the checklist. It sounds like a very systematic approach to investing. Any other takeaways that you would recommend for individual investors, as they’re going out and looking for the best opportunities in the stock market?

Brian Feroldi:

Yeah. I would say a watch list, a journal, and a checklist are three free tools that any investor can use to get better. And if you’re going to invest and if you’re interested

in learning more, write down what you’re doing. Really slow down and take the time to understand what you’re buying and why you’re buying it. How it compares to

other businesses. So watch lists, journals, and checklists are three amazingly useful tools. But if I was to guess, Simon, I would guess that 95% if not more of investors do not use them.

Simon Erickson:

I would agree with that. Especially the journal part of it. Because, you know, we see things we read things and we forget them. But a journal kind of forces you to go back and say, “okay, what was I thinking at that time? Was that right or wrong?” And improving that process is so important to returns.

Brian Feroldi:

Exactly. I mean, I’ve made so many mistakes in investing. I guarantee I’m going to make a lot more, but at least I have a system in place that I know that will inform me and help me learn from my mistakes so that I don’t make the same mistakes over and over.

Simon Erickson:

Well, I certainly think this process and this framework is very valuable for investors. Hey Brian, thanks very much for chatting with 7investing here this afternoon.

Brian Feroldi:

Anytime Simon. Good to see you, my friend.

Simon Erickson:

Great to see you as well. And thank you everyone for tuning in. Once again, we are here to empower you to invest in your future. We are 7investing!