Everyone, from the novice to the most experienced investor, quickly learns the importance of building a diversified portfolio, across asset classes, geographies and industries so that no one unforeseen event can do undue harm to your hard-earned savings. Not even the greenest rookie would buy five airline stocks and nothing else, no matter how good the prospects were for the firms in question. After all, a sudden conflagration in the Middle East could easily cause a spike in the oil price and do some serious damage to those airlines? profits and therefore share prices.

This raises the issue of what number of holdings makes the most sense. While his Berkshire Hathaway (BRK-A:NYSE) empire ranges from insurance to railroads to chocolate, legendary investor Warren Buffett is in no doubt less is more when it comes to portfolio picks and performance. The Sage of Omaha is on record as saying: ?If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.?

Academic theory shows that somewhere between 12 and 15 stocks will provide ample portfolio diversification, assuming they come from different industries. Greater reach can be achieved through professionally managed funds, investment trusts or exchange-traded funds, but for the do-it-yourself investor, a book of around a dozen individual equity picks is practical in terms of dealings costs, newsflow management and performance measurement.

The trick is how to find that elite group of names, since Buffett?s words emphasise the importance of understanding a company?s business model, assessing what drives its competitive advantages and ensuring you do not pay too high a valuation. This is where Shares comes in.

In this 10-part guide we will feature a checklist, designed to make stock selection easier. The Shares team already uses them every single time we produce a piece of research. The result of the team?s cumulative wisdom and the invaluable insights of experienced analyst, author and coach Michael Cahill, our checklists will help you quickly spot a potential plum and dodge a likely dud.

In this edition, we visit the concept of ?growth, risk and quality?, as devised by Cahill, and examine how to tie this triumvirate to valuation.

(Click on the following image to enlarge)

Good idea

Not surprisingly, since he is Berkshire Hathaway?s vice chairman, Charlie Munger shares Warren Buffett?s predilection for a fairly concentrated portfolio. At the investment company?s annual general meeting in 2004, Munger was quoted as telling shareholders: ?We believe that almost all really good investment records will involve relatively little diversification. The basic idea was that it was hard to find good investments and that you wanted to be in good investments, and therefore, you?d just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, it?s proven to be an obviously good idea. Yet 98% of the investing world doesn?t follow it. That?s been good for us.?

Besides his grasp of portfolio theory, Munger is also a keen student of behavioural finance and investor psychology. In a 1995 speech at Harvard Law School, he asserted: ?The psychology of human misjudgement ?.is a terribly important thing to learn. Terribly smart people make totally bonkers mistakes by failing to pay heed to it.?

Regular Shares readers will be well acquainted with the pitfalls presented by greed and fear and to combat these all-too-human instincts Munger is a strong advocate of checklists to ensure discipline is kept at all times.

His views here get strong backing from equity strategy research boutique Mirabaud Securities. It published a piece of research entitled The Power of Checklists which cited examples not just from money management but aerospace and medicine.

The paper cites Boeing?s (BA:NYSE) 1935 maiden test flight for the four-engined B-17 which resulted in a crash that killed the entire crew. The disaster was not due to mechanical failure but pilot error, as the man in charge had so many extra factors to consider owing to the extra engine power. The constructor?s response was to compile a list of basic checks that resulted in 13,000 B-17s making a massive contribution to the Allied effort in World War II as pilots flew the giant planes without further mishap.

Mirabaud also notes the case of American surgeon Atul Gawande. He was inspired by what he learned of Boeing?s experiences and applied them to surgery. The implementation of a two-minute checklist in eight New York hospitals in the early part of the last decade cut patient mortality rates
by 46%.

Cut out the noise

If checklists help people stay alive, then they can surely be applied to the financial markets, where information overload remains a problem. Munger?s classic text Poor Charlie?s Almanack sets out just four investment principles:

Do we understand the business?Does the business have an intrinsic value or durable competitive advantage?Does management have high integrity? Do we respect and admire them?Reasonable price?

Our ten checklists cover a range of eventualities and they will also become a habit and ingrained in your investment process to such a degree you will hardly notice you are using them. After all, when you began your investment journey you probably did not know how to work out a price/earnings (PE) ratio or net debt figure. Experienced investors will now be able to calculate these with the blink of an eye in order to carry out a swift appraisal of the profit and loss account and balance sheet accordingly.

This is not rocket science and it is all about eliminating costly errors and targeting picks that suit your investment goals, time horizon, target returns and appetite for risk.

Price must be right

Michael Cahill explains the growth, risk and quality concept neatly but a working example shows how it can be put into practice. Here we look at three sub-divisions of the alcoholic beverages industry, beer, wine and spirits. (Click the following image to enlarge).

A little common sense shows wine may be high growth but hugely high risk. This view is backed up by Treasury Wines? (TWE:ASX) cataclysmic profit warning this summer and the damage it did to Foster?s prior to the 2011 demerger from its then parent. Meanwhile China?s Dynasty Wines (0828:HK) saw its shares suspended in March, since when it has also disgorged a disappointing trading alert.

Contrast this with the more serene progress of the beer plays - Carlsberg?s (CARL-A:CO) Russian woes notwithstanding - and the dynamic re-rating enjoyed by the premium spirits companies.

Spirits stocks have generally been more highly rated than brewers or wine producers because of their superior growth prospects and the earnings quality conferred by their brands and pricing power. Think about it. People buy wine by the grape variety not the name on the bottle, in contrast to spirits where no-one cares about the juniper or grain and the brand is key. Crop failure or a glut can also hurt wine growers. It makes little odds to spirits firms.

Growth, risk and quality will therefore help you analyse a business and you can then tie this trio in to valuation. In the most simple terms, stocks are valued using the PE ratio. This is calculated by dividing the share price by the earnings per share (EPS) figure. This is just one tool and may not be suitable for every stock or industry - banks, real estate firms and insurers tend to trade off price to net asset value (NAV) and utilities by yield. In the case of firms with depressed earnings, enterprise value to sales could be used, while early-stage resource groups may have no revenues or profits at all. Gold explorers can be assessed in terms of a value for their ounces of reserves, while oil explorers can be gauged relative to the perceived worth of their proven and probable (2P) reserves.

In each case, growth, risk and quality can be used to assess the relative merits of an industry or stocks within a sector to determine which deserve a premium and which a discount. Again, the single most important determinant of your investment return is the price you pay for a stock. Buying ARM (ARM) in July 2000 at 758p would have been a blunder as it would have taken you 12 years just to get your money back. A swoop in October 2002, at the trough of 36.7p, would have brought huge riches. ARM was the unquestioned leader in the design of microprocessor architectures on both occasions. The valuation determined good or bad returns. Paying any price for a good investment case is likely to lead to expensive mistakes and the three-dimensional view offered by our checklists will help you avoid this trap.

The big decision

The stock market cannot always be right, as it would be impossible to make money, but it is smart and its views must be respected. Remember that if you are a buyer or a seller of a stock you are effectively saying the market is wrong because the valuation is either too high or too low. For your investment view to pay off, the market will have to change its view of the company and pay a higher or lower multiple of earnings.

? Growth: Earnings estimates will have to be met or exceeded if you are a buyer or missed if you are a seller.

? Risk: The business, financial and governance risks will have to go down if you are a bull or up if you are a bear.

? Quality: The predictability and visibility of profits and especially cashflow will need to improve for the shares to rise or worsen for them to fall.

The PE ratio is a starting point, no more. A stock?s rating, and especially its rating relative to the market, will tell you what the market is thinking. Changes in perception of growth, risk and quality will establish, accentuate or erode a premium or discount rating. This is important because total shareholder return comes from three factors:

? The level of a company?s profits and especially cashflow. Growth accounts for this and that is in turn the result of the firm?s business model and competitive strengths. This all generates the ?E?, the EPS figure, in the PE.

? The rating attached to the cashflow. Growth, risk and quality will each have a say in the ?P? in the PE. A higher rating (or re-rating) will boost returns, a lower one (or de-rating) erode them or even lead to losses.

? The dividend. Firms which pass the risk and quality tests are likely to be highly cash generative and thus capable of paying the growing distributions which, when reinvested and allowed to compound, can generate up to two-thirds of long-term shareholder returns.

The first of our 10 checklists explain what you need to consider when assessing these three factors, while our two examples below feature stocks where we believe a re-rating is due, as growth and quality surprise on the upside and the risks prove less than the market expects. In the next edition, we will move on to the subject of what catalysts to look for once you identify a stock which may be undervalued.

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