This Warren Buffett analogy makes picking your own stocks a slam dunk

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On several occasions, Warren Buffett used an analogy that, when I first heard it, completely changed the way I approach investing.

Asked about his methods for finding high-quality stocks, he describes a basketball coach walking down the street looking for potential players to sign. Great basketball players have attributes such as dexterity, speed, coordination, and high vertical jumps.

But there is one very obvious trait that many of the greatest basketball players share: they are tall.

Thus, Buffett said that if he was tasked with recruiting basketball players, he would simply start by looking for anyone over 7 feet tall.

While I’m not convinced the Oracle of Omaha would make a Hall of Fame basketball coach, his reasoning is sound. Not every 7 foot tall player will make a great basketball player, but the percentage of 7 foot players who are likely to be proficient players is much higher than that of 5 foot tall players.

This same concept applies to investing. When selecting stocks, it helps to have a quick method of telling 7ft from 5ft.

Let’s look at how to do this.

Image source: Getty Images.

The 7-foot test for stock picking

When I started investing, I frequently came across compelling ideas, but often after hours of research, I realized the company had serious flaws.

After hearing Buffett’s basketball coach analogy, I developed a set of initial criteria to help me quickly decide if an investment idea was worth pursuing.

Before diving into the details, I always make sure that a company ticks the following four boxes:

If a title doesn’t meet those criteria, I just move on instead of spending valuable time researching. If a business ticks all four boxes, I know it’s worth spending time analyzing the business.

I recently invested in the programmatic advertising company PubMatic (PUBM 5.46%).

Before diving into research, I put the company through my 7ft test, which it passed with flying colors.

Let’s take a look:

  • Its balance sheet has more than $400 million in current assets versus $200 million in current liabilities, which equates to a current debt-to-equity ratio of more than 2.
  • PubMatic has grown its revenue by an average of 32% per year over the past three years.
  • The company has generated positive cash flow from its operations for the past four years.
  • With $56 million in profit and $237 million in revenue over the past 12 months, PubMatic’s net profit margin is 23% and has been steadily improving.

These four criteria are easy to verify, which is important. This means that within minutes I knew the company was worth a deeper dive. And finally, after adequate research, I decided to buy stocks.

Your shortlist should reflect your investment style

The trick to developing an effective set of screening criteria is to first understand what you value in a quality company. Every investor is different, and knowing your own investment style is key to developing strong conviction.

If you are a growth investor, you may want to consider screening for price-to-earnings growth (PEG) and earnings growth. If you have an affinity for software-as-a-service (SaaS) businesses, you should probably look for a high net dollar retention rate (DBNRR).

Or maybe you’re nearing retirement, in which case you could start by looking at the Dividend Aristocrats.

In addition to the four criteria I use, here are some examples of attributes you might quickly look for:

  • Total assets greater than total liabilities
  • More cash and cash equivalents than long-term debt
  • Insider ownership of at least 10%
  • Company run by the founder
  • Net Promoter Score of at least 50
  • DBNRR of at least 110% (for SaaS companies)
  • Glassdoor CEO approval of at least 90%
  • Glassdoor employee rating of at least four stars
  • Gross margin of at least 50%
  • Increase in gross margin
  • Positive free cash flow
  • PEG ratio less than 2
  • Price-to-book ratio below 3
  • If the company pays a dividend, has it systematically increased it? Is he a dividend aristocrat?

Your time is precious, don’t waste it

Stock picking is not easy.

With over 5,000 companies listed on the stock exchange, it often feels like looking for a needle in a haystack. But developing your own 7-foot test will allow you to focus on companies that meet your definition of quality instead of spending valuable time researching companies you’ll probably never invest in.

Mark in white has positions in PubMatic, Inc. The Motley Fool has positions and recommends PubMatic, Inc. The Motley Fool has a disclosure policy.

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