Courtesy : Fortune Mgazine
According to studies conducted during the stock market boom of the
late 1990s, the average investor devoted far more time to researching
his next vacation
than to investigating the stocks he was buying. Sounds
foolhardy, right? And also a bit familiar. In truth, the thought of
thumbing through guidebooks to compare beachfront hotels in
Antigua is a lot less daunting to most of us than trying
to come to a meaningful understanding of something as complicated as a
public company. We'd rather just roll the dice.
But here's the really crazy part: Anyone can take a lot
of the luck out of investing by applying a relatively small amount of
time and effort. To demonstrate, we put together a
checklist of ten basic questions every investor should
ask before plunking his or her hard-earned money down on any stock.
Inspired by the ideas of corporate consultants like Ram
Charan, the approach doesn't require exhaustive
financial-securities analysis. In fact, some of the questions may sound
almost elementary. But we can guarantee this: If you take the
time to answer them before buying, you can make a wager
that is firmly grounded in the long-term prospects of a business rather
than merely hope for a hot hand.
( 1 ) HOW DOES THE COMPANY MAKE MONEY?
If you don't know what you're buying, you're hardly in a
position to know what you should be paying for it. So before you buy a
stock, you need to get a handle on how the company
earns its dough. As basic as that sounds, the answer is
not always so obvious. General Motors, for instance, sells millions of
vehicles every year--unfortunately, it's barely making
any money on them. In fact, almost 100% of GM's earnings
these days derive from loans the company makes to consumers through its
financing arm, General Motors Acceptance Corp. And
about half of those profits aren't coming from car
loans, as you might assume. They're coming from residential mortgage
loans that GM makes to homeowners through subsidiaries like
ditech.com (yes, the same outfit in those ubiquitous
television commercials). That doesn't necessarily make GM's stock a bad
investment. But clearly, it gives you a better
understanding of the company's risks and potential
profits.
Leaf through the filings of FORTUNE 500 companies, and
you'll find dozens of similar examples. That's why a company's most
recent annual report is required reading for any stock
investor. There you'll find a detailed description of a
company's business units and a breakdown of the sales and earnings
figures that come from each. You'll also find the answer to
another crucial question: Are those earnings likely to
be converted into cash for investors? While "net income" and "earnings
per share" results may dominate the headlines in the
business press, those figures are merely accounting
concepts. It's cold, hard cash that counts the most for
shareholders--either in the form of dividends or reinvestment in the
company's operations that should lift the stock price.
Turn to the statement of cash flow in the annual report and see if "Cash
flow from operating activities" is positive or negative
and whether it has been growing or declining. And check
for this red flag: Are net earnings (as reported on the income
statement) increasing while cash flow is declining? That could
signal the use of creative accounting practices designed
to goose paper profits that are of no benefit to shareholders.
(2) ARE SALES REAL?
Speaking of cash, it's important to realize that, thanks
to accounting rules, a company can book sales revenue long before the
cash actually comes in the door. (In the worst-case
scenario, the cash never comes in the door.) And that
can drastically affect the price you should be paying for the stock
today. How can you tell if it's the case? Often it's clearly
spelled out in the company filings. Take, for example,
the case of tech company RSA Security. In the footnotes to its 2001
first-quarter financials, the company revealed that it had
switched to an aggressive (but allowable) accounting
method that permitted RSA to book sales revenue as soon as its software
was shipped to distributors--why wait until an end user
actually purchased it?
Sometimes the warning signs of revenue manipulation are
more subtle. For instance, be alert to companies whose sales are
increasing at a far faster clip than those of its competitors.
"If you can't nail it down to something specific, like
the company having a product they can't keep on the shelves, you have a
right to be suspicious," says Jack Ciesielski, a
forensic accountant and publisher of the highly regarded
Analyst's Accounting Observer. Be wary also of companies whose sole
source of sales growth appears to come from gobbling up
other companies. If a firm is averaging more than a
couple of acquisitions a year, the motive is likely to be management's
desire to satisfy Wall Street's short-term expectations.
Over the longer haul, integrating a bunch of disparate
companies into one can get messy and costly.
(3) HOW IS THE COMPANY DOING RELATIVE TO ITS COMPETITORS?
Before buying a stock, it's vital to know how it stacks
up against the competition. The first readily accessible place to start
your analysis is with sales figures. "The best clue as
to whether a company is beating its competitors is to
simply watch year-over-year revenues," says mutual fund manager Ron
Muhlenkamp, whose eponymous fund has handily beaten the
S&P 500 index over the past decade. If the company
is competing in a high-growth industry (like videogames), are its sales
growing as fast as those of its competitors? If it's
operating in a mature industry (like grocery retailing),
have sales been holding their own over the past few years? Pay close
attention as well to the sales inroads made by new
competitors, especially in those industries that aren't
growing. "Wal-Mart going into groceries has upset the whole industry,"
notes Muhlenkamp. "Based on the past, Kroger and Safeway
may look cheap, but in the past they weren't competing
with Wal-Mart."
And don't forget the cost side of the equation when
comparing a company with its rivals. Automakers GM and Ford, for
example, are saddled with huge costs related to pension and
health-care plans for their retirees--costs that put
them at a severe competitive disadvantage to foreign competitors like
Toyota and Honda.
(4) HOW DOES THE BROADER ECONOMY AFFECT THINGS?
Some stocks are highly cyclical--in other words, the
company's performance is heavily dependent on the state of the economy.
And cyclical stocks aren't always the bargain they appear
to be. For example, when the economy is on a downswing,
the stocks of paper companies may begin to look incredibly cheap. But
there's a good reason for that: In tough economic times
many businesses cut back on their advertising,
newspapers and magazines get thinner, and paper companies therefore sell
less paper. Of course, the opposite effect usually occurs
coming out of a recession.
Investors should also pay close attention to trends in
interest rates, since rate moves can have a dramatic effect on many
industries.Perhaps one of the most important factors to consider
before buying a stock is the degree of price competition that exists
within the industry. Price wars may be great for consumers,
but they can quickly kill a company's profits. According
to an analysis of FORTUNE 1,000 companies conducted by consulting firm
McKinsey & Co., for each 5% decrease in its selling
price, a company would need to increase the number of
units it sells by 18% to break even. "For most industries that just is
never going to happen," warns Craig Zawada, a McKinsey
partner and pricing specialist. In most cases a company
fighting a price war must have a big cost advantage over its competitors
if it hopes to remain profitable. Just witness the
havoc the so-called "burger wars" have continually
wreaked on the bottom lines of McDonald's and Burger King.
(5) WHAT COULD REALLY HURT--OR EVEN KILL--THE COMPANY OVER THE NEXT FEW YEARS?
Before you invest in a company, you must give some
thought to the worst-case scenarios it may face in the years ahead. For
instance, a business that's dependent on one customer for a
huge chunk of its sales could collapse if it lost that
customer. You can get an idea of these risks by reading a copy of the
initial offering prospectus (if the company has just gone
public) or the most recent 10-K--the annual report a
company files with the Securities and Exchange Commission. (You can
download both documents at the SEC's website,
www.freeedgar.com.) Take fiber-optic maker Sycamore
Networks, which went public in late 1999. Anyone who had read the
offering prospectus would have discovered that the company had
only one customer, Williams Communications. Two and a
half years later Williams went bankrupt; today the stock of Sycamore
(which managed to pick up a few more customers along the
way) has plunged by about 97% from its 2000 high.
Some businesses are just inherently more risky than
others. Consider the many profitless biotech companies whose shares have
soared only to come crashing down after their wonder drug
got shot down by the FDA. Which brings us to another
important point: If the performance of a company is heavily dependent on
the actions and reputation of one person, then be aware
that the risk attached to the stock will automatically
be several notches above the norm. Indeed, the stock of Martha Stewart
Living Omnimedia is down some 50% since its namesake's
current legal woes began in June 2002.
(6) IS MANAGEMENT SWEEPING EXPENSES UNDER THE CARPET?
Throughout the course of a company's history,
write-downs and restructuring charges are often unavoidable. But alarm
bells should go off if a company has a habit of taking those
"one-time" charges year after year: It becomes
practically impossible for investors to figure out just how profitable
the company really is. For instance, in the years leading up to
its bankruptcy in 2002, retailer Kmart repeatedly took
one-time charges for everything from closing its ailing stores to
writing down its obsolete inventory to "redefining" its
Internet business. "That was just classic," says
Michelle Clayman, chief investment officer at New York investment
management firm New Amsterdam Partners, who has studied the
phenomenon of serial chargers. "They kept having all
these charges that their competitors weren't having."
Clayman advises that if you see one-time charges
appearing in at least three of the past five years of income statements,
you should be wary of the stock. In fact, her research has
shown that about 70% of the time, the stocks of
companies falling into this category consistently underperform the
S&P 500 index. Check the notes to the financial statements for
an explanation of the one-time charge; sometimes it will
relate to a move that has actually benefited the company, such as the
early retirement of debt refinanced at a lower rate. But
all too often the charges spell bad news for potential
investors.
(7) IS THE COMPANY LIVING WITHIN ITS MEANS?
Even if a company's profits look rosy today, those good
times simply won't last if it has racked up a gargantuan pile of
long-term liabilities. Before you buy any stock, check out the
amount of debt on the balance sheet--too much debt is
risky, since a slowdown in sales or a hike in interest rates could
threaten a company's ability to make interest payments. And it
greatly decreases a business's margin for error. "When
you have debt picking away at you, you not only need to be right, you've
got to know when to be right, or else you're dead,"
says Bob Olstein, founder of the Financial Alert fund.
What's more, debt holders come first in the pecking order: A company
must pay interest on its debt but is under no obligation to
pay dividends to shareholders. To determine whether a
company is overloaded, divide long-term debt by total capital (debt plus
shareholder's equity--both numbers are on the balance
sheet). If the result tops 50%, there's a strong chance
the company is borrowing beyond its means.
But debt isn't the only way a company can get in over
its head. Stock options--that great boon to executive compensation--come
at a steep price to shareholders. In the footnotes to a
company's annual report, it must disclose what earnings
would have been had options been factored into the equation. Make this
footnote required reading: Options can quickly turn
reported earnings into losses, as would have been the
case in 2002 for Apple Computer, Applied Materials, and Charles Schwab
had they expensed their options.
(8) WHO IS RUNNING THE SHOW?
Assessing the quality of a company's leadership team is
not always a straightforward exercise for the average outsider. Still,
experts say there are some classic indicators that
investors should consider before buying a stock. Mike
Mayo, the straight-shooting Prudential Financial bank analyst,
recommends that investors read several years' worth of the letters
that CEOs write to shareholders in their annual reports.
Has the management team been consistent in its message, or is it
constantly changing strategy or blaming outside forces for
poor performance? If the latter, steer clear of the
stock.
Even a company's headquarters can say a lot about where
the management team has placed its priorities. "If I see a big,
spanking-new headquarters, the stock's a sell," says Donald
Sull, an assistant professor at Harvard Business School
who studies CEOs and organizational behavior. "There's just too much
shareholder cash sloshing around." Sull cautions that
investors should steer clear of companies possessing any
of the following in their new headquarters: an architectural award for
design, a waterfall in the lobby, or a heliport on the
roof. As lighthearted as this warning may sound, Sull
insists he's dead serious. "Management is saying, 'We've declared
victory, and now we're building a huge monument to our
victory,' " notes Sull. "But they're not thinking, 'Hold
on a minute: Maybe the thing that got us here in the past isn't the
thing that's going to be best going forward.'"
(9) WHAT IS THE COMPANY REALLY WORTH?
The greatest company in the world can make for the
lousiest investment in your portfolio if you pay too much for the stock.
By the same token, a company with average fundamentals can
be your star performer if you buy it at a cheap enough
price. Still, as Warren Buffett pointed out in FORTUNE's 2001 Investing
Guide, investors will jump at the chance to buy just
about anything at a discount--except stocks. Indeed, all
too often investors prefer to wait until the price of a stock has gone
up before buying in.
Don't fall into this trap. If the stock you're thinking
about buying has been on a rip-roaring tear of late, hitting its 52-week
high, find out why: The fact that it's "hot" isn't
enough reason for you dive in. "Individuals tend to herd
into certain stocks," says John Nofsinger, a finance professor at
Washington State University and author of Investment
Madness: How Psychology Affects Your Investing. "But if
you're going to buy a stock because everyone else has bought the stock,
then aren't you the last one in? Wouldn't you rather
buy a stock before everyone else buys it?"
Here, the stock's price/earnings ratio (the stock price
divided by earnings per share) is still one of the best and quickest
ways to value a company. As a general rule, most
value-oriented portfolio managers won't touch a stock
with a P/E ratio above 30, even if it operates in a growing industry.
(And why would they? Compared with the overall market's
valuation, that means the company's returns would have
to be roughly 50% better for investors to profit.) Remember, if you're
using "next year's" or 2005's projected earnings to
calculate your ratio, you're guessing--not evaluating.
The next critical step is to review the cash flow statement, checking
for positive (and hopefully growing) cash flow from
operations. If a company has never managed to generate
positive cash flow, any rise in stock price will be much more a
reflection of wishful thinking than economic reality.
(10) DO I REALLY NEED TO OWN THIS STOCK?
With about 15,000 publicly traded stocks available for
sale on U.S. exchanges alone, there's no one "must have" investment. But
all too often, we allow ourselves to become convinced
that we'd be missing the boat if we didn't own the likes
of WorldCom or eToys. "Too much of the time we invest in a story, and
that usually works out badly," says Nofsinger. So make a
pact with yourself here and now that you'll hold off on
your purchase at least until you've answered questions 1 through 9. If
you invest on this basis, you'll have the conviction to
hold on to your stock throughout the broader market's
zigs and zags. You'll also have the comfort of knowing that you have
invested in, not gambled with, your long-term financial
future.
