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. Exhibit A: Enron.
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. The huge drop in interest rates over the past two years, for instance, has resulted in a record wave of home refinancing and spurred consumer spending. That has greatly benefited industries such as homebuilders, appliance manufacturers, and retailers. But interest rates can hardly be expected to go lower anymore, and most economists expect them to rise somewhat in the year ahead. So companies that benefit from falling rates may see their growth slow down significantly.
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.