ten questions every investor should ask

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Dow Jones & Reuters

Investor's Guide 2004Ten Questions Every Investor Should Ask Before Buying A ; Stock Before you bet your hard-earnedcash, run through this simple checklist to make sure you know what you're really getting yourself into.Janice Revell3220 words

22 December 2003Fortune122EnglishCopyright (c) 2003 Bell & Howell Information and Learning Company. All rights reserved.

According to studies conducted during the stock market boom of the late 1990s, the average investor devoted farmore 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 beachfronthotels in Antigua is a lot less daunting to most of us than trying to come to a meaningful understanding ofsomething 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 smallamount of time and effort. To demonstrate, we put together a checklist of ten basic questions every investorshould 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, someof the questions may sound almost elementary. But we can guarantee this: If you take the time to answer thembefore buying, you can make a wager that is firmly grounded in the long-term prospects of a business ratherthan 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. Sobefore 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 mill ions of vehicles every year--unfortunately, it's barely making any money on them. In fact, almost 100% of GM's earnings these days derivefrom loans the company makes to consumers through its financing arm, General Motors Acceptance Corp. Andabout half of those profits aren't coming from car loans, as you might assume. They're coming from residentialmortgage loans that GM makes to homeowners through subsidiaries like ditech.com (yes, the same outfit inthose 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 acompany's most recent annual report is required reading for any stock investor. There you'll find a detaileddescription of a company's business units and a breakdown of the sales and earnings figures that come fromeach. You'll also find the answer to another crucial question: Are those earnings likely to be converted into cashfor investors? While "net income" and "earnings per share" results may dominate the headlines in the businesspress, 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. Turnto the statement of cash flow in the annual report and see if "Cash flow from operating activities" is positive ornegative and whether it has been growing or declining. And check for this red flag: Are net earnings (as reportedon the income statement) increasing while cash flow is declining? That could signal the use of creativeaccounting 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 revenuelong 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 thecase? Often it's clearly spelled out in the company filings. Take, for example, the case of tech company RSASecurity. In the footnotes to its 2001 first-quarter financials, the company revealed that it had switched to anaggressive (but allowable) accounting method that permitted RSA to book sales revenue as soon as its softwarewas 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 companieswhose sales are increasing at a far faster clip than those of its competitors. "If you can't nail it down tosomething specific, like the company having a product they can't keep on the shelves, you have a right to besuspicious," says Jack Ciesielski, a forensic accountant and publisher of the highly regarded Analyst's AccountingObserver. Be wary also of companies whose sole source of sales growth appears to come from gobbling up othercompanies. 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 bunchof 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 accessibleplace to start your analysis is with sales figures. "The best clue as to whether a company is beating its

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competitors is to simply watch year-over-year revenues," says mutual fund manager Ron Muhlenkamp, whoseeponymous fund has handily beaten the S&P 500 index over the past decade. If the company is competing in ahigh-growth industry (like videogames), are its sales growing as fast as those of its competitors? If it's operatingin a mature industry (like grocery retailing), have sales been holding their own over the past few years? Pay closeattention as well to the sales inroads made by new competitors, especially in those industries that aren'tgrowing. "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 andFord, for example, are saddled with huge costs related to pension and health-care plans for their retirees--coststhat 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 ofthe economy. And cyclical stocks aren't always the bargain they appear to be. For example, when the economy ison a downswing, the stocks of paper companies may begin to look incredibly cheap. But there's a good reason forthat: In tough economic times many businesses cut back on their advertising, newspapers and magazines getthinner, and paper companies therefore sell less paper. Of course, the opposite effect usually occurs coming outof a recession.

Investors should also pay close attention to trends in interest rates, since rate moves can have a dramatic effecton many industries. The huge drop in interest rates over the past two years, for instance, has resulted in a recordwave of home refinancing and spurred consumer spending. That has greatly benefited industries such ashomebuilders, appliance manufacturers, and retailers. But interest rates can hardly be expected to go loweranymore, 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 competitionthat exists within the industry. Price wars may be great for consumers, but they can quickly kill a company'sprofits. According to an analysis of FORTUNE 1,000 companies conducted by consulting firm McKinsey & Co., foreach 5% decrease in its selling price, a company would need to increase the number of units it sells by 18% tobreak even. "For most industries that just is never going to happen," warns Craig Zawada, a McKinsey partnerand pricing specialist. In most cases a company fighting a price war must have a big cost advantage over itscompetitors if it hopes to remain profitable. Just witness the havoc the so-called "burger wars" have continuallywreaked 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 yearsahead. For instance, a business that's dependent on one customer for a huge chunk of its sales could collapse ifit lost that customer. You can get an idea of these risks by reading a copy of the initial offering prospectus (if thecompany has just gone public) or the most recent 10-K--the annual report a company files with the Securitiesand Exchange Commission. (You can download both documents at the SEC's website, www.freeedgar.com.) Takefiber-optic maker Sycamore Networks, which went public in late 1999. Anyone who had read the offeringprospectus would have discovered that the company had only one customer, Williams Communications. Two anda half years later Williams went bankrupt; today the stock of Sycamore (which managed to pick up a few morecustomers 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 companieswhose shares have soared only to come crashing down after their wonder drug got shot down by the FDA. Whichbrings us to another important point: If the performance of a company is heavily dependent on the actions andreputation of one person, then be aware that the risk attached to the stock will automatically be several notchesabove the norm. Indeed, the stock of Martha Stewart Living Omnimedia is down some 50% since its namesake'scurrent 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. Butalarm bells should go off if a company has a habit of taking those "one-time" charges year after year: It becomespractically impossible for investors to figure out just how profitable the company really is. For instance, in theyears leading up to its bankruptcy in 2002, retailer Kmart repeatedly took one-time charges for everything fromclosing its ailing stores to writing down its obsolete inventory to "redefining" its Internet business. "That was justclassic," says Michelle Clayman, chief investment officer at New York investment management firm NewAmsterdam Partners, who has studied the phenomenon of serial chargers. "They kept having all these chargesthat 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 incomestatements, you should be wary of the stock. In fact, her research has shown that about 70% of the time, thestocks of companies falling into this category consistently underperform the S&P 500 index. Check the notes tothe financial statements for an explanation of the one-time charge; sometimes it will relate to a move that hasactually 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 gargantuanpile of long- term liabilities. Before you buy any stock, check out the amount of debt on the balance sheet--toomuch debt is risky, since a slowdown in sales or a hike in interest rates could threaten a company's ability to


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make interest payments. And it greatly decreases a business's margin for error. "When you have debt pickingaway at you, you not only need to be right, you've got to know when to be right, or else you're dead," says BobOlstein, founder of the Financial Alert fund. What's more, debt holders come first in the pecking order: Acompany must pay interest on its debt but is under no obligation to pay dividends to shareholders. To determinewhether a company is overloaded, divide long-term debt by total capital (debt plus shareholder's equity--bothnumbers are on the balance sheet). If the result tops 50%, there's a strong chance the company is borrowingbeyond its means.

But debt isn't the only way a company can get in over its head. Stock options--that great boon to executivecompensation--come at a steep price to shareholders. In the footnotes to a company's annual report, it mustdisclose 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 AppleComputer, 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 averageoutsider. 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 severalyears' worth of the letters that CEOs write to shareholders in their annual reports. Has the management teambeen consistent in its message, or is it constantly changing strategy or blaming outside forces for poorperformance? 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 Isee a big, spanking-new headquarters, the stock's a sell," says Donald Sull, an assistant professor at HarvardBusiness 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 newheadquarters: an architectural award for design, a waterfall in the lobby, or a heliport on the roof. As lightheartedas this warning may sound, Sull insists he's dead serious. "Management is saying, 'We've declared victory, andnow 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 forthe stock. By the same token, a company with average fundamentals can be your star performer if you buy it at acheap enough price. Still, as Warren Buffett pointed out in FORTUNE's 2001 Investing Guide, investors will jumpat the chance to buy just about anything at a discount-- except stocks. Indeed, all too often investors prefer towait 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 its52-week high, find out why: The fact that it's "hot" isn't enough reason for you dive in. "Individuals tend to herdinto certain stocks," says John Nofsinger, a finance professor at Washington State University and author ofInvestment Madness: How Psychology Affects Your Investing. "But if you're going to buy a stock becauseeveryone else has bought the stock, then aren't you the last one in? Wouldn't you rather buy a stock beforeeveryone else buys it?"

Here, the stock's price/earnings ratio (the stock price divided by earnings per share) is still one of the best andquickest ways to value a company. As a general rule, most value-oriented portfolio managers won't touch a stockwith a P/E ratio above 30, even if it operates in a growing industry. (And why would they? Compared with theoverall market's valuation, that means the company's returns would have to be roughly 50% better for investorsto profit.) Remember, if you're using "next year's" or 2005's projected earnings to calculate your ratio, you'reguessing--not evaluating. The next critical step is to review the cash flow statement, checking for positive (andhopefully 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'town the likes of WorldCom or eToys. "Too much of the time we invest in a story, and that usually works outbadly," says Nofsinger. So make a pact with yourself here and now that you'll hold off on your purchase at leastuntil you've answered questions 1 through 9. If you invest on this basis, you'll have the conviction to hold on toyour stock throughout the broader market's zigs and zags. You'll also have the comfort of knowing that you haveinvested in, not gambled with, your long-term financial future.

Earnings-per-share figures may dominate the headlines in the business press, but it's cold, hard cash that countsthe most for shareholders.

Alarm bells should go off if a company has a habit of taking "one-time" charges year after year--it becomespractically impossible for investors to figure out just how profitable the company really is.

Be wary of companies whose sole source of revenue growth appears to come from gobbling up other companies.

"If I see a big, spanking-new headquarters, the stock's a sell," says Harvard Business School professor DonaldSull. "There's just too much shareholder cash sloshing around."

As Warren Buffett likes to point out, investors will jump at the chance to buy just about anything at a discount--except stocks.


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See also introduction on page 68 of same issue

FOUR COLOR ILLUSTRATIONS: ILLUSTRATIONS BY ROSS MACDONALD

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ten questions every investor should ask

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