What To Look For

In the past month I had had more than a few email conversations with readers who want to know what to look for before they buy a stock. Rather than keep saying the same thing to you individually, I will try to put it down here. Please continue to email me your investment ideas though, I do so enjoy the process. I need you to remember my mantra "successful investing does not need to be difficult". Here is where I start:

How far back to I look into a company's financials? Easy, as long as current management has been there. If the new CEO and his team have been there 2 years, who cares what the previous guy did 5 years ago? The new guy is making the decisions, what is done is done. The only reason to look back is to get an idea of the future and of what the priorities and strategies are. The guy that is gone cannot effect that, why look at what he did? In the same vein, I tend to avoid companies with new CEO's for that very reason, I have no idea what they are going to do. In full disclosure, one of my portfolio picks ADM, does have a new CEO. Patricia Woertz took over in November last year. I have looked past this because my vision for the company is for it to be the Exxon of biofuels. Woertz came to ADM from Chevron and was hired specifically with this goal in mind so in this case, I know her direction for ADM and mine are the same. You also have to consider that former CEO G. Allen Andreas remained on as Chairman of the Board until recently for continuity. This is a rare exception to the rule. I even avoid new CEO's that have "risen through the ranks" as there tends to be a desire on their part to "leave their mark" on the company. This leads them to at time create change just for the sake of change and the results are seldom good. GE's Jeffery Immelt is the rare exception to this rule. For this reason, two of the stocks we are watching now, Gap and Home Depot are not buys at any price until we know what the plans of the new CEO's are. If your new CEO came from another company, it would behoove you to look at what they did there. Tigers cannot change their stripes and managers do not usually change their methods, especially if they worked before.

Shares Outstanding: This should always be shrinking. If this number is going up your share of the company is going down, bad news. If the company uses stock for acquisitions or issues new stock for operations, it is you who are funding those uses. Here is how. Our company has 100 shares outstanding, they earn $100 ($1 a share) and you own 1 share (for easy math). In this scenario you essentially have ownership of $1 a share in earnings. Now, the company decides to buy a small supplier but does not have the cash so they issue 50 more shares to fund it and because of the acquisition, earning jump 25% to $125. Great news right? No. Because of the dilution of the shares (the extra shares out there issued for the purchase) you only earn 83 cents a share for the shares you own ($125 divided the 150 shares). In this case the extra stock issued for the purchase that caused the 25% increase in overall profits resulted in a 17% drop in your earnings per share. Put another way, you (and the other shareholders) gave up 17 cents to fund the total $25 increase.

Price Earnings Ratio & Growth Rate: These two important metrics are seldom talked about together but I can't see how they can be separated. Let's walk through this. The price you pay per share for a stock is neither cheap or expensive because it's price is $1 or $100. It is only cheap or expensive depending how that price relates to its earnings. For instance, lets say the $1 stock earns 1 cent per share. That means it has a price earnings ratio (PE) of 100 ($1 price divided by the 1 cent per share in earnings). Put another way, the premium you are paying for the stock is 100 times its earnings, you are paying $100 for every $1 in earnings. Now, the $100 stock earns $5 a share. That gives this stock a PE of 20 ($100 divided by$5). In this case the $1 stock is actually 5 times more expensive than the $100 stock (100 PE vs. 20 PE). Does that mean we should run out and buy any low PE stock because it is cheap? Not exactly.

Now we need to talk about the growth rate. This is the rate of growth in earnings per share, not net income. This is another very important distinction. In the first section, our company grew net income but earnings per share dropped because of the extra shares outstanding. The opposite could also be true that net income is flat and because the company bought back shares, the total number of the outstanding shrunk therefore the amount available per share (earnings per share) actually increases. This is why share buybacks help, they provide a cushion. Our new company earned $1 last year and $1.10 this year so they grew earnings 10% (10 cent increase divided by $1 prior year earnings). You want the premium you pay to be as close to or below the growth rate as possible for stocks with steady or increasing growth rates. If the stock has had an abnormally high growth rate and it is falling you must pay far less than the growth rate (I would avoid these stocks until they settle into a sustainable rate). As a rule, I will never pay more than 25 times earnings unless there are unusual extenuating circumstances.

Why is the PE ratio to growth rate so important? It gives you your payoff on the stock or, how long it will take until the total earnings have paid off your initial investment. Our company is growing at 10% and has $1 per share in earnings. We have two investors, (A) pays a premium for the shares (PE ratio) equal to the growth rate (10) and the other (B) pays twice that (20). Now, the question is how long will it take for the earnings we receive each year to equal the purchase price when they grow at 10%? Investor (A) would have to wait just under 7 years while (B) would have to wait 11 years or almost 60% longer!

Going further, let's assume that both investors bought 100 shares. (A) paid $1000 (100 x$10) and (B) paid twice that $2000. Here is the important part. We are now 10 years down the road and the market is pricing the shares at a PE ratio of 15, or 1.5 times the growth rate (I split the difference). At year 10 earnings per share would be $2.56 and the 15 PE would give the shares a price of $38 per share. Investor (A) has almost quadrupled his money ($1000 to $3800) while (B)'s has not even doubled ($2000 to $3800)! Let's reverse the scenario and say earnings growth slows to 5% in year 10 and the market decides it will only pay twice that for the shares (PE of 10) at the same $2.56 in earnings the price of the stock would be $25. That means (A) has more than doubled his money ($1000 to $2500) and (B) has only made 25% ($2000 to $2500).

When you pay a premium for shares equal to or only slightly higher than the growth rate, you do two things, you limit your downside risk and maximize your upside potential.

The caveat here is that earning growth rates have to be stable or increasing, not decreasing. If you pay a premium equal to the growth for a stock with decreasing earning growth, the shares will keep falling to the growth rate which means a smaller premium and share price each year. See my Google post for more on this scenario.

Cash Flow From Operations: This tells us the health of the business operations. It gives the amount of money left over after operating expenses are paid. That extra cash can be used for dividends, paying off debt, building new plants, buying other businesses or my favorite thing, buying back shares. It also tells you what management is doing with the extra $$. They may be approved by the board to buy back shares but did they? Here is where you find out. Caveat: Avoid the Net Cash line until later and I will give you a real life example of why. In 2005 Eddie Lampert purchased Sears and formed Sears Holdings (this is a stock I own and you must also). Cash flow from operation in Jan 2005 before he took over was $1 billion and the net cash was $1.3 billion, great job. In Jan. 2006, the year after he took over cash from operations was $2.3 billion but net cash was only $1 billion. If you are only following the net # you would think that things deteriorated. But, by starting at the cash from operations # we see that Eddie did two things we love. He spent $455 million buying back shares and $800 million paying off debt, both of which are actions that benefit shareholders. It should be noted that the first 9 months of fy2007 saw another $800 million in stock buybacks and $500 million in debt payoffs. By starting at the cash from operations line and working your way down you can determine the health of the business and what management is doing with the extra money.

Now, as Deep Throat said in the movie All The President's Men, "follow the money". Once you have cash flow from operation you have to determine where it goes. If it goes to Capital Expenditures (new plants, repairs on them etc) pay close attention. If this number is regularly larger than Flow From Operations, that means the cost of maintaining or expanding the business is greater than the cash it generates. The only way this works is to either use more debt or issue more shares. This will occasionally happen in a certain years but if it is a regular occurrence, alarms & whistles should go off.

Skin In The Game: This isn't an old John Holmes movie. It simply concerns the stake management has in the company. Not only do we care if they own shares but more importantly "are they buying them on them on the market". I am going to avoid the insider selling issue here. There are dozens of reason insiders may sell stock and most of them are not bad. Some executives are compensated mostly in stock, in order to receive income they must sell some, many sell stock at regular intervals to diversify their holdings, retiring CEO's often sell chunks to fund retirement and management sells the options (options are a "use them or lose them" proposition) they receive to get the cash. All of these scenarios do not necessarily mean anything negative about the company and all companies see insider selling from time to time. Can anyone think of a reason management would go into the open market and buy shares of the company they work for? The only thing I can think of is they are excited about it future prospects. In the Value Plays Portfolio, OC, SHLD, and DOW have all experienced heavy insider buying. SHLD director Richard Perry recently plopped down $5.3 million of his own money buying SHLD shares when they hit an all time high, clearly he sees a bright future and Eddie Lampert owns 65 million shares. Do you think he will do anything he thinks will wreck the stock price?

To review, while insider selling can be a bad sign, it quite often is not. Insider buying however, in my opinion is almost never bad news.

In Review: If you find a company with stable management, decreasing shares outstanding, increasing cash flow from operations, increasing earnings, with management buying shares and the premium you have to pay is close to or below the earnings per share growth rate, stop and take a closer look. They have the key elements in place for success and warrant a much closer look.

All these figures can easily be found online, I personally use Google Finance but most of the online finance sites will give you the same info.

If you want me to expand on a particular area, comment and I will do my best to accommodate.