5 Stocks You Can Understand

I believe Peter Lynch advised spending as much time researching a stock as you would buying a refrigerator. Indeed, in my household, we've been looking for a new refrigerator for four months! Good investment analysis takes work.

Every month, I screen data for hundreds of stocks, pulling out a select group for closer inspection of their quarterly and annual reports filed with the SEC. Every day, I review (at last count) 60 model portfolios online of stocks I've researched over the years for news affecting fundamental analysis and for price changes that may bring the stock to a more favorable valuation and risk-reward ratio. Screen, read quarterly and annual reports, enter data in spreadsheets, rinse, repeat.

That's why when anyone asks me, "What do you think of x stock?" I usually have to demur. It takes a few weeks, if not months, to work up any sort of view of a company beyond the first-level screen. To paraphrase Jack Germond about politics, "Analysis ain't bean bag."

In the stock analysis and selection process, for a stock to cross over the moat on a drawbridge, reach the castle, and pass the sentries, it must answer three questions appropriately:

1. "Halt! Who goes there?"

Are this business' financial statements recognizable, that is, within my expertise to evaluate? Do they reflect the business easily enough for me to understand the risks?

2. "Whence do you hail and are you worthy?"


Is the business run by experienced people who allocate the cash to increase shareholder value?

3. "You may be the bravest knight in all the land, but do you belong in Camelot?"


Does the stock fit in my three-part investing strategy: At its current valuation and given the nature of the business, does the potential reward justify the level of risk? And does that equation beat that of every stock I currently already own?

I'll look at each question in turn today and over the next two Tuesdays and name companies that score well.

Halt! Who goes there?
Are this business' financial statements recognizable, that is, within my expertise to evaluate? Do they reflect the business easily enough for me to understand the risks?

Without a clear grasp of the financials, it's impossible to value the business and determine risk and potential reward.

Read the latest quarterly and annual reports for the company. Ask these questions: How complex are the three major financial statement entries for this company? Does the income statement break out every major business segment by revenue and expense? If not, can you easily find this in the notes to the financials?

A favorite holding, The Sportsman's Guide (Nasdaq: SGDE  ) makes much of its increasing e-commerce sales, but the income statement does not break out catalog sales from e-commerce sales. You find the percentages in the financial statement footnotes and sometimes in press releases.

Does management provide more detailed discussion of results on a quarterly earnings conference call (which I usually review later as a CCBN/StreetEvents transcript), during which they treat substantive questions directly and with respect? They are free to disdain rudesters, but as Zeke Ashton recently pointed out, if they hedge or curse reasonable questions, watch out.

I like companies whose SEC filings and conference calls are so clear that you never need to talk to anyone at the company. Sure, it's good to listen to the calls to get a sense of the people, but don't expect anything except the Minister of Corporate Propaganda if you call the company itself, with the possible exception of small companies. There, management will often talk to you like a real person.

Once, I spoke with a company's financial officer at a micro-cap turnaround, and all of a sudden he blurted out, "Tom, our bankers -- the ones on the workout side of the house who saved us from bankruptcy two years ago -- now think we're so creditworthy they're sending the people from the investment bank side over to finance acquisitions. I'm saying no thanks, but it's the clearest vote you could ask for that we've turned the corner."

Nice.

Clear as glass
Here are just a few companies I own or have owned whose easy-to-understand financials clearly reflect the company's business model. First, two "tech" stocks -- businesses in computer technology and semiconductors. Even though their actual technology is not easy to understand, their financials are and clearly reveal their business models. Don't be afraid of stocks whose products seem complex as long as you can follow how they make money and whether they are making more of it (or less).

For example, Rambus (Nasdaq: RMBS  ) develops and licenses computer memory technology and provides some services to companies working to incorporate it into products. It collects royalties on licensed products. This is all crystal clear in the financials and there is no hiding business performance. It's not cheap today, implied by the title of my recent column, Tech Survivor Gets Pricey, which gives background on the company. Note it was written before the stock climbed even farther after the Supreme Court let stand a Court of Appeals verdict in favor of Rambus.

A foreign issuer of stock traded in the U.S. is usually harder to follow because it doesn't have to file quarterly reports with the SEC, but ARM Holdings (Nasdaq: ARMHY  ) -- a stock I picked for Hidden Gems' predecessor last year -- is an exception. Management's quarterly press releases are so fabulously detailed for every business segment that you can follow quarterly progress well. The company's business model is similar to Rambus', except change "computer memory" to "semiconductor core" and cut the litigation sentence. For more, enjoy World Tech Domination?

Other favorites
Among retailers, Overstock (Nasdaq: OSTK  ) is a model of clarity, not only in its SEC filings but in press releases, on its website, and on conference calls. I own the stock, and it's never been hard to understand the different parts of its business and their performance.

When I asked my Foolish colleagues for their ideas, Bill Mann offered Costco (Nasdaq: COST  ) and Jeff Fischer chose Johnson & Johnson (NYSE: JNJ  ) -- both without missing a beat.

Not so easy
On the other hand, there's Energy Conversion Devices (Nasdaq: ENER  ) , a stock I used to own and that has taken a beating both for filing its annual report late and for five quarters of collapsing year-over-year revenues. I once recommended the stock as a Rule Breaker speculation, but when revenues first started falling off I advised selling and sold my own shares.

The company's many joint ventures made it very difficult to understand, and management was notoriously tight-lipped on conference calls. But I thought I was so clever to decipher it all and believed the structure spread the investment risk among a lot of unproven technology joint ventures. You know the saying "too clever by half"? In retrospect, having to work so hard to decipher the structure should have been a sign of more risk, not less.

Not bad, just not me
While all of us want to expand our financial statement expertise, we should not exceed it when making an investment. For example, it takes special skills to analyze the financial statements of bank and financial services companies, and I haven't put much work into learning them yet. I'm sure there are great investments there, but that's why investing is like Dickens.

Yup. I love and savor every word of every Dickens I've ever read, but it's very comforting to know that I will never read them all -- that when I'm 85 and sitting in my chair by the window, there will be another Dickens tome to enjoy. Ditto industries and financials. There will always be more to learn. Banks and bank statements are my investing Dickens.

If your portfolio's companies do not have financials that tell you everything you need to know about the business, it's time to increase your skill or sell the holding. Unless you can clearly see the performance through the numbers, you can't evaluate risk or when to sell.

Next Tuesday: finding good cash managers. Have a most Foolish week, and thanks for reading!

Senior Analyst Tom Jacobs owns shares of ARM Holdings, Overstock, and The Sportsman's Guide. To see his stock holdings, view hisprofile, and check out The Motley Fool'sdisclosure policy.


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