7 Stocks Raising Another Red Flag

While high-frequency trades spat out by computers may appear to drive today's market, there is still room for investors to earn fat returns through old-fashioned fundamental analysis.

Beginning in 2002, activist value investor Bill Ackman became convinced that the bond insurers were much riskier than their triple-A rating suggested. When the extent of their exposure to structured mortgage securities came to light during the credit crisis, the stocks imploded, and Ackman's short positions turned into huge winners.

A showman and a serious analyst
Although he is primarily known for his brash tactics, Ackman is first and foremost a deeply inquisitive security analyst. On MBIA alone, he amassed 140,000 pages in documentation in the course of his research. One of Ackman's favorite investing books is Thornton O'Glove's Quality of Earnings, a primer on a rigorous, skeptical approach to financial analysis that enables investors to identify "time bomb" stocks for protection -- and profit.

All serious investors should put Quality of Earnings on their reading list. In the meantime, let me give you a taste of what O'Glove calls "the best method I have ever discovered of predicting future downwards earnings revisions of Wall Street security analysts." This method covers two balance sheet accounts: accounts receivable and inventory.

In this article, I'll focus on the former.

  • What are accounts receivable?

When a company has delivered goods and services for which it has not yet been paid, the sums it is owed go onto the balance sheet under accounts receivable.

  • What can accounts receivable tell you?

As O'Glove points out, if accounts receivable are growing faster than sales, this could indicate the company is granting its customers more favorable payment terms or that it is having a hard time collecting what it is owed -- neither of which is a positive sign for the business. Another possible explanation is that the company is offering aggressive incentives to goose sales, which hurts profits while providing only a temporary boost to the top line.

Say it ain't DSO
An easy way to track the growth of accounts receivable relative to sales is a metric called days sales outstanding (DSO), which is the amount in accounts receivable expressed as a multiple of the company's daily revenue. By definition, when the DSO increases from one period to another, accounts receivable growth is outpacing sales growth. The following table contains seven stocks from the Russell 1000 index that exhibited a high increase in their DSO over the most recent four quarters:

Company

% Increase in DSO (Last 4 Quarters)

DSO (Latest Quarter)

DSO (Latest Quarter -- 4)

WMS Industries (NYSE: WMS  )

78%

133.2 days

74.8 days

Cisco Systems (Nasdaq: CSCO  )

38%

52.6 days

38.0 days

RadioShack (NYSE: RSH  )

38%

26.7 days

19.3 days

NVIDIA (Nasdaq: NVDA  )

35%

51.9 days

38.5 days

Seagate Technology (Nasdaq: STX  )

33%

48.8 days

36.8 days

Huntsman (NYSE: HUN  )

27%

55.7 days

43.7 days

Hasbro (NYSE: HAS  )

26%

73.4 days

58.4 days

Source: Capital IQ, a division of Standard & Poor's.

Now, let me be very explicit that these are not short recommendations. Statistical screens are powerful tools for sifting through large amounts of data; however, they are blunt instruments when it comes to analyzing individual stocks. Screens highlight "high-probability" pockets in the market, but you need to conduct detailed company-specific analysis in order to confirm that a specific result isn't a false positive.

Good businesses, bad surprises?
Cisco Systems, for example, is a terrific business that I have highlighted as a potential buy recently for its low multiple and expanding business.

Nonetheless, even great companies aren't immune to negative earnings surprises that are predictable with a careful analysis of earnings quality. One must perform adequate follow-up research to determine for each specific company whether the DSO is truly a harbinger of an imminent problem or not.

Your next step
If you'd like to learn more about ways to spot potential ticking time bombs to protect your portfolio or profit on short ideas, enter your email in the box below to receive John Del Vecchio's free report "5 Red Flags -- How to Find the Big Short." Del Vecchio has an impeccable record as an analyst and a money manager; most recently, he managed the Ranger Short Only portfolio from 2007 to 2010, where he outperformed the S&P 500 by 40 percentage points. John's report is free, and it's the first step toward putting powerful analytical tools to work for your portfolio.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. Hasbro and NVIDIA are Motley Fool Stock Advisor recommendations. The Fool has written calls (Bull Call Spread) on Cisco Systems. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (72)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2010, at 5:14 PM, Bobmoll36 wrote:

    So the Fool has us in Hasboro. Now you raise this potential downward pressure. Do we sit on this stock and get whacked or do we take our profits?

  • Report this Comment On August 30, 2010, at 9:02 PM, polenium wrote:

    I would be happier to have read a more complete analysis of Cisco. If you have been recommending the stock, wouldn't it be the responsible thing to put this information into context and compare others in the same industry. Is the economy, Cisco, the way we live today or is Cisco in trouble?

  • Report this Comment On August 31, 2010, at 4:44 AM, Estiv wrote:

    @daytrader82 Stock Adviser is all about going long. Are you day trading Stock Adviser recommendations ?

  • Report this Comment On August 31, 2010, at 8:51 AM, BioBat wrote:

    This is simply an analysis of where these stocks are headed in the short term. It's not all that surprising seeing as there has been a slowdown from rapid growth from the doldrums of the recession to what is now looking like low or no growth for a while. Sell Hasbro if you like but as the Stock Advisor says - they have franchises gaining steam that someone like Disney may just chomp at the bits for IF they're stock reaches an attractive takeover price. If you sell, you take your profits now. If you wait, you continue to get a solid dividend while the stock plays like a yo-yo and potentially miss out on a big payday if it gets taken over.

  • Report this Comment On August 31, 2010, at 3:21 PM, mikecart1 wrote:

    This is why I thumbed down Radio Shack for the past year. It is a poorly run company.

  • Report this Comment On September 03, 2010, at 11:38 AM, sirbeaky wrote:
  • Report this Comment On September 03, 2010, at 12:03 PM, KZMike wrote:

    OKAY. . . so how does the MF membership determine DSO. I don't ever recall seeing that info in looking over fundamental stats. I am not sure whether the explanation above included a calculation 'method'. . ."the amount in accounts receivable expressed as a multiple of the company's daily revenue." ???

  • Report this Comment On September 03, 2010, at 1:22 PM, warrenrial wrote:

    This is a very poor article.

  • Report this Comment On September 03, 2010, at 2:30 PM, TMFAleph1 wrote:

    @KZMike,

    Thanks for your question. Here is the explicit formula for Days' Sales Outstanding (DSO):

    DSO = (Average Accounts Receivable Over Period/ Total Revenue During Period) * Number of Days in Period

    The Accounts Receivable figures can be found on the balance sheet and the revenue figures are on the income statement.

    Best,

    Alex D

  • Report this Comment On September 03, 2010, at 2:37 PM, omt68 wrote:

    This piece is an attempt to obtain subscribers to Del Vecchio's Big Short here at the Motley Fool. As a marketing piece it is well enough written. If you choose to subscribe you probably get an opportunity to learn the technis in question.

  • Report this Comment On September 03, 2010, at 3:08 PM, BitBangerDBA wrote:

    I think you are all missing the point ... this is an advertisement! They did not even bother to go into the calculation of the metric for inventory! While the A/R metric is a good indicator, you need to look at the whole picture. Maybe only when both metrics are showing negative implications should you take action. I.E. The metrics are positively coorelated.

  • Report this Comment On September 03, 2010, at 3:25 PM, Dima wrote:

    Is it likely that the lack of the market for account receivable securitization is the primary cause of these DSO increases? I am pretty sure that's the case for Hasboro for example.

  • Report this Comment On September 04, 2010, at 12:37 AM, efmagowan wrote:

    When I think of Seagate (and Western Digital) I think of hard drives. I may have a multi-terabyte backup drive in a few years, but I know my computer will have a solid state drive, and most likely one which I can swap between computers. So will everyone else's. Food for Foolish thought.

Add your comment.

DocumentId: 1285216, ~/Articles/ArticleHandler.aspx, 8/1/2014 11:01:39 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement