6 Inviolable Rules for Analyzing Stocks

Recently, I was a member of a panel that judged a multi-school business case competition at McDaniel College in Maryland. The case was about a junior hedge fund analyst who had to choose between making a long or short recommendation on a stock, after examining all of the relevant financial information.

This case was extremely complicated. It centered on a quasi-government entity making a gigantic capital expenditure to help lower the production costs for a very dangerous and highly regulated commodity. At the conclusion of the event, my fellow judges shared our insights with the students. Below are some of my takeaways from the case for aspiring investment analysts.

1. Humility trumps brains
In the real world, this stock would have gone into my "too hard pile" very quickly. I encourage all analysts to avoid difficult problems when they can. As they say, there are no called strikes in investing. It turns out that humility is a rare, yet extremely valuable, commodity in the investment business.

2. Think before you plug and chug
Most students working on this case were unfamiliar with the actual business, yet dove right into creating a valuation model. They invested hours doing Monte Carlo simulations, and calculating the Weighted Average Cost of Capital. Most never really took the time to understand the type of company they were analyzing, and which parts of their model were most important to get right.

Always ask yourself if you're looking at a fixed- or variable-cost business. Does it have a competitive advantage? Where is value created and captured in the particular industry?

3. You must understand where value is created and captured
Always remember that a low-cost provider wins in a commodity business. However, if there's some new technology that will lower your production costs dramatically, remember that all those savings will likely be passed directly along to customers. In other words, don't buy rosy predictions of cost savings flowing to the bottom line if you operate in a commodity business.

4. Culture eats strategy for breakfast
This case was all about strategy, internal rates of return, and breakeven analysis. In the real world, culture and people are really what you're investing in. With the explosion of the Internet, there are so many non-traditional ways to measure the power of culture at an organization, yet so many schools focus solely on strategy instead.

For example, most of the great businesses of our time make as many mistakes as other companies. No one is going to be 10 for 10 in strategic decisions. Remember Netflix's (NASDAQ: NFLX  ) disastrous "Qwikster" decision? Even Berkshire Hathaway (NYSE: BRK-B  ) has stumbled with the David Sokol debacle. The great businesses have dynamic leaders who build outstanding cultures. Those cultures don't always prevent mistakes, but they do allow the company to adapt more quickly and learn from failure.

The word "mistake" is the one word that you should look for in an annual report to see if you're investing in a learning culture or not. My tip is to spend more time investigating the culture than you do understanding the financial statements.

5. Intangible assets outweigh tangible ones
Most investors check the stock price first, and then go right to the financial statements. I have news for you... all those numbers represent history, and the value of the business lies in the future. No one would recommend you drive a car by looking through the rearview mirror, yet people do that in investing all the time.

Here are a few things to ponder. Where is the value of Jeff Bezos reflected on the balance sheet of Amazon? What about the value of Elon Musk for Tesla? How about the strict underwriting discipline at Berkshire Hathaway? How about the brand value of Coca-Cola? Each of these companies possesses a rare and highly valuable asset that doesn't appear on the balance sheet. Good analysts take the time to analyze and understand these competitive advantages.

6. Being conservative in your assumptions can be very costly
This last piece of advice might actually violate Warren Buffett's "rule number one," which is to never lose money. The flip side of Buffett's maxim is that the best investors in the world are wrong about 40% of the time. The analysts who use conservative assumptions when deploying their discounted cash flow models would have never bought great businesses like Amazon or eBay. If you're looking for extraordinary businesses, you'll need to be careful that you're not too conservative in your assumptions.

Against the wind
Case studies are a good way to learn. At The Motley Fool, we value a multi-disciplinary approach to company analysis. We also appreciate independent thought, and civil and open debate. When it comes to investing, we've learned that both a kite and a portfolio can rise against the wind.

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Comments from our Foolish Readers

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  • Report this Comment On November 30, 2013, at 9:39 PM, zantor2 wrote:

    After reading that article I now know for sure why an investor should rarely to never trust an 'analyst' = they are apparently told to be bold and go out on a limb. problem is it sounds like their 'expert opinion' is more based on 'feelings' and intangibles than real facts.

    Motley Fool just adds to the problems of the market with articles like this.

    although thank you giving some inside info about why most of the experts really know nothing.and if you make decisions on their analysis you are likely to get killed financially and they don't really care.

  • Report this Comment On December 02, 2013, at 10:58 AM, hbofbyu wrote:

    Who are the investors that buy "the too hard" pile?

    It has to not be too complicated for someone, right? Or is every stock holder of a company like that a sucker? ie. Fannie Mae.

  • Report this Comment On December 02, 2013, at 11:17 AM, ScoopHoop wrote:

    It would be nice to know the name of the stock that students were studying.

  • Report this Comment On December 02, 2013, at 12:10 PM, josephpporter wrote:

    I only have doubts about two of your items: 5 & 6.

    An intangible asset is something "I know not what" about a company or a product that grabs the investor's/consumer's interest. Such things tend to be ephemeral, and far more subject to the vicissitudes of fickle fate than tangible assets. Can you say "high beta"?

    I equate being "conservative" with being cautious, and with looking before you leap. Apple is still 20% below where it was over a year ago. Cisco started off the year pretty well, but has gone cold. Shorting HerbaLife was "the thing to do."

    There's a reason book value excludes intangible value, and why Buffet resists following the herd.

  • Report this Comment On December 02, 2013, at 4:15 PM, whyaduck1128 wrote:

    " However, if there's some new technology that will lower your production costs dramatically, remember that all those savings will likely be passed directly along to customers."

    In your dreams. In the real world, the company will keep a lot of those savings and try to keep more. They may pass along some, even a lot, but it would be miraculous if "all" the savings made their way to the customer.

    In fact, if they did, what would be the company's incentive to implement the new technology, given the usual capital and financing costs? Isn't the idea to make MORE money from innovation?

  • Report this Comment On December 02, 2013, at 4:51 PM, TMFBuck wrote:

    Hi whyaduck1128,

    Remember I'm talking about a commodity business here. Berkshire textiles came to Buffett and said they could lower their production costs by 30% if they invested in new looms. His response? " I hope it's not true or I'm shutting it down." It was true and he shuttered the operation. He realized after years of failed negotiations that the no one really cared who made their suit linings. He couldn't raise prices even a fraction of a cent. So if he reduced costs, his competitors would follow and all those savings would get passed on to the customers in the form of lower prices.

    Competitors make the investment b/c prices are decreasing and they need to stay competitive. Most don't have the freedom to deploy capital in other ways like Buffett does. Just take a look at the hardware business or the airlines for two other great examples.

    This doesn't mean that commodity businesses can't be good investments. Southwest has been a wonderful investment, in one of the worst industries around, but they are by far the low cost operator. AWS, Amazon's cloud initiative, has been very successfully deployed. But in a short time they've lowered prices 19 times. If you're going to play in this space you better be the big gun with the lowest costs and get scale mightily quick or you're gonna get steam rolled.

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