Avoiding the Road to Ruin

All cheap isn't created equal
When you're looking for value stocks, one of the toughest jobs is winnowing the cheap from the hopeless. Ratios such as price-to-book, price-to-earnings, or enterprise value-to-EBITDA tell you only part of the tale, and the same operational hiccups that put a stock onto your value radar in the first place may also render useless these common measuring sticks.

That's why when I am culling my watch lists, I start with some even simpler tests. If a company flunks, I don't even look further. After years of learning the value ropes through hard knocks, successes, and watching the techniques of my colleagues and sharp community members like the ones at Motley Fool Inside Value, I find that a tough first edit not only saves me time but also helps me avoid stocks that are headed nowhere but down.

A modest proposal
Let's start with something I take for granted in this stock-picking business.

You don't lose any money when you don't win a bad bet -- even if others win that same bad bet.

What I mean here is that these three screening techniques may very well toss aside winners, even legitimate values, from time to time. That said, the occasional phoenix that rises from these ashes shouldn't keep you from giving your stocks the trial by fire. With that, let's take a look at our simple gauntlet.

Grabby Gregs and tall tales
Management humility and honesty may not assure you a winning stock, but rapacious or dishonest management (and let's face it, those last two often go hand in hand) will nearly always cost you. Smart and motivated + greedy and unscrupulous = major troubles. I refer you to the textbook scandals at Enron, WorldCon (oops, I meant WorldCom), HealthSouth, Computer Associates (NYSE: CA  ) , Waste Management (NYSE: WMI  ) , etc. etc., in perpetuity, let us never forget.

Greedy management is a no-go. Always.

I've written about this before with characters such as Hollinger International's former boss Conrad Black and WorldCom's Bernie Ebbers. A look back at their compensation packages and other dealings should have been enough to warn investors that something was rotten. And let's be clear -- we're not limiting ourselves to actions that rise to the level of "theft" to the SEC or a court. By the time the authorities are onto things, the damage to you will be done, and your money will be gone.

You need to try to predict the pilfering, and your best indicator is the proxy statement, the DEF 14A. Take a hard look at management's pay and related-party transactions. Guaranteed bonuses, excessive option and warrant grants (especially those made below the stock's fair price), contracts with outside consulting agencies or real estate firms that just happen to be owned by management -- these are common ways to spot the Grabby Gregs before they get their paws on your dough.

If you want to know just how bad it can get, take a look at David Brooks, CEO of DHB Industries. This is a guy who was in hot water with the SEC back in the early '90s, when he paid nearly half a million bucks to settle an insider-trading charge. But he later acquired some bulletproof-vest companies and came roaring back on war contracts. How has he treated outside shareholders? He sold at the top, granted himself millions more through in-the-money warrants, and recently tossed his daughter a bazillion-dollar Bat Mitzvah that would have made Kozlowski blush. This is exactly the kind of character we want to avoid at all costs. He may or may not do anything illegal, but he certainly isn't interested in helping us get wealthy. But even now, you see people clamoring to get back into the stock. Greed is a powerful motivator, and speculators never learn.

Running on fumes
If there's one thing that's nearly as bad as running on bad management, it's running on fumes. Businesses that can't produce cash, for long periods of time, well, they're not creating any value at all. They're destroying capital. But unfortunately, the numbers Wall Street likes to report -- earnings -- don't give an accurate picture of who's revving up and who's sputtering out.

For a better picture of reality, your best friend is the cash flow statement. How much does the firm make, in cash terms, after capital expenditures? This is easy to calculate. Simply take the cash provided by operations, and then subtract capital expenditures (and maybe acquisitions, if the firm does a lot of that.) Voila, you have a decent look at what kind of real money the firm is producing. If this number is consistently negative, you have trouble. (By the way, if you want to know just how such companies survive, in the absence of cash from operations, a company will have to get funds via sales of stock or debt. Conveniently enough, this will also appear in the cash flow sheet.)

The perfect storm is a company with slowing sales and increasing costs, one that survives almost entirely on borrowing yet faces bigger prices because of that borrowing. In the current rising-interest-rate climate, everyone will be paying more to lenders and bond buyers, but a company whose credit ratings are dissolving into junk and worse will feel the pinch even quicker.

By now, many of you will recognize that automotive suppliers Delphi and Dana (NYSE: DCN  ) both suffered from such troubles. Dana survived on transfusions of debt and divestitures. My colleague Nate Parmelee tried to warn folks about the Dana situation back in September, but a lot of investors don't want to see the obvious.

The disappearance test
This one is pretty simple. Close your eyes and step into the world of make-believe. Now ask yourself, "If this company disappeared from the world tomorrow, would anyone care?"

Would anyone even notice?

If the answer is "No," I suggest you move along. Pier 1 has attracted a lot of attention as a potential value, especially after word came that Berkshire Hathaway was in. But I never gave it a second thought. If it were doing a decent job with sales, hey, that'd be one thing. But when it's obviously struggling, it has to face the disappearance test. And it flunks.

If this company, or, say, Linens 'n Things (NYSE: LIN  ) disappeared tomorrow, people would continue to drive past its stores -- as they apparently do now anyway -- to throw their money into the cash registers at Ikea, Pottery Barn, and many other competitors.

On the other hand, it's pretty much impossible to imagine the world without Microsoft (Nasdaq: MSFT  ) and its ubiquitous logo, McDonald's (NYSE: MCD  ) and the more than 1 billion burgers it's sold, or PepsiCo (NYSE: PEP  ) and its fizzy soft drinks and salty snacks. Which is why when these companies get "going out of business" cheap -- as they occasionally do -- you'd be wise, by which I mean Foolish, to take notice.

Foolish bottom line
There are always bargains out there in the market. The trouble we have, as investors, is narrowing the list to those with the best odds. While no system is completely foolproof, a few simple tests can at least get rid of the firms most likely to sink you. And that alone will greatly increase your odds of beating the market.

If you'd like to learn more about navigating the choppy waters of value investing, our own Philip Durell (aka TMFAdmiral) can help. A 30-day free trial of Inside Value will get you a look at companies that have already survived his gauntlet, as well as a monthly watch list of potential picks.

For related Foolishness:

This article was originally published on Dec. 22, 2005. It has been updated.

Seth Jayson is always looking for easier ways to find great stock values. At the time of publication, he owned shares of Microsoft, but he had no positions in any other stock mentioned here. View his stock holdings and Fool profile here. Microsoft is aMotley Fool Inside Valuerecommendation. Fool rules are here.


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