Fool.com: In-Depth Due Diligence[Fool on the Hill] March 24, 2000

FOOL ON THE HILL
An Investment Opinion

In-Depth Due Diligence

By Bill Mann (TMF Otter)
March 24, 2000

Well, we opened up a can of worms, didn't we? Wednesday, I wrote in this space about the goings on at MicroStrategy (Nasdaq: MSTR) and its loss of more than 70% of its market capitalization in the span of two weeks.

The large number of responses to this article led me to believe that a follow-up was necessary. Some people objected to being pontificated at, some took umbrage at my criticism of technical analysis, and some wanted to know where they can find information in company financials.

To those of you who thought I was being a little harsh, yep, I was. But I dare say that my article was a lot less harsh than the billions of dollars lost by investors holding shares in this company. Look, I'm not running for public office here, so I'm not in the position of trying to please everyone. The object of my diatribe was simple. I read several hundred posts on various message boards following the drop in MicroStrategy shares, and I was struck by the consistency of a single lament: "They did this to me." My response was to be a reminder that, no, "they" did not. No one put a gun to your head and told you to buy MicroStrategy. You bought, either a) knowing as much as you could about the company and its risk profile; or b) not knowing enough. Either way, in this case, you were punished for your choice to invest in the company.

Just so you know, had there been signs of gross impropriety by the company, I would be shouting from the mountaintops, calling for the inquisition. But there weren't. There was no billing scandal, no sign of a "pump-and-dump" scheme, no SEC investigation. This was just a company that had used a certain accounting method, a very aggressive one, having to alter their earnings statements.

Investing in companies, particularly growth ones, is all about minimization of risk. There is no such thing as elimination of risk, nor is it possible to know every single risk. But the Foolish mantra that anyone can invest does not mean that it doesn't take a time commitment to do so. Don't have time to do research? I'm not passing judgment on you, I'm just saying that perhaps you should have an investing regime that is consistent with the amount of time you wish to allocate. There is nothing wrong with index funds or blue-chip investing -- they have both provided significant gains to patient investors. But investing in aggressive companies that you don't have time to follow or learn about? That is a recipe for disaster, sooner or later.

OK, next item. In my opinion, and in my research, technical analysis is pretty much worthless for providing superior returns over a simple buy-and-hold strategy investing in top companies. So, there, you have my bias right up front. No need to write in telling me how biased I am. I KNOW that already. But here, in this event, I'll describe why technical analysis could not have foreseen the severe drop in MicroStrategy.

It's because the drop was based on news. News is something that happens at a random point in time. It is not predictable, that's why they call it news. Neither the Psychic Friends Network nor the eyeshade crowd can come out and say that "based upon X, Y, and Z external factors, there is news that is going to come out to dramatically affect the stock." It cannot be done. So, for the person who made this impassioned response to the article, let me say, you're just wrong.

There are two types of risks to stocks. Systematic Risk shows that the price of the stock moves in sympathy with the overall market, or, for a negatively correlated company, the opposite is true. So, for example, unemployment numbers for the month come out, and they are strong, and "the market" as a result rockets upward, including the stock in question. Or there may be no driving news, but the overall market moves downward. Companies that go along for the sympathetic ride are doing so based upon risks way external to their operations. These are only as predictable as the general direction of the market is. But let's just say, for the moment, that, yes, past moves have some weak correlation to future ones. Unsystematic Risk ruins this correlation because it is based not on general market conditions, but on an external event peculiar to the company in mind. For example, MicroStrategy announces a restatement. The president makes a comment about ownership of genetic code. Whatever. These events are random, and they are not predictable.

As an aside, here is the big problem I have with technical analysis. It is a self-defeating utility. Technical analysis assumes that by looking at yesterday's action on a company, one can tell what is going to happen next. For example, if a stock has had a run-up and then shows signs of slowing, we can assume that over the next week it is going to drop. Well, if this were the case, with certainty, why would it wait until tomorrow to drop? Why not just drop right now? And the more people using technical analysis, the less successful it can be. Again, the above situation. If 10,000 shareholders using technical analysis were looking for the same sign, then they'd all pull the sell trigger at the same time. So then, to gain an advantage, you'd have to look for a sign of that sign to beat the rush, and then a sign of a sign of a sign. And so on, until an unsystematic risk factor comes and blows up the patterns anyway.

I see no evidence that technical analysis would have signaled the imminent problem that hit MicroStrategy since the event was, at its origin, a random event. If anyone can show me in the charts where a news event of this magnitude was predicted, I'll be all ears.

Finally, people asked where to find the information needed to properly assess the potential risks in a company. Since many companies use their financial statements as another type of marketing material, you do have to read between the lines a little. If the investing community wants to see revenue growth, well that's what is going to be accented in the financials. If net margins are what the company's management is being evaluated upon, then rest assured that net margins are going to be as good as possible. But remember that investing is an art, not a science. If it were a science, there would be hard-and-fast rules that would make us gazillionaires. Fortunately, one does not need to be an accounting savant to get the information that is needed to make an informed decision. Remember, the name of the game is risk reduction -- there is no such thing as risk elimination.

To reduce your risk in investing, first you must understand the company's product. Even services, in the end, are products. Then, learn how the company makes money on that product. You may be stunned to discover, for example, that insurance companies routinely lose money on their policy underwriting, that they make money based on their ability to invest the "float" (monies received in premiums but not yet paid out in claims). In this case, MicroStrategy has a software suite and then long-term service contracts. For any company with service or other long-term contracts, go to the Summary of Accounting Policies, which is included in every 10-K and 10-Q. In this will be a section called "Revenue Recognition," where it will describe, in some form, how the company accounts for its contracts. If this doesn't answer your question, there is nothing wrong with picking up the phone and calling investor relations. Doesn't take very long, and in most cases, it's free.

Look at it this way -- how much research do you do before you buy a car? Or even a television or stereo. I submit that in the long run these decisions are much less important than those pertaining to where you invest. There is very little to lose from taking the additional time to do this, and so much to gain in terms of understanding the company you are studying, and gaining greater knowledge of the laws of commerce at large.

Sometimes the information you are looking for is not right there on the surface; in fact, it almost never is. But don't be afraid to break out the calculator, read the annual report, pick up the phone and call investor relations, or post the question on the Fool boards. If these actions don't convince you that you understand the company's business model, well, there are 9000 other companies on the major exchanges where you can put your money. Not all companies are good investments, of course, but it is always advantageous to put your money in a company that you understand.

This week the Fool writers put together a series explaining where we go to do our research. It is a great resource, and it may help you separate some of the wheat from the chaff in terms of where to go to do your own due diligence.

Fool on and have a great weekend!

Bill Mann, TMF Otter on the Fool Boards