Hopefully, we've made it very clear both in The Motley Fool Investment Guide and in this column that just because a stock appears on the Foolish 8 spreadsheet doesn't mean it's a "buy." The F8 is just a screen designed to give you a manageable number of stocks for further research, and sometimes that research can alert you to situations you'll want to avoid.
That's not surprising, really. Small companies are inherently riskier investments than large ones. A smaller company may lose just one customer, for example, but be devastated because that customer accounts for a majority of its revenue. A company like General Electric (NYSE: GE), on the other hand, is so huge that even if one of its subsidiaries lost an important customer, it would likely have little if any impact on GE's bottom line. And that's just one example. Smaller companies are also generally more susceptible to paradigm shifts within an industry, economic downturns, and any number of other negative factors.
Now, it pays to follow any company you own -- or are thinking about owning -- as closely as you can. But because of these risks, this is especially important for small-cap investors. At a minimum you should be all over the quarterly earnings reports and conference calls. You should always be on the lookout for warning signs, and it certainly doesn't hurt to discuss these issues with other investors on our discussion boards.
For the sake of example, let's take a look at former Foolish 8 company Cutter & Buck (Nasdaq: CBUK). It first appeared on the list in July of 1998. Since then, it has lost about three-quarters of its value. The S&P 500, by comparison, has edged up 3.5% over that same period. This is a devastating loss, of course, the kind every investor hopes to avoid. Was it possible to see the warning signs and get out before taking a big loss? Let's find out.
Cutter & Buck is a decidedly low-tech, easy-to-understand company. It makes shirts. Golf shirts, specifically, and very nice ones at that. (I have a couple myself.) It also manufactures other sportswear like shorts, caps, and jackets, but it's known mostly for its high-quality shirts.
When it made the list, it had been growing sales and earnings between 45% and 50% annually. Its price-to-earnings ratio (P/E) was around 22. Business was good, and management was beefing up the sales force.
After the first quarter of fiscal year 1999 (which ended July 31, 1998), management told investors during the conference call that sales were so good it couldn't keep its "Classic" shirts in stock. Golf pro shops and other stores ordered merchandise well in advance, and it was relatively easy for Cutter & Buck to plan for that demand. But it was losing sales to corporate customers who wanted shirts with customized logos. Those customers wanted merchandise quickly, and C&B couldn't deliver.
CEO Harvey Jones said C&B would build up inventory to meet demand, but that inventory should track sales going forward nevertheless. Generally speaking, investors should be comfortable with inventory (as well as receivables, which is money that customers owe the company) growing as fast as sales, so this seemed like the right decision.
Indeed, by the next quarter (Q2 1999) inventory had increased significantly, but still was growing at a slower pace than sales. But during the third quarter, inventory increased 80% from the prior year, while sales were up only 63%. And then in the fourth quarter, things really blew up, as shown in bold below:
Year-over-year growth Fiscal 1999 Fiscal 2000 Q1 Q2 Q3 Q4 Q1 Q2 Q3 ------------------ ------------- Acc. Receivable 40% 48% 61% 61% 66% 54% 59% Inventory 19% 40% 80% 117% 117% 89% 57% Sales 44% 49% 63% 53% 64% 42% 37%
Certainly this was a warning that was easy to see at the time, and the above table shows Cutter & Buck had inventory and accounts receivable issues for several more quarters. As if that wasn't enough (and by golly, don't you think it should be?), we were given another red flag, this time on the cash flow statement:
Net cash provided by (used in) operating activities
(Dollar figures in thousands.)FY Q1 Q2 Q3 Q4 ----------------------------------------
1999 $1,956 (4,228) (1,944) (10,468) 2000 (3,273) 4,789 (4,739)
You'll recall that a company will not make the F8 list unless it has positive cash from operations. While Cutter & Buck certainly did at the time, the next several quarters saw it dip back into negative territory. With its growing inventory and receivables choking it, the company saw $14.7 million more in actual cash from operations flow out of its business than into it in fiscal 1999.
This is in stark contrast to the picture painted on the income statement, which shows $8 million of net income earned during the year. It's also a good example of how elements of one financial statement can impact another -- in this case rising receivables and inventory on the balance sheet were driving down cash from operations on the cash flow statement.
While there are sometimes perfectly legitimate reasons for a business to have extended periods of negative cash flow, it's a good rule of thumb to look upon something like this with skepticism. While C&B has reported only one losing quarter in the history of the company -- and that was just a $1 million loss two quarters ago -- it has had to issue new shares and take on $10 million in debt in order to keep its cash balance high enough to keep the business running. This points out the importance of scrutinizing the cash flow statement.
Given the warning signs above, investors could have sold Cutter & Buck well before it started the long slide to its current environs, just north of $5. The day after the Q4 1999 earnings release, the stock closed at $17.63. The following quarter, it closed at $15.25 the day after earnings. As the chart shows, the market gave every opportunity for C&B investors to sell through the third quarter of fiscal 2000, which ended Jan. 31 of 2000.
Things are always clearer in hindsight, and at the time, it was easy for investors to put their faith in management in hopes that the inventory buildup would lead to more sales. But issues of inventory, receivables, and cash flow are very important for any company -- especially for small caps -- and it pays well to understand them.