Many of the criteria in our Rule Maker portfolio require investors to crunch numbers -- net margins, gross margins, Foolish Flow Ratios. We need this to understand where a company has come from. Is it profitable, and how much so? Is its capital structure weighted down with debt, and what kind of cash is on hand?
Obviously, this is information we have to know. It gets us centered. It's like the basic information you collect from a partner on the first few dates, only the Securities and Exchange Commission (SEC) isn't interested in whether your date is properly recognizing revenue.
Investors who read a lot of SEC filings, however, are familiar with boilerplate language that past performance is no guarantee of future results. It's easy to skip over this legalese, but it's a mistake to do so. Not only does the business world change fast, but a cursory look at the financial statements is backward-looking.
The markets are interested in what's around the corner, and stocks are always priced on expectations, not past performance. A perfect understanding of a company's previous financial statements, in isolation, is like a good read of yesterday's newspaper.
The takeaway here is twofold. First, investors must look for trends in financial statement data, not just single data points. One quarter's gross margin or level of receivables is worthless without context provided by similar data from previous periods, tempered with an understanding of what's happening to the business at present.
The best way to analyze trends is through the use of what's called common-size financial statements, most often used to analyze income statements and balance sheets. It's pretty simple. If you want a common-size income statement, just take each account item and calculate it as a percentage of total sales. If your favorite company spends $150 in a given quarter on research and development, and has $1,000 in sales, then a common-size statement tells you R&D represents 15% of sales. If you want a common-size balance sheet, just take each balance sheet item as a percentage of total assets. Common-size statements are often provided in a company's 10-K, so some of the work will be done for you.
We can do two kinds of analysis with these numbers, each of which has, in the fine tradition of opaque financial lingo, a clunky name. Time series analysis is when you look at a given company's ratios to get a feel for one company's progress over time. Cross-sectional analysis is when you compare a given company's ratios with those of a similar group of companies -- regardless of whether these companies are different sizes. It helps us develop a pecking order.
If we can spot a trend in the numbers, our backward-looking data might suddenly spring forward, providing a glimpse of the future, or at least good questions that need clarification, and that's the whole idea behind financial analysis. We've seen trends in a number of our Rule Makers that merit tracking: Microsoft's (Nasdaq: MSFT) and Cisco's (Nasdaq: CSCO) rising Flow Ratios, and Intel's (Nasdaq: INTC) declining operating margins, for example.
The second lesson from boilerplate warnings about future results is that we have to know where a company is headed, how the gravity of the current business atmosphere is reshaping business.
We're getting a more precise handle on what we mean by expanding possibilities in the Rule Maker thanks to some thinking from one of our managers, Zeke Ashton. Zeke is telling us to look for three things in Rule Maker companies:
- Will they be more or less relevant in the future? Will consumers drink more Coca-Cola (NYSE: KO) in 30 years than they do today, or will substitute products keep the company's beverages from filling refrigerators from Rome to Romania?
- Will the industry support strong future growth, as we hope the market for Cisco's routers will, or are investors already looking at a market saturated by your company's products the way the world is over-run with cars, and worse, car commercials?
- Does the company have options to grow? We know that Coca-Cola hopes to ignite growth in its business by moving into non-carbonated drinks such as water and sport drinks. Sure, that's one option. But there are also bet-the-company moves into largely new lines of business, such as Microsoft's .NET initiative, a highly uncertain endeavor, though Microsoft is in a strong position to take a stab at success.
Don't kid yourself that these three questions are easy to answer. Obtaining an understanding of these issues means understanding an industry's trends and a company's strengths and weaknesses -- and it's a lot harder in many ways than reading a balance sheet. But that's where we need to go.
Have a great day.
Richard McCaffery lives in Laurel, Maryland with his wife Linda. Richard doesn't own shares in any companies mentioned in the above article. The Motley Fool is investors writing for investors.