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January 5, 1999

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Subject: Re: SEC Filings
Author: BDKliewer

Do any of you ever use these filings to determine whether to buy or sell. I am a pretty new investor-started last year, and have yet to use them for any purpose other than to read after I have exhausted all other outlets I have for information.

Absolutely. I use them as my primary source of information before reading much else. I prefer to make some initial judgements before reading the spin from other sources.

The financials are a very rich source of information when you learn how to read them (and read between the lines). I only have time to give a few quick examples, but there are plenty of other detailed explanations through this site.

" The financials are a very rich source of information when you learn how to read them (and read between the lines)."

Particularly, I like to look for anything unusual -- particularly by benchmarking line items on all three primary statements: income (profit/loss), balance sheet, and cash flow against top line (gross revenue) growth or decline. Unusual can be good (such as administrative expenses growing slower than revenues) or bad (such accounts payable growing much faster than revenues).

I usually skew my attitude toward looking for problems. After all, just about everything else you hear/read will be trying to skew your view toward the positive and the company is definitely trying to portray itself in the best light.

Sometimes the discrepancies can be alarming -- such as consistenly negative operating cash flow vs consistently positive net earnings. A company may be sinking into a quagmire of debt, mismanaging inventory, selling to unreliable customers or using too generous terms and growing receivables (and/or extending collection times), expanding too quickly (buying facilities or equipment at an unsustainable pace), etc.

I like to compare financial statements over the course of several years -- particularly when dealing with smaller companies. You should see continually improving disclosure of details and consistency of reporting. For example, as a company adds new divisions it should break out key financial data for all signficant divisions (earnings, expenses and growth attributable to each division). My guard immediately goes up if a company lavishes detailed praise about a particular product or growth statistics later quits mentioning it in the statements. I like to see management that's willing to frankly discuss problems and disappointments rather than "ignoring" them.

Keep your eyes on share growth and management options. In many companies, the growth in stock options can significantly dilute earnings for the paying shareholders (sometimes companies compensate for this dilution by buying back shares -- this is usually a good thing).

If a company uses debt (hopefully not much) are they using bonds (the more favorable method roughly equivalent to a mortgage on your home) or lines of credit (more like using a credit card)?

Also look at the filing for some of the company's competitors. Are they disclosing at least as much detail? And are they reporting things in a similar manner? Some companies can inflate their sales figures by aggressive accounting (things like counting sales at an earlier stage than the industry standard or underfunding reserves against losses for non-payment [or any other risks such as depreciation or spoilage of inventory]).

"I bet many people spend more time inspecting the food they buy than the companies they invest in. Would you just pick up any piece of fruit or meat in the store without giving it a once over or checking an expiration date?"

Read the resumes of management and the board. Are these the kinds of people you want running your company? Do at least some of them have prior experience in quality, publically held companies? Are they really independant (not primarily from one family or a close-knit consortium of companies)? Are the directors able to keep their focus on management (that is, are they not serving on five or few other boards -- hopefully many on less than four)? Look for stability -- particularly CFOs and CEOs who are not replaced every few years.

Read management's discussion -- particulary pay attention to the risks. Read the through the information on lawsuits. Read all of the footnotes. Even the best companies can have some scary stuff in there, but is it reasonable for the business they're in? And how big a threat to the business are the risks? Is the sole supplier of a key part located in a backwater country with an unstable economy or government? Or does it simply come with the territory (a smaller competitor may invent a revolutionary product that obsoletes your company's)?

And make sure the financial reports are not sloppily prepared. I've seen incorrectly reported figures (copied verbatim from prior quarters) and signs of rushed preparation (like someone was cramming last-minute for an essay test). It's simply amazing how much garbage can get past auditors and analysts. But then, there are only a handful of auditing firms covering thousands of companies. Ditto for analysts.

I bet many people spend more time inspecting the food they buy than the companies they invest in. Would you just pick up any piece of fruit or meat in the store without giving it a once over or checking an expiration date? Do you just blindly trust the inspectors and stock people to keep everything in order? Auditors and analysts are the same, they have a lot to work through and things sometimes slip by. So check it yourself. Aim for the cream of the crop and you will find fewer sour cartons in your refrigerator.

All of these things are fundamentals. Too many investors make the mistake of thinking only the quantitative data is fundamental. Fundamentals are qualitative, too. Quality of managment. Quality of earnings. Quality begets quality and often (but not always) leads to outperformance.


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