7 Stocks Worth a Look Under the Hood

My name is James Early, and I've handled more panties in a month than most men do in their entire lives. At my former hedge fund, "hands-on" research meant just that.

I've continued that practice as an advisor to the Motley Fool Income Investor investing service, and I'd like to help you do the same.

And just to get you started, I'll even give you seven stocks you may want to investigate.

Analysts do this all the time
Let me first clear my name. My panty-handling involved checking prices during store visits to Victoria's Secret, owned by Limited Brands. Store visits are a staple of in-depth analysis -- and one you can easily do yourself.

Of course, this "non-parametric" research -- or scuttlebutt, as it's called in the industry -- isn't just a panty party. I've gotten dish on Vulcan Materials from the passenger seat of a company truck looking for bonsai soil. I've measured parking lots at Target. I've been to coal mines, dug for dirt on scientists through other scientists, and learned what Ford engineers think of management.

To investigate "Vicki's Secret," as it's known among analysts, I became a mall crawler. I hit venues all over the state, schmoozed with managers and employees, and watched customer behavior. What did I find?

While Victoria's Secret was hot, the parent company's namesake Limited stores were not. In fact, Chairman Les Wexner later broke down and sold them off, along with Express, another underperformer.

Of course, underperformance shows up on the financial statements; I didn't need a store visit to know that Express and Limited stores had been struggling. But accounting statements can also distort reality -- and whatever happens there happens on the front lines first.

And so can you
You don't have to be a hedge-fund analyst to investigate scuttlebutt -- or to use it to help you flesh out financial information. Here's how you can use scuttlebutt to check your investing theses:

1. Work your connections: Brother's in refining? Ask him about the "crack spread." Neighbor's an importer? See how the dockyards are doing. Six degrees of separation connect you with a lot of knowledge, so ask around.

2. Build new connections: When you meet people in different industries, build relationships. Reach out and speak with folks -- people are often flattered by your interest and may be happy to dish.

3. Become a scientist shopper: We all think we have an eye for trends, but if you swap out your inner Pierre Cardin for your inner scientist, you may catch movements before they hit the financial statements -- especially if you have the opportunity to visit the same store in multiple regions. Hover around registers. See what people are buying. Talk with clerks and customers. You don't work for the company, so people will be more honest. Use your free focus groups to spot trends in how the company's offering is being received.

Doing the math
Scuttlebutt is an interesting and even fun way to research a potential investment -- and it amply rewards you with the kind of details that companies don't publish in annual reports. But although investigating scuttlebutt can be exciting, it's not the first step. The first step is doing a basic quantitative analysis to make sure the company you're interested in is worth all of that time.

At Income Investor, we want to find the very best dividend stocks -- because studies show that dividend payers outperform non-dividend payers -- at the very best price. We also seek out great management, enough size to be relatively stable, strong financials, and a competitive advantage.

Those are the things we look for. But there are also things to look out for, including the following three:

1. "Hare" revenues vs. "tortoise" earnings: It's OK for revenues to outgrow earnings as a young company emerges, but if earnings don't catch up soon, you should flee. That's a sign that the company looks good on the surface but isn't making money in spite of all of its revenue. Those businesses don't last long.

2. Accounts receivable growing faster than sales: When companies sell goods on account, they'll show an "accounts receivable" balance. This figure should keep pace with sales; much faster growth means a company is recording revenue, but the cash isn't flowing in.

3. Unsustainable dividends: Studies show that dividend stocks outperform, but high payout ratios mean the company is stretching to pay those dividends and might be in danger of cutting or suspending them. Here's a trick: When you calculate payout ratios, don't use earnings -- swap in free cash flow instead, and you'll have a much better grasp on a company's true dividend credibility.

Seven stocks worth a look under the hood
So, what kind of company might be worth investigating further? I ran a screen in Capital IQ, an institutional program (and a division of Standard & Poor's), to cull seven companies whose three-year earnings growth is higher than revenue growth, whose sales outgrew accounts receivable over the past year, and whose dividends are less than 80% of free cash flow.

Although not formal recommendations, they can be starting points for further research, both quantitative and hands-on:

The Foolish bottom line
It pays to do your research, both financial and "non-parametric." Learning about a company in detail can prevent you from buying companies with obvious warning signs.

If you don't have the time or the inclination to crawl the mall yourself, consider a free 30-day trial to our Motley Fool Income Investor service, which is beating the S&P by more than seven percentage points. We run the screens, check behind the scenes, and provide two vetted recommendations every month. Click here to get started -- there's no obligation to subscribe.

James Early owns no stocks mentioned in this article. Eli Lilly and Limited Brands are Motley Fool Income Investor recommendations. Vulcan Materials and Limited Brands are Inside Value selections. The Motley Fool has a disclosure policy.