Back at the beginning of 2005, I came across a stock with some unbelievable numbers. Revenue was up nearly 40% per year for the past three years. Income had grown 50% over the same time. Return on equity was a robust 27%, and net margins were close to 70%. And it was a major player in the strengthening housing market. Its name? Doral Financial
Based on what I knew -- which wasn't much -- I gave Doral a lot of consideration, but did I pull the trigger? First, let me say that even thinking about making an investment without weeks of research is alien to me. I come from a value-focused hedge fund. We had all day to analyze stocks, and we used it, often burning the midnight oil. Hedge funds have a reputation as the gunslingers of the market, but I assure you, mine was anything but. We held just a handful of stocks, and we knew them cold. But keeping track of them -- and finding new ones -- took a lot of time. That kind of thoroughness is what The Motley Fool is all about. When it comes to burning the midnight oil, David and Tom Gardner -- Motley Fool co-founders and lead analysts of the Motley Fool Stock Advisor newsletter -- could give the hedge-fund crowd a run for their collective money.
No, I didn't buy Doral. And I'm glad I didn't, considering that the company has dropped more than 95% since then. It dropped because of some aggressive valuations (since restated) on its mortgage-backed securities and serious management missteps that a cursory browse on Yahoo! Finance wouldn't have revealed beforehand. But I'm not really here to criticize Doral.
Regardless, risk exists, and with any investment, it's important to know what you're betting on. No screen or quick peekaboo would inform you that video game makers such as Electronic Arts
Having the time to do some diligent digging is crucial in avoiding potential blowups.
The "Are you kidding me?" formula
There's more. Years ago, I read a book about theories underlying accounting and financial statements. It spent a lot of pages on a common solvency formula: earnings available to pay fixed charges divided by those fixed charges. Via several chapters of buildup, it replaced the simple version with a "corrected" formula that made several tweaks to the numerator and denominator. Was it right? Yes -- it eliminated a lot of flaws in the raw accounting numbers. But that accuracy came at the expense of a formula so complex that individual investors would need days to calculate it.
Lack of time tends to pull investors in one of two ways. The first: making futile grasps in a blizzard of information overload. The second: tunnel vision toward stocks you've already researched. Let's face it -- either one can burn you.
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This article was originally published on Feb. 23, 2005. It has been updated.
James Early does not own any of the stocks discussed in this article. Microsoft is a Motley Fool Inside Value recommendation. Yahoo! and Electronic Arts are Stock Advisor recommendations. The Motley Fool has a disclosure policy.