In the middle of 2006, I came across a stock with some unbelievable numbers. Revenue was up more than 80% per year for the past three years. Income had grown 95% over the same time. Return on equity was a robust 47%, and net margins were close to 42%. Plus, it was a player in the growing student loan market. Its name? First Marblehead (NYSE: FMD).
Based on what I knew -- which wasn't much -- I gave First Marblehead 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.
Hidden risks
No, I didn't buy First Marblehead. And I'm glad I didn't, considering the recent credit fears that have spooked investors, and the specter of defaults that has slashed the stock by more than 50%. But I'm not really here to criticize First Marblehead; it recently got a boost of confidence from Goldman Sachs (NYSE: GS), and several of my colleagues continue to like its long-term prospects. Indeed, it may still make for a fine long-term investment.
Regardless, risk exists, and with any investment, it's important to know what you're betting on. No screen or quick peekaboo would warn you of the effect the credit markets would have on First Marblehead, or the significant exposure Merrill Lynch (NYSE: MER), Citigroup (NYSE: C), and Morgan Stanley would have to subprime loans. Then you have companies such as Bed Bath & Beyond (Nasdaq: BBBY) and Blue Coat Systems (Nasdaq: BCSI), which had to take charges recently due to options backdating.
Granted, these risks may all be on the obvious side, but have you ever been burned because you missed a material piece of information? 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 Feb. 23, 2005. It has been updated.
James Early does not own any of the stocks discussed in this article. The Motley Fool owns shares of Bed Bath & Beyond. First Marblehead is a Motley Fool Hidden Gems and Inside Value recommendation. Bed Bath & Beyond is an Inside Value and Stock Advisor pick. The Motley Fool has a disclosure policy with regard to such interests.
