The informant long known only as "Deep Throat" gave the journalistic duo Bob Woodward and Carl Bernstein some sage advice: "Follow the money." Tom Cruise updated that statement a little bit in the movie Jerry Maguire, when he said "Show me the money!" In both cases, it's also a bit of investment wisdom that all shareholders would do well to heed.
Specifically, investors need to know three specific things about their companies:
- How do they make money?
- Who are their customers?
- Where's the money coming from?
All too often, the money is coming from a single source, whether it's a large customer, a single supplier, or a lone partner.
Follow the money
The monkey wrench that wasn't fully realized back then was that Cantel Medical heavily relied on a single distributor for some 30% of its revenues. Worse, a Cantel subsidiary counted on the distributor for 80% of its revenues. When that distributor announced it was terminating its agreement with Cantel, the stock was dealt an Olympic blow and tumbled 40%; it has yet to recover.
Compare that with medical-device maker Stryker's
Putting a stamp on pyrite
When I first looked at Escala
Although I had been a shareholder of Escala, I wondered whether it was really running a glorified Ponzi scheme. Spanish auction house Afinsa Bienes Tangibles accounted for about 80% of Escala's revenues, which was noteworthy despite its 25-year history of making good on its word. I ultimately sold my shares. Six months later, Spanish authorities raided the offices of Afinsa. Even though the scandal has yet to officially touch Escala, its stock fell from a high of $35 a share to a low of around $4 a stub.
Another Hidden Gems recommendation with a seemingly similar problem is skateboard-crowd clothier Volcom
In all three scenarios, had investors simply followed the money, they could have sidestepped the inevitable tumbles their shares took when problems gripped these companies' major distributors, customers, or partners.
Show me the money
While a diversified stream of revenues is not a cure-all for a plummeting stock price, it's important to understand the risks involved when a company has a very narrow source of money. When your company's fate is tied to the well-being of another company, you'd better be sure that the foundation between the two is rock-solid. And even then you should be prepared for a few earthquakes.
Fools don't like to see one particular customer, supplier, or distributor account for more than 10% of sales. You can find this figure for yourself in any company's annual report. In fact, the SEC requires companies to highlight any revenue stream that reaches that 10% threshold. In addition to diversified revenue streams, Fools like to look for traits similar to these in their investments:
- Shareholder-friendly management with a large, personal stake in the business.
- A solid asset base with little or no debt.
- Dominant positioning in a prosperous niche.
That's allowed us to avoid companies like ImClone Systems
Foolish bottom line
There are many factors affecting a business' bottom line over which investors have no control. But looking at top-line revenues and demanding to be shown the money is an easy step every investor should take. That's what we attempt to do at Hidden Gems, having learned from Cantel's troubles. It's our goal to find those top-notch companies that exhibit the best characteristics for long-term growth and profits. Click here for a free trial, and you can see all of the stocks we're recommending right now.
Fool contributor Rich Duprey does not own shares of any stocks mentioned in this article. You can see his holdings here. Cantel Medical and Volcom are Hidden Gems selections. Pacific Sunwear is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.