Fire Your Stock Analyst!

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Fire Your Stock Analyst!

Analyzing Stocks on Your Own

Harry Domash

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Library of Congress Cataloging-in-Publication DataDomash, Harry Fire your stock analyst! : analyzing stocks on your own / by Harry Domash p. cm. Includes index. ISBN 0-13-035332-9 (alk. paper) 1. Investment analysis. I. Title: Analyzing stocks on your own. II. Title.

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To my loving wife Norma,who read every word of this book more than once.

FIGURE CREDITS

The author gratefully acknowledges permission to use the following—

• Figures 2-1, 6-1, 7-1, 10-2, 12-1, and 14-1-14-4: MSN Money.• Figure 7-2: Courtesy of Hoover’s, Inc.• Figures 9-1, 9-2, 13-1, and 15-1: Reuters.com.• Figures 10-1 and 13-2: Chicago-based Morningstar, Inc. is a leading

provider of investment information, research, and analysis. For more information about Morningstar, visit www.morningstar.com or call 800-735-0700.

• Figures 10-10 and 10-11: ValuBond, Inc.• Figure 14-5: BigCharts.• Figure 15-2: Financial Times

x i

Introduction xix

Acknowledgments xxvii

PART ONE GETTING STARTED 1

Chapter 1 The Analysis Process 3

Finding Candidates 4Analyzing Stocks 4Quick Prequalify 4Detailed Analysis 7

TABLE OF CONTENTS

F i re Yo u r S t o c k A n a l y s t !x i i

When to Sell 11Summary 11

Chapter 2 Evaluating Risk 13

Market Valuation 15Market Direction 18Spotting Strong Industries in a Weak Market 19Company-Specific Risks 19Company-Specific Risks Described in Subsequent

Chapters 23Summary 24

Chapter 3 Screening 27

Sample Growth Screen 28Value Screen 32“MSN Money” Down & Out Value Stock Finder 34Reuters Investor Bulletproof Stocks 37The Zen of Screening 40Premade Screens 40Summary 41

PART TWO ANALYSIS TOOLS 43

Chapter 4 Analysis Tool #1: Analyzing Analysts’ Data 45

Who Are the Analysts? 46Analysts’ Ratings 47“Sell” Is a Four-Letter Word 47Consensus Ratings 49Do Strong Buys Outperform Sells? 50Number of Analysts 52Sentiment Index 53Analysts’ Estimates 56

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Forecast EPS Trend 58Earnings Surprise 61Sales Forecasts 62Regulation FD 64Research Reports 64Summary 65

Chapter 5 Analysis Tool #2: Valuation 67

Implied Growth 68Growth at a Reasonable Price 73Dividends 77Summary 77

Chapter 6 Analysis Tool #3: Establishing Target Prices 79

The Process 80Cisco Systems 88Summary 93

Chapter 7 Analysis Tool #4: Industry Analysis 95

The Business 95Industry Growth Outlook 96Industry Concentration 99Picking Winners in an Emerging Fragmented

Industry 101Industry Scuttlebutt 107Summary 107

Chapter 8 Analysis Tool #5: Business Plan Analysis 109

Introduction 110Overblown Competitive Advantages 118Business Plan Score Scorecard 120Summary 120

F i re Yo u r S t o c k A n a l y s t !x i v

Chapter 9 Analysis Tool # 6: Management Quality 123

Key Executive and Board Quality 123Clean Accounting 125Earnings Growth Stability 127Stock Ownership 127Summary 128

Chapter 10 Analysis Tool #7: Financial Fitness Evaluator 129

Financial Fitness Counts 129Pinpointing Financially Challenged Companies 130Simplify the Problem 131Low Debt 131Detecting Potential Busted Cash Burners 133Detailed Fiscal Fitness Exam 139Bond Ratings 159Use Bond Risk Premiums to Identify Risky Debtors 162Summary 166

Chapter 11 Analysis Tool #8: Profitability Analysis 169

Where Do Earnings Come From? 170Analyzing Sales (Revenue) History 171Analyzing Margins 178Gross Margin 178Operating Margin 179Net Profit Margin 180Comparing Margins 180Gross Margins 180Operating Margins 182Analyzing Margins 184

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High vs. Low Margins 186Analyzing Overhead Expenses 188Profitability Ratios 189Marginal Return on Assets 198Cash Flow Analysis 199EBITDA vs. Operating Cash Flow 206Free EBITDA 208Summary 209

Chapter 12 Analysis Tool #9: Detecting Red Flags 211

Sales Growth Trends 213Accounts Receivables & Inventories 217Statement of Cash Flows 225Pension Plan Income 228Yellow Flags 229Summary 232

Chapter 13 Step 10: Ownership Considerations 235

Institutional Ownership 235Insider Ownership 237Summary 240

Chapter 14 Tool # 11: Price Charts 241

Trends 241Moving Averages 243Avoid Downtrends 245The Risk Zone 246Chart Types 246Trading Volume 247Summary 247

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PART THREE THE ANALYSIS PROCESS 249

Chapter 15 Quick Prequalify 251

Profitable & Snapshot Report 252Valuation Ratios 254Financial Highlights Report 257Ratio Comparison 257Check the Buzz 259Summary 260

Chapter 16 Value Investing: The Process 261

Cycles 262Normalizing 263Value Analysis Process 263Step 1: Analysts’ Ratings & Forecasts 264Step 2: Valuation 266Step 3: Target Price Ranges 270Step 4: Industry Analysis 275Step 5: Business Plan Analysis 276Step 6: Management Quality 278Step 7: Financial Health 279Step 8: Profitability Analysis 280Step 9: Red Flags 283Step 10: Ownership 284Step 11: Charts 284When to Sell 284Summary 286

Chapter 17 Growth Investing: The Process 287

Growth Candidates 288The Process 289Step 1: Analysts’ Ratings & Forecasts 290Step 2: Valuation 294

Ta b l e o f C o n t e n t s x v i i

Step 3: Target Prices 296Step 4: Industry Analysis 300Step 5: Business Plan Analysis 302Step 6: Management Quality 303Step 7: Financial Health 305Step 8: Profitability 307Step 9: Red Flags 311Step 10: Ownership 315Step 11: Price Chart 316When to Sell 317Summary 319

PART FOUR MORE TOOLS 321

Chapter 18 Earnings Reports & Conference Calls 323

Reported Earnings 324Summary 326

Chapter 19 Detecting Scams, Frauds, and Pump & Dump 327

Opportunity Knocks 328Shoestring Operation 328Hyping Pays Well 329Quick Hype Checks 330Summary 331

Appendix A How to Read Financial Statements 333

Income Statement 334Balance Sheet 335Statement of Cash Flows 338Finding the Data 340Pro Forma Accounting vs. GAAP 341

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Appendix B Analysis Scorecards 343

Value Stock Analysis Scorecard 344Summary 346Growth Stock Analysis Scorecard 346Summary 350

Appendix C Glossary 355

Index 363

x i x

This is a book about analyzing stocks. The process of writing this book turned out to be a huge educa-

tional experience for me. I thought that I knew something about the sub-ject when I started. After all, I’d been teaching it, writing about it, anddoing it for years.

I had pored over scores of investing how-to books by famousand not so famous gurus and studied their teachings. I meticulously re-searched how I would have fared if I had followed their strategies in thepast. Based on their work, I synthesized and tested my own strategies.

In the process of researching this book I interviewed 15 profes-sional money managers and market analysts. I had never met any ofthem when I started. I found some because they managed best-in-classmutual funds with solid long-term market-beating performance records.Others were market analysts or private money managers practicing in-novative strategies that I’d heard about from other professionals or

INTRODUCTION

“Not everything that can be counted counts,and not everything that counts can be counted.”

—Albert Einstein

F i re Yo u r S t o c k A n a l y s t !x x

through their own writings. About half of those I contacted graciouslyagreed to talk to me.

In truth, I may have misled them. They probably thought I waswriting one of those books that features a single guru per chapter, a sortof minibiography describing their childhood, working style, office envi-ronment, as well as their investing methods.

I didn’t do any of that. I focused our conversations on just threeareas: (1) how do they identify investment candidates, (2) how do theyanalyze them, and (3) how do they decide when to sell.

I had interviewed money managers before, but not at that level,and not in this context. It was an on-the-job learning experience, and Iflubbed the first couple, in terms of asking the right questions. But aftera while, I got the hang of it.

Interviewing a money manager is a lot different from reading abook they’ve written, or hearing them speak. For starters, you don’thave to go over the same ground if you’ve already read their works, orheard descriptions of their methods. Instead, you can zero in on the de-tails, asking questions like: How do you define overvalued? How do youidentify good management? How do you pinpoint an industry’s stron-gest player? What are your sell signals?

Often the conversations took me to unexpected places. For in-stance, I was unaware of Porter’s Five Forces Model before NicholasGerber gently brought it to my attention (by the time Ken Shea men-tioned it a week or so later, I responded as though it were old hat). ThePorter model inspired the business plan evaluation strategy that becameTool #5.

Some interviews led me to academic research that I’d always as-sumed was just too, well, academic, to be of interest. That’s how I dis-covered the work of University of Chicago Business School professorJoseph Piotroski, whose research inspired the fiscal health exam fea-tured in Chapter 10.

Perhaps my biggest surprise concerned value investing. I couldnever figure it out before. I’d read books packed with data proving thatlow P/E stocks outperform glamour stocks, but I could never make itwork. The turkey P/Es just kept getting lower after I bought them. Afterinterviewing several money managers, it hit me that what they did borelittle resemblance to what I’d read about value investing. They weren’tbuying low P/E stocks. They were buying great companies that hadstumbled! There’s a world of difference between those two approaches.

I n t r o d u c t i o n x x i

The wealth of information that these market experts and re-searchers so kindly shared with me forms the basis for what follows. Butbeing an ungrateful sort, I didn’t give them their deserved recognitionby describing each of their strategies separately. Rather, I distilled theminto the combined analysis tools and strategies that make up this book.

Who Should Read This Book

This is not a get-rich-easy kind of book. There are no magic for-mulas revealed. I wrote it for people who know that making money inthe stock market takes more than running a screen or watching CNBC.I wrote this book for investors willing to put in the time and effort ittakes to find and research profitable stock investments.

What’s in This Book

I’ve read many investing books filled with great concepts andstrategies that left me feeling unfulfilled, because they didn’t tell mehow to put those wonderful ideas into practice. This book describespractical step-by-step strategies for finding, researching, and evaluatinginvestment candidates. Equally important, it also tells you when to sell.

I describe two step-by-step strategies, one for growth stocks, andthe other for value investors. Some experts advise that both are, in fact,similar strategies. While it’s true that you can have a value-pricedgrowth stock, the two analyses processes are very different. When valueinvestors are selling, growth investors are buying. So it’s unlikely thatthe value and growth investors would own the same stock at the sametime. While the two strategies are different, they draw on a common setof analysis tools.

What’s Different?

This isn’t a rehash of conventional wisdom and familiar strate-gies. The methods described make use of information readily availableto anyone connected to the Internet, but in new ways, including:

F i re Yo u r S t o c k A n a l y s t !x x i i

How to Gauge the Risk of Owning a Specific Stock

Typically, investors rely mostly on past performance to deter-mine the risk of owning a stock. But in the end, stocks move in responseto changes in a company’s earnings prospects. A price chart shows youhistory; analyzing fundamentals can help you see the future. You’ll dis-cover how to use those fundamentals to evaluate the risks specific toeach stock.

Analyzing the Analysts

Recent events demonstrate that you can’t depend on analysts’recommendations to make money in the market. But there’s still muchto be learned from their ratings and forecasts.

What a Stock’s Valuation Tells You

Knowing the expectations implied in a stock’s valuation tellsyou much about the rewards versus risks of owning the stock.

How to Set Target Prices

Something that the pros always do, but nobody ever told you.

Industry Analysis

Has your candidate picked a market worth pursuing? If so, areyou riding the winning horse?

Business Plan Analysis

Is your candidate more like Wal-Mart or Kmart? Analyzing itsbusiness plan will help you find out.

Financial Fitness Evaluator

Bankruptcies are bad news for stockholders, but nobody evertold you how to find out if your stock is a bankruptcy candidate.

How to Use Sale Forecasts

Analysts’ consensus sales forecasts have only recently becomeavailable. Here’s how to use them to identify companies likely to comeup short at earnings report time.

I n t r o d u c t i o n x x i i i

Analyze Profitability

Profitability is more than earnings per share. Here’s how to findout if your candidate is really making money.

Detect Accounting Shenanigans

Some executives will do whatever it takes to meet earnings fore-casts. Here’s how to find out if they’re cooking the books to do it.

When to Sell

Specific rules for selling, depending on whether you’re a growthor value investor.

Notes on Examples

Most of the examples used to illustrate the recommended analy-ses strategies draw on data that was available on a particular historicaldate. However, many of the strategies developed out of interviews andresearch conducted specifically for the book. Consequently, the exam-ples demonstrate what could have been done, but not necessarily what Idid on those dates.

Many examples compare annual operating characteristics offirms that have different fiscal year-end dates. For the sake of clarity, Iused the closest calendar year for the comparisons. For instance, if onecompany’s fiscal year ended November 30, 1999, and another on Janu-ary 31, 2000, I labeled the annual data for both as calendar year 1999.So while the figures shown may be technically inaccurate, they’re closeenough to support the point made by the examples.

Accounting Shortcuts

Certain accounting formulas such as return on assets call for de-termining the average asset totals over the course of a year. Instead, I usethe year-end figures because you can pick them directly off of the bal-ance sheet instead of having to calculate them. Consistently applyingsuch shortcuts simplifies the calculations and won’t materially affectyour results.

F i re Yo u r S t o c k A n a l y s t !x x i v

Frequently Mentioned Websites

These Websites are the primary resources necessary to imple-ment the analysis described in this book. Most are referenced through-out the book, so I’ve listed their Web addresses (URLs) here rather thaneverywhere that they appear.

The addresses of additional Websites required only for specificanalysis strategies are included where they’re referenced.

SEC Info (www.secinfo.com): All firms’ SEC reports are post-ed on the SEC’s own EDGAR database (www.sec.gov), but most re-ports are lengthy and it’s difficult to locate specific information. SECInfo and a number of other sites provide a table of contents for most re-ports so that you can locate and download specific sections such as themanagement’s discussion, the statement of cash flows, and so forth.Most of these sites require a subscription; however, SEC Info, as of July2005, was still free.

Hoover’s (www.hoovers.com): A good source for an easy-to-understand company description, and best of all, a usually accurate listof a firm’s top three competitors.

Morningstar (www.morningstar.com): Morningstar’s Finan-cials report saves you the trouble of computing trailing 12 months’ op-erating cash flow, a data item required in the Busted Cash Burneranalysis (Chapter 10). Morningstar’s Stock Valuation report listing his-torical price/earnings, price/sale, price/book and price/cash flow ratiosfor the trailing twelve months as well as each of the past 10 years isalso unique.

MSN Money (money.msn.com): One of only two sites I’vefound that provides detailed financial statement data in user friendlyformat. MSN Money’s 10-Year Financial Summary reports are themainstay of the target price strategy (Chapter 6). MSN Money is theonly site I’ve found that lists EBITDA, a data item required to assess fi-nancial strength (Chapter 10), on its income statements.

Reuters Investing (www.reuters.com/investing): In my view,the best source for viewing financial statements. Reuters statements areupdated faster, are more accurate, and provide more detail than any oth-er source I’ve found. Reuters powerful Ratio Comparison report enablesyou to compare a company’s valuation ratios, performance measures,and much more, to its market sector, industry, and to all the firmsmaking up the S&P 500 Index.