Chapter 6:Simple Defence--Know Yourself

8/14/2019 Chapter 6:Simple Defence--Know Yourself

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Peter Lynch, OShaughnessey, ValueLine, or even contrarian approaches while adding

your own criteria. For instance, if you are for the preservation of the environment, and

you are a value investor, then you should look into investing in environmentally friendly

company that is also classified as a value investment. Calvert Fund has such a fund just

for you.

If you want to combat breast cancer, you can get a degree in biology:

microbiology, bio-chemistry, pathology, or you can invest in companies that employ staff

with those degrees and strive to cure breast cancer. If you believe that the boom in the

housing market will result in increase furniture, fixtures, and appliances purchases then

you may want to invest in the home goods manufacturers. In this chapter, we will

present actual portfolios that are affinity ones. The first portfolio is based on our belief

about breast cancer treatments and working to a cure, and the second one is based on the

belief that the war in Iraq will make some companies very rich with high risk high

premium operational work in Iraq. In the first portfolio we are investing in what we

believe, while the second portfolio has to do of our perception that the chosen companies

will profit greatly from the Iraq war.

The idea of designing a breast cancer index came to us while analyzing socially

screened funds, and the non-profit breast cancer fundations: Susan Komen Breast

Cancer Fund, and Avon Fund. In 1998, we noted that the Socially Conscious Funds run

by Calvert were attracting money implying that people want a true value based investing.

In 1999, there were 168 socially screened funds, with assets of $154 billion, one of them

was, and still is, the Womens Equity Fundthat invest in public companies that

advance the social and economic status of women in the workplace.


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The investors to socially screened funds understand that good governance makes

profitable and sustainable companies, and they are willing to bet with their own money in

such companies. They understand that although lawsuits can destroy a company such

socially responsible companies are less likely to be sued due to sexual harassment or

environmental pollutant. What caused Anderson, one of the largest accounting firms to

go under, was not its lack of liquidity, but its loss of credibility among not only its

investors, but also the public at large by the perception that it covered the misdeed of

Enron. By seeking quick cash with total disregard to ethics or morals Anderson traded

long-term growth for sort-term profits to the level of self-destruction.

In early 1990s PG&E contaminated the drinking water with toxic chromium

which when consumed by humans causes birth defect, and cancersin the Southern

California town of Hinkley, and covered its misdeed by buying the contaminated land.

When the misdeed was discovered, the citizen of Hinkley mounted an action law suit and

in 1996 PG&E agreed to settle for $400 million i. PG&E, total disregard for human life,

lost a significant amount of money that it could have utilized to expand its business and

to make more money.

Good governance companies make good investment, and hence, companies that

work to diagnose, find a cure to a disease or help patients with a disease could be a viable

alternative to industry and market capitalization investing strategies. Mutual funds that

specialized in industries such as biotechnology companies and pharmaceutical companies

existed but they were based on industry not on affinities. While some were, and still are,

representing all the health care industry, such as S&P Health Care Index (HCX) and

Morgan-Stanley Health Care Payor Index, others restricted themselves to a sector in the


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industry such as pharmaceutical: Amex Pharmaceutical Index. We even found a Cancer

index that contained only biotech and pharmaceutical companies that manufactured

medication for all cancer types. Unfortunately, none of these funds contained what we

were seeking.

We also looked at foundations, such as the Susan Komen Breast Cancer, and the

Avon Foundations. These foundations rose, as we discovered in 1999, and still raise a lot

of money for the cause. In 2004, Komen foundation received over $151 million in

donation money, by 2005 it received $200 millionover 30% increase. In 2005, most of

Avon Foundation revenue came from breast cancer crusade, out of its $56 million, $35

million came from the breast cancer crusade62% of its revenue came from breast

cancer crusade.

One can only conclude from these figures the importance of such issue to the

public at large. Like, the mutual funds, index funds these foundation still did not

encompass our needs. They were very good at providing awareness about breast cancer,

and providing funds to some women to get breast exams or treatment, and providing seed

money to universities. Of course, awareness of such illness is vital, early screening

increase significantly the survival rate, but without new medications, and better

diagnostic approaches, awareness alone has limited success. Hence, we decided to create

a breast cancer index (BCNDX), which we followed from 2000 until 2003.

While designing our index, we looked for companies that have the following

criteria:

Provide care for breast cancer patients Are in the process of developing new drugs for breast cancer Have drugs for breast cancer Develop machineries to detect or remove breast cancer tumors


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Help patients deal with their illness Provide support to breast cancer patients Have or are in the process of developing product for breast cancer Involved in biotechnology, medical, diagnosis and biochemical research and

development in breast cancer

Involved in the ownership and/or operation of healthcare facilities that deal withbreast cancer

Are in insurance industry Design, manufacture, sell or supply medical, hardware or services that deals with

breast cancer

We started our search looking at the obvious industries: drug companies, and

biotech companies. We went to web-site looking for companies whose drugs are in

clinical trials, as well as, we searched for companies that already have products to fight

cancer (such as the National Cancer Institute, www.cancer.org). For instance, we chose

Neopharm Inc. (NEOL) because it concentrates solely in finding a cure to cancer.

Although the portfolio contained mostly pharmaceutical or biotech companies, we were

able to add two insurance companies such as Aetna (AET), and Oxford Health Plan OHP

{Merged with UnitedHealth Group on July 29, 2004,)), as well as imaging companies:

GE and Fisher Imaging (FIMG), and a wig maker company Regis (RGS), whose cater to

women with breast cancerwomen who lost their hair due to chemotherapy.

Companies tickers are in Table 1

Table 1.Ticker of companies in the Breast Cancer Index

Symbol Symbol Symbol Symbol Symbol

ABT AET AMGN AZN BIOM

BMY DNA ELN FIMG GEGNTA GSK IMMU IMPH ISIS

JNJ LLY NEOL OHP PFE

PHA RGIS SGP


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On January 2000, we started an index, which we called BCNDX, to follow the

performance of these companies. We used an arithmetic stock price weighted index. We

created an index so to be comparable to other indices (S&P500, QQQ, or Dow Jones).

The design of an index has two steps: index creation, and index update. First, to create

the index: each stock is giving a weight that is derived from taking the ratio between its

price and the total value of the portfolio, than their weights are added and multiplied by a

starting valuewhich by convention is assumed to be equal to 100. Second, we setup a

system so the index is updated daily (during a business week): every day, the percentage

change of each stock in the index is multiplied to its weight and added up. This sum is

added to 1 and multiplied to the previous index value. To calculate the new index, you

need only the last value of the index, last stocks prices and their weights. The calculation

of index is simple enough that we have decided to present it now.

As an example of index development, we decided to choose the following

companies: General Electric GE, Eli Lilly and Co. LLY, Elan Corp. (ELN), Amgen Inc.

(AMGN), and Schering-Plough Corp. (SGP). We recorded their prices as of 2/1/06,

which we assumed the inception date, and we decided to check the performance of the

index on 3/1/06 for this example. Notes, we chose the dates randomly.

Table 2. Index Setup

Initial Price2/1/06

InitialWeight

TodayPrice

3/1/06

%PriceChange

%PriceChangeWeighted

GE $33.14 0.16 $32.76 -1.15% -0.002

LLY $56.89 0.28 $55.89 -1.76% -0.005

ELN $15.90 0.08 $12.99 -18.30% -0.014

AMGN $76.19 0.38 $76.05 -0.18% -0.001

SGP $19.15 0.10 $18.36 -4.13% -0.004

Total $201.27 1.00 0.974


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Table 3. Index Value

Initial Cost of the index $201.27

Initial Index Value 100

Index Change 3/1/06 0.974

Index Value as of 3/1/06 97.41

Set up the index

Step1. Add up the stocks prices (Column Initial Price). In this example you will

need to add the stock price as of 2/1/06 of GE, LLY, ELN, AMGN, and SGP.

This sum is equal to $201.27.

Step 2. To get the weight of these stocks in the index, divide each stock price by

$201.27. So divide GE, $33.14 by 201.27, LLY, $56.89, by $201.27, etc. Their

sum will be equal to 1, which is the starting value of the index, and we multiply it

by 100, the breast cancer inception value.

Keep track of Index Change

Step 1. Calculate percentage change between final price of a stock and its

previous price. For instance, the percentage change of ELN stock price from

2/1/06, and 3/1/06 is -18.30%.

Step 2. Multiply each stock percentage stock price change (%Price Change) by

its weight to get the percentage price change weighted. For instance, ELN

%Price Change Weighted is equal to -0.014.

Step 3. Add 1 to the sum of all these %Price Change Weighted.

Step 4. Multiply the total from step 3 by the Index value. Et Voila, you have the

new value for the index.

Note: If you have to calculate the index for multiple days, you just need to repeat

Keep Track of Index Change procedure, making sure to keep the latest calculated


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index value, the weights, and the last stock prices for which the index was calculated

for. In case of a split, you just need to multiply the split number by the company weight.

Now, lets get back to our Breast Cancer Index (BCNDX). Initially the index

contained 30 companies, but with merger, acquisition, and de-listing the number of

companies dropped to 23. We followed the index until 2003, and compared its

performance to Nasdaq (QQQ), Dow Jones (DIA), and S&P500. From the graph, you

can see that, in most cases, the index performed better than other major indices,

especially true in 2001 when investors flocked to biotech companies. When investors

moved to other sectors in end of 2002, the index barely kept pace.

From this simple exercise we learn a lot from the market. Flavor of the day can

influence the performance of your index. Our index was heavily weighted on

pharmaceutical and biotechnology companies. When investors flocked out of these


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industries the index get hit, but not as badly as the broad markets (S&P 500, or Nasdaq

100 (QQQ). By 2003, the index was close to its inception value of 100.

Indices are cheaper to manage than mutual funds. Unlike mutual funds, most of

the costs in managing and running indices are related to setting them up; indices require

little management, and they have low companies turnover. While a mutual fund

manager can add and drop a company from its portfolio anytime, an index manager has

more rigid criteria. The reason is that an index is supposed to follow an industry, a

sector, or the market, and not to influence the market. Hence, an index manager cannot

drop or add a company just because of its performance only. She can drop the company

from the index if the company has been bought, or gone bankrupt.

We set the index to 100 so we can easily follow the performance of the index. If

the index is at 120 we know that the index gained 20%; on the other hand, if the index

goes to 80, we can conclude that it lost 20%.

This was not our only index we also created a Sinvestor index, which we tracked

for only few months. Some of us will want to invest in what we understand about human

nature, or our environment. We believe that there will always be addicted to alcohol,

tobaccos, and gambling, so such industries are never going to disappear. If we cannot

eradicate addiction we can at least profit from it. We followed such index for few

months, the problem with such index at that time is that those industries were in a big

shake up. Large amount of acquisition, and bankruptcy occurred, which resulted in an

index that is too active, not what an index is supposed to be. One may assume that we

could have solved this problem by concentrated on the largest companies only, but then it

will not a true sinvestor Index.


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What we have presented are only few of possible approaches to design a

portfolio. The possibilities are infinite, and you as an investor do not have to follow only

a narrow path to investing. You do not have to stick only with traditional investing style

(growth, value, large, medium, or small companies). Investment world is larger than our

immediate environment.

You have to come to the realization that we are part of a global village so what

happen around the world will and can have an effect on our life. We are paying more for

gas price not only because of our large trust for oilwe represent less than 5% of the

world population and we consume around 22% of the worlds annual energy

productionand the increase in the demand from China and India. When China decided

to become a market economy, it not only became the manufacturer of the world, but also

it increased the demand for cars and, of course, of fuel. Fortunately, China consumption

of fuel is still not at our level yet. We cannot explain the increase of gas price by the

prosperity of China and India alone, but they are a major influence to the increase. The

war in Iraq, the diplomatic conflict with Iran, and the new stand of Venezuela and

Bolivia toward their natural resources are also the reason of the oil price hike.

All these events may appear insignificant to our daily life, but in reality we

cannot just ignore them and put our head in the sand. They happened thousand miles

from here, but they have a direct influence on our financial health. If gas price has a

negative influence on our financial health it has a very good affect in some companies:

Oil companies, and oil exporting countries are the ones to be enriched by the demand.

From the basic economic stand point as the demand of a product increase while its

supply decrease so its price will increase. Whoever, noticed the change of Chinese and


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Indian economy and noticed an increase of production of World goods from such

countries and an increase demand for cars will have come to the conclusion that the

demand of oil can go only up; The instability of oil producing countries is another sign

that the only way the oil price can go is up.

You can see the signs that we are part of the global village by observing the

increase of education level in India. The increase of the education level in India created a

highly skilled and cheap labor which through sophisticated telecommunication means

enabled the US to tap on it. Your child tutor may be in India, your insurance claims may

be send to India to be processed, or the customer service representative of the company

you are calling to may be located somewhere in India.

We have companies, located in India, whose sole job is to provide skill labors to

the US companies. Some of these companies have been lucrative enough to become

public companies and to attract American investors. One of such company is Infosys Co

(INFY), provider of off-shore IT labor. In the past five years this company has seen a

tenfold stock price hike and a triple earning ($0.31 in 2002, to $1.00 in 2006) Figure 1.


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QuickTime and aTIFF (Uncompressed) decompressor

are needed to see this picture.

Figure 1. Infosys Technologies Ltd. Five Year Price Chart

If you are still skeptical about the relationship between events and public

companies performance, you just need to look at who profited from the war in Iraq. War

brings misery to the majority and prosperity for the few; and it is expensive: in money

and lives.

When Bush decided to go to war we asked ourselves: Who will profit the most

from such war? Our answer was anyone and anybody that provide services or goods to

the army. To go to war an army needs arms, clothes, blended cars, safety jackets,

aircrafts, peripheral technologies required for fighting, or amassing intelligence, etc.

From this small exercise, on February 27th, 2003, we decided to create a small portfolio

with companies 3 companies that serve the pentagon. The companies that we chose are:

Hughes Supply (HUG), Haliburton Co.(HAL), and Fluor Corp. (FLR). On April 15,

2003 we added Computer Sciences Co. because we read that it may win a contract with


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the government for IT consulting. We decided to check its performance after 3 years.

We made sure to include the transaction cost for each sell and buy while calculating the

performance of the stocks prices.

From the Table 4 you can see that these companies stock price increased a lot. In

fact, FLR, and HAL stock price more than doubled, while HUG stock price doubled. If

you look at these three companies charts you will notice that before the war in Iraq these

stocks were performing poorly, it is the war that propelled them to their rich valuation.

Table 4. Performance of the Iraq War Portfolio

Tickers Position Buy Price Sell Price %Change

CSC 2500 31.41 54.7 74.15%

FLR 2000 $28.01 $88.08 214.46%

HAL 4000 $19.97 $69.00 245.52%

HUG 2500 $22.89 $46.22 101.92%

Total $271,590.00 $704,460.00 159.36%




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We tried to show you that you can expand your investment strategy and can still

come out a winner. Understanding events and their repercussion on some companies or

economy can help you create a winning investment strategy. Soros, Buffet, and Peter

Lynch became great investors because they understood the relation between the

companies they invested in and the economy (local or global) and events, and they know

how to act on them. Our point is that you do not need to restrict yourself to one point of

view, or one philosophy. You can search for the next big company, using the traditional

investment screening tools, or you can analyze events and extract the companies that will

benefit the most.

Of course, in many steps that encompass an investing strategy, we presented you

only one; we have not discussed timing, exit, risk and benchmarkwhich are important

element when designing any investment, or trading strategies.


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Benchmark

Benchmark, as defined in a dictionary, is a standard against which something

can be measured or assessed. In the stock market, the most likely benchmark is an

index, such as, S&P 500, NASDAQ 100, Dow Jones, Russell 2000, and Wilshire 5000,

to name a few. S&P 500 contains the 500 economy representative companies.

Comparing the performance of your portfolio to S&P 500 is equivalent to comparing the

performance of your portfolio to the market. Professional investors, especially in Mutual

Fund industry, prefer this index as their benchmarkit follows the economy at large.

Sometimes, using other indices as benchmark can increase your insight in your

own portfolio than sticking only to S&P 500. If most of your companies are non-

financial ones and they are mostly in NASDAQ, you may prefer to compare your

portfolio to Nasdaq 100Nasdaq 100 index contains 100 largest market capitalization

non-financial companies in NASDAQ; if you have mostly small to mid-cap companies,

you compare your portfolio to Russell 2000.

You can also use multiple benchmarks. If your portfolio contains mainly

companies from one sector or industry, then, in addition to the S&P 500, you may prefer

to use that sector or industry indexsuch as Dow Jones Wilshire US Retail if your

portfolio contains retail companies. In this case, you may want to know how well your

sector portfolio performed compared to the average performance of all the companies in

its sector, and how well it has performed compared to the market.

In the case you want to compare the performance of your portfolio to all public

companies, then you will use as your benchmark Wilshire 5000originally called Total

Market Index. Contrary to its name, Wilshire 5000 index contains 6000 stocks, and


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follows the performance of all public companies in the US, but it is heavily weighted on

the 500 largest stocks: 70% of its weight is on the 500 largest stocks.

Professional investors use a benchmark as comparator to convince investors to

invest with them, to learn more about their portfolio and to improve the performance of

their portfolio. From a simple chart comparison between their portfolio and the

benchmark, professional investors can infer: if their performance is at par with the

benchmark, if their portfolio is more volatile than the benchmark, if relevant news, such

as interest rate change by the Fed, are influencing similarly the performance of both the

benchmark and the portfolio.

The simplest approach to comparing the performance of ones portfolio to the

benchmark is to super-impose the daily performance of ones portfolio and the

benchmarks (Figure ). For instance, from superimposing BCNDX with S&P500 (SPY),

Nasdaq 100 (QQQ), and Dow Jones indices one can infer that: During most of the three

years, BCNDX performed better than all these indices, but its best performance was in

2000 where it appreciated by more than 60%, while all the other indices performances

were flat or falling. Unfortunately, by mid-2001 BCNDX lost all its gains, and dropped

as fast as QQQ. From mid-2001 to mid-2002, although it performed better than all the

indices, its performance appeared to follow the trend of DIA and SPY. After a deeper

analysis, we concluded that From the early great performance of BCNDX was do to

sector rotation strategy that investors at that time opted for when the technology sector

collapsed.


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Professional investor may calculate the correlation coefficient to confirm the

trend similarity between a portfolio and indices, as well as, they may calculate and

compare the return from holding their portfolio, and the return from holding the indices.

Correlation measures the degree of mutual variation between two random

variables. In this case the random variables are the benchmark and either a stock, an

index, or a portfolio. The range of the Correlation coefficient is between -1 and 1. 1

means total correlation, -1 total negative correlation, and 0 means no correlation.

If the correlation between the two is zero, one can assume that they do not

correlate, and one can conclude that each perform at a different drum beator different

trend pattern. If the correlation coefficient between a portfolio and the S&P 500 is zero

than one can assume that given the events investors react differently toward the S&P500

and the portfolio. Good news may result the S&P500 to trend up but the stocks within

the portfolio to lose, and visa versa.

A positive correlation coefficient indicates that to that certain degree both the

benchmark and your portfolio are in trending in the same direction. A correlation

coefficient equals to 1 indicates that your portfolio and the benchmark synchronize: if the

S&P 500 goes up, the portfolio goes up, on the other hand, if the S&P500 goes down the

portfolio goes down. The implication of such behavior is that what ever has an affect on

the portfolio has also an affect on the market at large. From the BCNDX graph you can

see that the Dow Jones Index, and the S&P trends were in sync most of the time.

A negative correlation coefficient indicates that to a certain degree both the

benchmark and the portfolio are drifting in opposite direction. For instance, the portfolio

is going up, while the S&P 500 is going down. Just looking at the BCNDX graph, one


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notices that during the second half of 2000, BCNDX all three indices were moving in the

opposite direction.

PUT CORRELATION TABLE HERE

Another important comparison, is the comparison between the average PE in your

portfolio to the average PE in a benchmark. For instance, if the companies in the SP500

have an average PE of 20, but the companies in a portfolio have an average PE of 50,

seasoned investors will want to understand this discrepancy. If seasoned investors

cannot rationalize such high multiples, they may decide to sell their holdings.

A known motto among investors is a stock is worth as much as investors are

willing to pay for it. During the late 1990s some technology companies with no

products and little earning had their PE equal to 100, while the SP500 companies PE was

in the 30s. Now, why these companies were worth buying and holding? The burst of

the bubble in 2001 answered this question. At one point, companies can become so

expensive that no rational investors will want to buy or hold them. The effect of

investors selling or not buying a stock on the stock price is its fall. A stock price needs

buyers to sustain it or boost it and only its weight to fall. ii


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Know What You Are Investing In

Great investors are great at investing because they know the value of the

company they are investing in. They know its fair value. They understand that just like

a real estate investor or a businessman the secret to successes in commerce is knowing

the value of what one is buying. From this simple truth, great investors will not chase the

last one bases point for the extra profit, and will buy a company stock if its price is below

its fair value.

From such insight which they acquire from in-depth study of the companies they

invest in, they buy these companies stocks when these stocks are below the company

worth, and they sell when these stocks are over the company worth. Furthermore, they

understand the crowd mentality that plague the stock market and that causes a stock price

to rise or fall rapidly for no apparent reason, and they use such knowledge to decide

when to buy or sell. All of us, who are not yet Warren Buffet, or Peter Lynch we should

follow these mantra to become better investors. Ultimately the purpose of any investor is

to make more money than losing it.

We cannot guaranty that if you follow our methodology you will have always

profitable investment. Investment is not an exact science, what is hot investment today,

may become a bad investment tomorrow. Sudden news can cripple at any time so what

ever assumption you have made about the company future can become absolute in a

flash. A manufacturer for you company can not deliver a part, your company recalls its

product, a drug is not approved by the FDA, and a law suit is set against your company,


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to name a few, can all result in the stock price falling down. Some of these falls are so

hard that you, as individual investor holding this company stock, surely will lose a lot of

money.

A company coming short in its earning announcement, and future growth can

cause its stock price to plunge. In 2004, Ebay announced that its earning for its 4th

quarter was 30 cents compare to 21 announced at the same period a year earlier.

Therefore, EBay, in 2004, had its earning equal to $1.14 compare to $0.67 with a growth

rate lower than analysts estimated growth rates between 57.3% and 66.7%. With such

impressive numbers of yearly and quarterly earning increasing by 70% and 43%,

respectively, one may have assumed that Ebay stock price will stay flat or move up, but

the stock price did not stay flat or move up, it tumbled (FIGURE); Ebay missed analysts

earning estimates: 1 penny for the quarterly, and 2 pennies for the yearly, most

importantly, Ebay announced lower future earning growth. Investors discovered that

their earlier estimation of the company growth, which dictates the fair price of a

company stock, was too optimistic; and the company stock was overvalued. They sold

their holdings in drive, and in the process, depressed to stock price.

From Ebay chart you can see that a price gap was formed where the price went

from $103.05 on January 19th, 2005 to $84.68 on January 20th, 2005almost 20% loss in

valuewith no values in between; in one day, Ebay lost around 10 billion of its worth.

Only investors who bought the stock before September 2004 were able to save their

principle, all others found themselves with a loss.

A gap forms in a chart when the there exist an interruption in the price

range in a graph; yesterday price ranges do not overlap with today price ranges. Gap


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forms when a stock is permitted to be trader after the market closes (4:30 to 6:00pm), or

before the market opens (8:00 to 9:30am). Institutions, as well as some individuals have

access to after hour trading, and use it to protect their investment. In this case, if you do

not have access to pre or post market trading you cannot stop your losses. Some

investors will tell you that eventually all gaps closes. The reality gap closing depends

mainly on the company and the news that caused the gap in the first place. This bring us

to the subject of how should one choose companies, and how should one buy or sale the

company stock.

Before you embark into buying a company stock you need to make sure the

company is sound financially, and that you are paying at below the fair price for the


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privilege of holding it. Holding stocks is equivalent to investing in a venture where you

hope that your initial capital will grow; hence, the importance of analyzing the company

to find the fair price value. You may wonder what is the fair price? Is it not the fair

price is the price others are willing to pay for? Before, we start answering these

questions we have to find out if the company we are willing to put our money in is not in

big trouble that buying it or not selling it will be equivalent to burning money. We need

to present the red flags that every investor should be aware of. Then we will show how

a fair value for a stock is calculated, and finally, how to set up sell points.

Looking for Red Flags

In the previous chapters we presented relevant examples and reasons for the individual invest

to be vigilant with their investment, and to not wait for regulators to regulate the stock market, the

auditors to audit, the board member to look after the investors interests, and executives to assure the

accuracy of their company financial health. In the age of 401(k), and IRAs, the investors are presse

educate ones selves on the art and science of not only investing but also on the art of detecting obviou

distressed companies. Signs of a distressed companies show sometimes years before the companies

decide to file for chapter 11, but when the signs are unraveled to the public it is always too late for th

individual investors to salvage their money.

Enron, and WorldCom financial troubles were apparent years before they declared bankruptc

Investors just have to look at few publicly published numbers to know that these companies were not

sound investment. Instead, a lot of investors and analysts decided to ignore the signs, and when thes

companies announced they were filing for bankruptcy, it was too late for them to salvage their


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investment. In most cases, investors did not need to be forensic accountants, or even be accountants,

they just needed to observe the clues that were in these companies financial reports, and in these

companies press releases.

No doubt, sometimes the signs of distressed companies are hard to detect. In early 1998,

Sunbeam Inc., maker of small appliances, troubles were not apparent, not even to the best analysts N

Heymann who worked at Prudential Securities detected the company troubles. The company was ab

to give the appearance that it was doing well by sending too much goods to stores and booking them

sale and profit, and failing to record returned goods. Its trouble unraveled when its CEO, Al Dunlap,

was fired by its board.

This example should not stop you from doing due diligence. If you, as individual investors,

want to preserve your wealth you need to separate junk companies from solid ones. You need to look

a company as a whole, and not concentrate only on one of its aspects. You cannot expect to make an

informed judgment while looking one aspect of a company. Some investors will concentrate on

analyzing the financial numbers disregarding pertinent companys press releases that can influence th

numbers, or statements that are in the financial reports. They assume, wrongly, that accounting is an

exact science like Math or Physics, while in reality accounting is more an art, where subjective

judgments play a role on how the numbers are calculated or presented. In fact, accounting practices,

law suit, the number of clients is some of factors that can have a considerable influence on the compa

bottom line, but one cannot find these by looking at the financial numbers.

So an investor must analyze the quantitative and the qualitative aspects of a company.

Quantitative aspects encompass the financial numbersfinancial statements, and financial ratiosan

the qualitative aspects encompass the press releases and the statements in the financial reports.


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Even within each aspect one cannot rely on one fact. For instance, while analyzing the

quantitative aspect of the company one cannot concentrate on the income statement and ignore balan

sheet and cash flow. Unfortunately, a lot of investors during the 90s bubble relied on only that to m

an investment decision. They ignored cash flow, and balance sheet to their detriment, hence enabling

AOL, WorldCom, and Enron to hide their losses in the cash flow.

So, what we as individual investors have to do? We need to be more financial fluent and lear

detect problem companies before we decide to invest. We need to create line of defenses that consis

looking for red flags in the press releases, the business model, the financial numbers, and statements

the financial reports.

When Not To Buy

Qualitative (Smoke)

Press releases can have red flags that you should take seriously: Company releases its

earnings but does not release its balance sheet or its cash flow statements, or the companys CEO lea

it suddenly after a short stay. Without Cash Flow Statement and Balance sheet investors and analyst

cannot make an informed investment decision. In 2001, what triggered Wall Street Journal journalis

Rebecca Smith and John R. Emshwille authors of 24 Days: How two Wall Street Journal Reporters

Uncovered the Lies that Destroyed Faith in Corporate America to check Enron was not the opaque

financial reports, but that its CEO Jeffrey Skilling, then only 46 years old, retired suddenly from his

position after just 6 months on the jobiii. On April 3 1998, Andrew Shore, analyst at PaineWebber,

downgraded Sunbeam, maker of small appliances, stock when in April 2 Dunlap fired Donald R. Uzz

Sunbeams well-regarded executive vice-president for world wide consumer products, and investor

relations chief Richard Goudis quittediv. Chanos, a prominent short-seller, confirmed that profession


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investors do see that a sudden leave of a CEO as a reason to check if the company is in trouble. He

stated: We look for any abrupt senior management changes or resignationsThat is usually a big re

flag for us that something is a miss, particularly when it is abrupt and hasnt been telegraphed for

quarters or months end.v CEO, just dont leave million dollar jobs for no good reason except when t

are fired or they are aware of some shenanigans.

If a company released its earnings without balance sheet, or cash flow statement you should n

be quick to make an investment decision. What triggered Chanos to analyze Enron was Enron releasi

its earnings without a balance sheet, or cash flow.

Credit rating downgrade is a big red flag. The main credit rating companies are Moodys and

Standard & Poor. They provide a reasonably independent objective assessment of the credit worthin

of companies and countries which issue debt. Investors and banks look at the rating as one input in

deciding to invest, or provide credit. A company, whose rating is downgraded, is riskier, can see

investors bailing out from it, and banks charging it higher loan rates. A company whose credit rating

downgraded cannot get loans at a preferred rate that it was accustomed to, and can be forced to repay

debts when it does not have enough cash to repay.

For a company that is strapped for cash that is a death sentence; it can find itself enable to

support its business and pay it debt obligations. Enron executives understood this, and manipulated

third-quarter 2001 to ensure that the reported charges would not trigger credit rating agencies to

downgrade it.

The following table shows the possible rating from Moodys and Standard & Poor. A rating

is below Baa, or BBB implies that the companies are speculative investment or junk. They are high

and are in financial trouble. C, or D implies that the companies are in default--they cannot honor thei

financial obligations.


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Moody Standard & Poor Investment Implicatio Investment Risk

Aaa AAA Investment Lowest Risk

Aa AA Investment Low Risk

A A Investment Low Risk

Baa BBB Investment Medium Risk

Ba,B BB,B Junk High Risk

Caa,Ca,C CCC,CC,or C Junk Highest Risk

C D Junk Default

We can tell you to be suspicious of CEOs who are in binge buying or selling, but in most cas

unless one has full knowledge of the company or the industry one cannot assess if the binge has a me

or not. A company will buy its competitors if it translates into higher slice of the market, or fire wor

if the economy is slowing down or the goods are selling poorly. In early 1990s Morgan Stanley, an

investment bank, diversified into pig farming investing in a venture located in Missouri and contain

2 million hogs. Morgan Stanley and its management had no previous experience with pig farms, and

showed. Just after it invested millions, and floated junk bonds to raise even more money, the feed pr

rose and a swine virus reduced substantially the number of pigs to the point that Morgan Stanley lost

only $190 million on the venture but could not repay $412 million in junk bonds that it floatedvi

. Pet

Lynch calls it deworsification. Some companies buy other companies to create market events,

appearing to do something even if the thing is detrimental to its financial health.

Before the 2002 Sarbanes Oxley Act, investors had to be wary of CEOs who went on buying

sprees. They bought companies that added little to the company business for the only purpose to

increase their companys worth, and of course, earning. They bought companies using no cash and o


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shares, in the process, they increased their company net worth and the shareholder valuationthey

entered the value of the new acquisition as goodwill and they did not record the expense in the earnin

In short, the companies increased their assets, and their earnings were not affected.

On the other hand you have CEOs that love to restructure. Restructure for some CEOs mea

indiscriminately firing employees, selling parts of a company, as well as, reducing maintenance,

marketing, and research expenses. For instance, Al Dunlap, also called Chainsaw and CEO of Sunbe

from July 1996 to late 1998, was known for firing people and cutting costs. The Street might have

perceived his actions as an added value to the company, while he was sending Sunbeam Corp.

bankruptcy protection in 2001. Dunlap fired some 18,000 employees, stopped his employees from

attending road shows, stopped the tradition of once a year inviting the suppliers to a gathering, and

reduced Sunbeam suppliers from 20,000 to 2,000. He reduced the HR office from 80 to less than 17

employees and shutdown or sold two-thirds of Sunbeams 18 plants. He cut through not only the fat

to the bones and reduced to company to a corpse. In the mean time he made more than $100 million

When he was finished and Sunbeam board fired him, the management team was left with a mammoth

job, and only one exit strategy where its lenders and shareholders paid dearly: chapter 11 in 2001.

Some other events may appear insignificant. A company may decide to release a bad news o

the eve of a holiday or during the holiday hoping that the investors will not have enough time or will

too busy to react to it. For instance, to cover its bad news, Computer Associate (CA) decided to post

warning about lower-than-expected profit a day before July 4th, 2000 at midnight. CA hoped that

investors would be too busy celebrating or vacationing to notice such news. Unfortunately, when the

market opened on July 5th

, investors sold their shares and CA stock price plunged 42%vii

.

A company may decide to postpone releasing its financial results to delay possible fall of its

stock value, or report its earning as pro forma, operating, as reported, normalized, or core


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instead of net earning. In both these cases one can come up with one possible conclusion: the comp

is either in financial trouble or is hiding something. Professional investors translate pro forma,

operating, as reported, normalized, or core as garbage in garbage outMeaningless labels th

add little knowledge to the investors.

A prominent short-seller is looking at the company you are looking at, and short positions on

company have increased are other events that are not so apparent but may be important in during

investment decisions. You can find short interest in Wall Street Journal, www.wsj.com, under

Company Research.

All these possible signs that a company is in trouble require the investors to become inquisitiv

and a skeptic. While news can trigger you to suspect a company from cooking the books, one can

confirm ones suspicion only through reading the company financial reports. SEC requires that all pu

companies to publish financial reports: annual and quarterly reports called 10K and 10Q, respectively

turn SEC provides the reports for download from its website www.sec.gov.

Financial Reports

You do not have to calculate ratios or go to the annual reports to get a summary of the financi

number. In fact, you can find financial numbers of a company in www.NASDAQ.com, www.msn.co

www.morningstar.com and even in www.nytimes.com. Unfortunately, some entries are subject not o

to the industry the company is in, but some are too obscure to decipher their meaning. For instance,

entry extraordinary items, in the income statement is vague. What does this entry relate to? You h

no alternative but to read the reports to figure out what it stands for. Reports go beyond explaining t

financial numbers; they are rich of additional information, such as: competition, lawsuits, risks,


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accounting practices, business model, and clients. You will find the answer to the following question

Is the CEO truthful? Did the Auditors found anything that should make me suspicious of the compan

numbers? If a company decided suddenly to change its accounting practices, why did the company

change its accounting practices?

Annual report is what the company sends to its investors, and 10K is a detailed representation

the company annual financial standing without graphs, fluff, or president statement. Annual report w

contain president statement, and graphs to clarify issues or financial numbers. Some companies in

trouble will go to great length to present a beautiful annual report with a lot of graphs and a very upb

CEO letter to investors. The purpose of the graphs and the wording of the CEO letter are to give the

impression that the company is doing better than the reality. Although the president introductory

statement cannot be a strong reason to shun from a company, some professional investors read it

thoroughly looking for smoke. For instance, Professor Martin Kellman found that the word

challenging when it is uttered more than three times in the front page of the annual report it means

your company has lost money, is losing money, and will continue to lose money.viii Another hint if

president statements contradict the numbers in the financial statement than one should pass the

company.

After the President statement, investors should read the auditors comments. Auditors are

required by law, even if they failed us during the 90s, to report any inaccuracy of the company

accounting practice. As the auditors finding are only in the 10K, annual report, under the title Repo

of Independent Registered Public Accounting Firm, it is vital that investors read it before even

contemplating investing in the company. A company is in trouble if its auditors do not include a

statement about the accuracy of the accounting practices. We have included the example of auditors


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opinion produced by KPMG about Adobe Systems, producer of Photoshop and Acrobat softwares,

financial reporting.

In our opinion, management's assessment that Adobe Systems Incorporated maintained effective internal contro

over financial reporting as of December 2, 2005, is fairly stated, in all material respects, based on criteria established in

Internal ControlIntegrated Frameworkissued by COSO. Also, in our opinion, Adobe Systems Incorporated maintaine

all material respects, effective internal control over financial reporting as of December 2, 2005, based on the criteria

established inInternal ControlIntegrated Frameworkissued by COSO.

In contrast, auditors of CardioDynamics International Corporation, developer of non-invasive

technology to monitor the heart ability to deliver blood to the body, 2004 annual report Report of

Independent Registered Public Accounting Firm found and published their concern about this comp

financial.

Our report dated March 28, 2005, on managements assessment of the

effectiveness of internal control over financial reporting and the effectiveness of internal

control over financial reporting as of November 30, 2004, expresses our opinion that

CardioDynamics International Corporation did not maintain effective internal

control over financial reporting as of November 30, 2004 because of the effect of

material weaknesses on the achievement of the objectives of the control criteria and

contains an explanatory paragraph that states that management identified a

material weakness in internal control over financial reporting related to the

Companys accounting for income taxes and a material weakness related to the

calculation of the Companys allowance for doubtful accounts.

The most important part of this section is the last paragraph where the auditors, KPMG LLP,

express concern about the company inability to CardioDynamics International Corporation did not maint

effective internal control over financial reporting as of November 30, 2004. From this paragraph you can

deduct that the company has taken non-conforming approach to asses its income taxes and its allowa


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for doubtful accountsestimated money that the company is owed and doesnt expect to be paid bac

What the auditor is stating here is that the company has under estimated its income taxes, and its

allowance for doubtful accounts.

In addition to the auditors opinion, companies also provide their accounting policies, and

footnotes, which are sometimes under the heading Notes to Consolidated Financial Statement, to

explain entries in the financial statement. Professional investors know that companies hide all their

shenanigans in the financial reports. Companies know that few investors bother reading reports, and

they know that by SEC requirement they have to reveal any problems in the financial reports under a

called footnotes. Hence, they will hide their problems deep into footnotes and use elaborated

unintelligible statements that are incoherent to even professional investors. Footnote is where

companies hide the bad stuff they didnt want to disclose but had to they bury the bodies where the

fewest folks find themin the fine print.

You can look at the footnotes to have a better understanding of the financial numbers. Beside

explanation of financial numbers, footnotes can have information about a companys subsidiaries,

executives compensation, the company credit rating, or possible law-suits. What is the company

accounting policy? What are the risks that are lurking in the company shores? Who are its clients? H

much are its executives compensated? How does it expect to grow? Who are its partners? What is its

credit rating? They are all important questions whose answers are hidden in the financial reports.

Of course, you cannot tell how a company will get out after a law suits, or if the government h

found anything bad, but still you need to read and analyze the information before you make an

investment decision. Merck, the giant pharmaceutical company, is being sued for not disclosing Vio

side-effects to its patients. To reduce the effect on its bottom line Merck has put aside over $300

million; its action of putting aside money for future law suit does instill trust among its investors that


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company is a good investment, but its does not prevent that the amount may be insufficient to cover a

the law suits. In this instance, no right answer exists. You can decide to invest or not invest dependi

on your perception of how these suits will affect Merck bottom line.

You should be worried if the company has only one client. If the client goes bankrupt so wil

your company. You should be worried if the company is following non standard accounting principl

If the company decide to recognize revenue when the goods are shipped, not when they are accepted

you should be worried. In the 1990s many companies were caught enhancing their income statemen

by shipping more goods than clients ordered and entering the shipment as revenue. Cisco is one

example to come to mind. Others will lengthen the depreciation horizon so enhance the earning. Fo

instance, a company will increase the depreciation of its computers from 3 years, which is the averag

age of computers, to 10 years. By doing so, it boosts the value of if income statement, and by the sam

token it gives the investors a shifted idea of the company performance. For instance, Union Carbide,

company that existed in the 1970s and early 80s, reported an earning increase by $217 million. On

way it accomplished this increase was by changing from conservative depreciation to more liberal

policies, and hence, reducing the annual depreciation expenses that it reported in its income statemen

Another thing to look at is any entry called extraordinary entry also called non-recurring an

located in the income statement. Some companies try to cover what is a usual business expense as a

time expense, also called one-time charge, and hence enhancing their revenue. Revlon, in the ninetie

was known for abusing such entry. Some companies go to a length to make us believe that this

extraordinary item has no consequence on the company bottom lineprofit. For instance, Tyco bou

a financial group called CIT for almost $10Billion and few months later, sold it through an IPO for

$4.6Billion. The one time $10Billion expense became the permanent $5Billion loss. This $5 billion

real money not monopoly money, it could have been used to expend other department within the


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company, to acquire new markets, or just to keep it in the reserve for future loss. To provide yoursel

true picture of the company earning you should remove any extraordinary entries from earning.

So far we have discussed qualitative red flags that can help you avoid shaky companies. You

still need to look at quantitative red flags. While qualitative red flags are the clue, quantitative red fl

are the evidence, such as DNA and finger prints, to a detective. Qualitative red flags are the smoke,

while quantitative red flags are the fire.

Quantitative

We all know that we should not invest in company that is unprofitable, but few of us know th

we should not invest in companies that lose money year in year out. We all get delighted when our

company beat the analysts estimate, but we all fall short to look in depth about the peripheral

information. Earning does not always give a full picture of a company financial health, nor do balan

sheet and cash flow. In most cases you have to look at all of them as an integrated group instead of

disconnected parts. Sometimes each can reveal major problems in a company, and in this instance, u

the individual investor, can detect the problems with ease.

For a company not to fold, it needs to make moneypreferably cash. A company can make

sustain profit but still be strapped for cash. In accounting 101 you learn that a company that has larg

assets but little or no cash is designed as a bankrupt one. Just like individuals, it can spend more than

can bring to the point that it cannot even pay for its basic necessities, such as leases or short-term deb

For a company to grow it need to have its profit and cash grow. The only way to assess if the compa

is not in trouble is to look at balance sheet, income statement, and cash flow jointly and to compare

different periods from them. The company can have growing earning and be strapped for cash becau


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its revenue is growing slower than either inventory or receivable. The company can be profitable and

still not have working capital to cover its short-term debt, or it can have good financial leverage and

be a bad investment.

The media and popular publications have condition us to concentrate on companies earnings.

a company announces earnings that are better than expected some of us will interpret it as a sign that

is a viable investment, even after extensive research has disproved the existence of such relation

between earnings announcement and stock price. Unfortunately, while we are marveling at such

numbers we are ignoring signs of troubles that should have pushed us to sell or run away. We are no

talking about subtle signs such as the company restructuring, but of signs concrete signs of trouble.

You have to look at the earning in accordance with free cash flow and debt ratios, and income

statement in accordance with cash flow and balance sheet to ensure that the company is as profitable

it appears to be. Sometimes, looking at the cash flow alone will give you a clue that the company is

trouble; Etoy Inc., WorldCom, AOL, and Enron are such examples of companies.

Free Cash Flow (FCF), the amount a company has left after it pays for its expenses and

expansions within a business period (quarterly, or annually), helps you see if the company is increasi

or burning its cash reserve. Unlike earning, which you can read from the income statement of a

company, you have to either look up FCF from financial web-sites such as www.morningstar.com or

compute it yourself. Of courser, the more cash a company is able to save during each period, the bet

it is able to withstand economic downturn. You can think of FCF as the monthly money you put in y

savings; Individuals who save monthly a percent of their income are better of at withstanding loss of

than individuals that live from paycheck to paycheck.

Two possible approaches exist to calculating FCF. The first approach takes the difference

between the Cash Flow from Operation (CFO) and the capital expenditure (CE). The second approa


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takes the difference between CFO and the Cash Flow from Investment (CFI)to distinguish between

these two approaches, we will call the latter FCF2, and the former FCF1. The choice between these

formulas depends on your assumptions: If you assume that management may misplace certain type of

operations and that all investments are for expansions than you compute FCF2, else you compute FC

To show the importance of looking at FCF, we have decided to present relevant examples.

Etoy, Inc. an internet only toy company that existed between late 1990s and early 2000s, is our firs

example. Etoy was a hot company that analysts called it the next ToysRUSa clue that the compan

was going to sink.

From its 2000 annual report, Etoy total debt to Equity was 0.77, which is less than 1 and

reasonable, its quick ratio, and its current ratios were both above one2.83 and 4.35 respectively. In

March 31st, 2000, Etoy total current assets totaled $214,286,000 and its total current liabilities totaled

$49,301,000. These numbers did not signal that the company was in trouble; the company could cov

its debts and was safe. On the other hand, the cash flow presented a bleak view of the company

financial health. From 1999 and 2000, its CFO worsened: the company went from having -$2.13

million in losses to -$174.44 million in losses; the total amount of cash out-flowing from 1998 to 200

was over $250 million and $229 million for FCF1 and FCF2, respectively (Table 5). Its only exit

strategy was to declare bankruptcy. It needed to sell over $200 millions in toys in 2001 to be able ge

out of the red, but with only one avenue of selling the goods and too many competitors, this was an

impossible task.

Table 5. Etoy Inc. FCF


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FCF for Etoy Inc. (in Thousands) 2000 1999 1998CFO -174,435 -23,930 -2,127

CE -44,252 -2,119 -178

CFI -26,842 -2,720 -448

FCF1 -218,687 -26,049 -2,305

FCF2 -201,277 -26,650 -2,575

As for Enron, if you look at its total cash movement between 1998 and 1999, you will notice

the company had a cash outflow of over $1 billion if you use FCF1, and over $4 billion if you use FC

(Table 6). However, if you expend your analysis from 1998 to 2000, you will notice that while the to

FCF1 was an inflow of cash of over $1billion, the total FCF2 was still over $4billion outflow. In fac

FCF1 in 2000 was over $2billion, but FCF2 was just over half a billion. Looking at FCF1 from 1998

2000 you will have assumed that the company is replenishing its cash and has no financial troubles, b

looking at FCF2 you come up with the opposite conclusion. The company in 1998 and 1999 had a

negative cashflow of over $4.5billion, while bringing only $515 million in 2000. FCF2, in this case,

presented a bleak view of the company financial problems.

Table 6. Enron FCF

FCF for Enron (In Millions) 2000 1999 1998

CFO $4,779 $1,228 $1,640

CE -$2,381 -$2,363 -$1,905

CFI -$4,264 -$3,507 -$3,965

FCF1 $2,398 -$1,135 -$265

FCF2 $515 -$2,279 -$2,325

In case you are still not convince of the importance of checking FCF, we have decided to pres

one more example. WorldCom filed for chapter 11 in 2002, but the signs of its weak financial statem

were apparent many years earlier (Table 7). While looking at WorldCom FCFs between 1998 and 20


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you can see that FCF2 is worse than FCF1. Within this four years period, it lost over $1billion if you

use FCF1, but over $10 billions if you use FCF2. After WorldCom restated its financial statements,

investors discovered that WorldCom overstated profits while it understated liabilities in the amount o

$3.9 billion. Subsequently, the Ex-WorldCom CFO confessed of moving WorldCom losses to the ca

flow.

Table 7. WorldCom FCF

Unfortunately, Looking at the balance sheet to find trouble would have provided you no stron

evidence that the company was in trouble. Its debt management ratios (debt to equity, current

liabilities/equity, and long term debt to assets) were decent. As of 2001 its debt-to-equity was 0.15,

current liabilities/equity was 0.52, and its long term debt to assets was 0.29. On the surface, these sig

a healthy company. Its liquidity was a concern but not enough to scare away investors who kept

investing in the company. In 1999, and 2000 its current and quick ratios were under 1 implying that

company did not have enough liquid assets to cover its current liabilities, which should have scared

investors, but investors, at their detriments, looked only at earningswhich were positive and growin

These examples show the importance of cash flow statement. Cash flow contains some vital

information about a company financial health. In some cases only cash flow will have the signs of a

troubled company. Good earnings and low debts can mislead you in believing that the company is

healthier than it is. In here we showed, through relevant examples, the importance of companies Cas

Flow.

WorldCom FCF (in Millions) 2001 2000 1999 1998

CFO 7,994 7,666 11,005 4,085

CE -7,886 -9,868 -8,716 -5,418

CFI -9,690 -14,385 -9,555 -9,433

FCF1 108 -2,202 2,289 -1,333

FCF2 -1,696 -6,719 1,450 -5,348


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Comparing receivable and inventory to sales can also show you that a company is in trouble.

company can have its inventory and receivable grow because it cannot keep up with competition. W

it cannot keep up with the competition, its trouble show up in a subtle manner; its inventories start

growing, the company start extending credit to its customers, and its suppliers start requesting to be p

pronto. The fact is that sells or revenue, entries in the income statement, do not mean that the compan

received the cash, and the cash is in its bank. A company can have a positive income and have receiv

little cash from it

If the company receive cash for its products than the cash will be recognized as cash, but in th

case its customers do not pay in time than the company has to categorize such amount as a receivable

From the prospective of the customer it is a credita short-term one nonethelessand from the

company prospective it is a sale where hard cash has not been realized, but, in case the company is

desperate to make a sell or has very few customers that dictate when it will be paid, than the company

will expand its receivable to enhance its earning, net paper profit.

In March 31, 1988, Regina Company, a leading seller of vacuum cleaners and floor-cares in t

late 1980s, and whose market value reached $250million in 1988, sales grew by 28%, but its invento

increased by 52%, and receivable by 54%--a sign that inventory was not selling and that receivable w

not being collected. By June 30, 1988, sales were up 41%, but inventory jumped 100%, and receivab

ballooned 187%1. This should have been strong enough signal to decide not to invest in such compa

Peat Marwick, accounting company hired by Regina to conduct a full-scale investigation of the

companys accounting records, discovered that Sheelen, then Reginas CEO, had ordered his chief

financial officer to manipulate the reported figures on product returns and sales.x

By April 26, 1989,

1 Howard M. Schilit, Financial Shenanigans, McGraw-Hill, Inc., New York, 1993


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Regina filed for bankruptcy, and on June 7, 1989 Electolux Corporation, an Atlanta floor-care compa

acquired it.

Although Sunbeam Executives filed for bankruptcy protection in 2000, the signs that it was

gearing toward bankruptcy started appearing in the second quarter of 1997, one year after Al Dunlap

took over the company. Andrew Shore, PaineWebber Inc. analyst stated he knew the company was

gearing toward troubles when he noticed that the company was holding an abnormal high inventory,

receivable. Through his investigation he discovered that Sunbeam was giving lucrative terms to deal

to ship products aggressivelyxi. This example shows that red flags can exhibit in various forms.

To expedite your inquiry you can read inventory turnover, and receivable turnover from finan

web-sites such as www.morningstar.com. Inventory turnover is the ratio between annual sales and

average inventory during the year. It is the number of times a company sells its inventory within a ye

Receivable turnover is the ratio between the annual sales and the average receivable within year. It i

the number of times a company collect its receivable annually. When the inventory or the receivable

increase faster than sales, the ratios will decrease. For instance, if inventory turnover change from 5

within a year you should conclude that the companies goods are not as sought for as before. If

receivable turnover change from 5 to 3 from one year to another than you should conclude that the

company is having problems collecting its money or it is giving a deal to its clients that are hindering

the company profitability.

We should note that an increase of inventory or receivable effect negatively a company CFO,

because their increase is removed while CFO is calculated. Hence a problem in the inventory or

receivable will reduce CFO, and most cases you can detect a problem with a company by checking F

Companies can manipulate how they recognize their inventory, which explains why analysts

prefer to use quick ratio while checking if a company can honor its short-term debts. Quick ratio is


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important if the company has inventory, as it exclude the inventory from the comparison between sho

term debt and short-term assets. Although inventory, theoretically, can be changed to cash in short-

term, if its content is perishable or is obsoletesuch as clothingthe company will be unable to

recuperate the cost of production and it will not be able to cover the cost of its short-term debt. A

company that changes how it recognizes its inventory can boost its current ratio, but it cannot change

quick ratio.

We are all aware of important ratios such as short-term debt to short-term assets ratio, financi

leverage, quick ratio, current ratio and even return on equity (ROE) and return on investment (ROI),

there are other ratios that are as important as important as these. You can find all these ratios alread

calculated in most financial web-sites. We would like to present one more ratio called quality of inco

that Mr. Schilit presents in his book. Qualitative of income is the ratio between CFO and Operation

income (OI). This ratio helps us decide if a company is efficient in converting its operating income t

cash. This ratio tells you how much of the CFO is left from OI. The higher the ratio the better is the

quality of the income. For instance, if the quality of income is equal to 0.5 than for each one dollar

made before interest and taxes, 50 cents is kept as cash.

1. Quality of income = CFFO/ Operating income

In summary, before we rush to put our money on the next big company, we,

individual investors, must make sure that we are not taken by surprise by the faith of our

holdings. In the age of internet where we are provided easy access to a company news,

finances, and reports we have no excuse of buying companies stocks blindly without due


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diligence. As we stated earlier a company stock price falls through it own weight, but if

its weight is too heavy than only the ground will sustain it. This brings us to its fair stock

price value.


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Fair Value

From the financial statement, ratios, and evaluations you arrive to the decision

whether the company is worth investing in. Now you have to decide if it is priced fairly

by the market. Just like any real estate investor or business man you want to buy at the

cheap and sell high, and the only way to do it is to know the worth of what you plan to

invest in. You do not want to buy a company stock for $10.00, when it is worth only

$5.00; what you want to at least make 10% profit.

Academician and professional investors have developed methods to derive the

fair value of a company. Some of these methods are based on cash generated by the

company and estimated company future growth; others are based on the given PE, and

future company earning growth. Either way, estimated company future growth is crucial.

If a company grows by 5%, than its expected yearly price appreciation should be around

5%. Of course, a company price fluctuates between its target price and other prices. You

should not expect the price to reach its target value and stop there.

You want to distance yourself from companies whose growth rate is slower than

treasury notes, the safest investment, and the company required ratediscount rate, also

called WACC, which represents the necessary growth rate a company must have in order

to cover its debt obligations.

If 10-year note return is 4.97% yearly and the company that you plan to invest in

is lower than 4.97%, will you invest in it? Of course not, you know that it is safer and a

better investment strategy to invest in a note that is backed by the government than in the

company stocks.

To calculate the internal return of a company you use Capital Asset Pricing


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Model (CAPM). This model says that equity shareholders demand a minimum rate of

return equal to the return from a risk-free investment plus a return for bearing extra risk.

The additional risk of a company is its debt and its volatility compare to the overall

market, which is assumed to be SP500. More precisely, it is the average between the risk

of holding the equity and having debts. Therefore, the calculation of Weighted Average

Cost of Capital (WACC) has been designed. If the business is to prosper in the longer

term, it has to earn more than the WACC. Most importantly, the cost of both equity and

debt has to be exceeded if the business is to survive in the longer term. It is only when

this condition is met that we can talk about the creation of shareholder value.

The advantage of such model is it does not require dividend, which is issued by

some but not all public companies. In fact, some cash rich companies prefer to buy back

their stocks and thus increase the value of the shareholders and remove the tax burden

that its shareholders my endure if it has provided dividend. Therefore, one should not

back off from a public company just because it does not distribute dividend. This is not

based only on our opinion, but on a survey on 50 of the largest investment houses paid

by Putman fund it found that these investment houses use cash approach to make

decisions on whether to invest. In the following web-site

www.expectationsinvesting.com/tutorial8.shtml you can find an excel worksheet that

will do the calculations for you.

WACC is a weighted average of the cost of equity, CE, and the cost of debt, CD.

Its formula is as follow:

WACC = CE * (MVE/(MVE+Debt))+ CD * (1-effective Tax)* (Debt /

(MVE+Debt)


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Where,

CE stands for the Cost of EquityMVE stands for the Market Value of EquityCD stands for the Cost of Debt

In here, Debt encompasses only short and long term loans.

The cost of equity, CE, is equal to:

CE = (Risk Free Interest) + (Market Risk Premium * Beta)

Where:

Risk Free Interest is the 10-Yr Treasury Notes, which you can find on

www.nytimes.com front page, on August 27th, 2004, its value was equal to 4.97

Market Risk Premium is the additional risk related to the market, in this instance,

the equity market. Historically this value has been between 3 and 5%. We will use 3.2%

for the market risk premium. Valuation expert Professor Damodaran of NYU's Stern

School of Business has published an informative article on equity risk premia that can be

downloaded free of charge. {REF}

Beta represents how volatile, or how risky, a specific security is compared to the

total market, which is assumed to be the SP500. A Beta value of 1 implies that the

security is as volatile as the overall market, while a Beta larger than one implies that the

security is more volatile. On the other hand, a Beta less than 1 implies a security that is

less volatile than the overall market, which is assumed to be represented by the SP500.

One would prefer a Beta to be closer to one as this implies that the company stock is as

risky as the overall market. You can find the value of Beta for a public company in

most financial web-page such as www.clearstation.com, www.nasdaq.com,

www.yahoo.com , www.msn.com, www.morningstar.com.

To show the process of calculating WACC, we have decided to use Home Depot (HD) as

an example.


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HD Beta is equal to 1.41, therefore

CE = 4.97 + (3.2*1.41) = 9.48%

Aswath Damodaran. The cost of debt, CD, is equal to:

CD = Risk Free Interest + Debt Risk Premium

To get the cost of debt, you need to look at the footnotes that come with the 10-K, 8-Q,

or 10-Q of the company, or you can go to www.mergentonline.com. From the footnotes

you should find the interest paid. For instance, HD states that the interest in most of its

debt is equal to LIBOR rate + (0.30 to 2.45%) (1.67+(0.3+2.45)/2)=3.03%, where

LIBOR rate is the interest rate banks in UK loan each other money. LIBOR rate can

easily be found in www.ft.com or even www.wsj.com.

Now that you have the cost of Debt, CD, and cost of equity, CE, you need

to calculate equity as a percent of the total market Capital, ETMC, and debt as percent of

the total market Capital, DTMC, where total market capital is equal to the sum of the

total equity and the total debt.

As we have stated earlier, Home Depot has $1.634 billion total debts. As for its

Market Value of equity (MVE) it is equal to the product of the current price of the stock,

which is 36 Dollars as of August 28th, 2004, and number of shares outstanding, which is

2,289 millions, which comes to $82.34 billion. Therefore

ETMC = (MVE*100/ (MVE+Total Debt)) = (82.34 *100/ (82.34+1.634)) = 98.06%

DTMC = (Total Debt * 100/(MVE+Total Debt) = (1.634 * 100/ (82.34+1.634)) = 1.94%

From SEC filing and by checking www.morningstar.com under key ratios and

Profitability tab we know that the effective tax rate is equal to 37.1%


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Now we can calculate WACC which is equal to.

WACC = (0.0948 * 0.93 + 0.3*0.0678*(1-0.371)) = 0.094 which is equivalent to 9.4%

To make it attractive to use, the minimum return we will expect from Home Depot is

9.4%. In www.morningstar.com, under Data Entrepreter, one can see that the Home

Depot sustainable growth rate is equal to 16.6%, which is higher than the calculated

WACC. Therefore, one can assume that Home Depot has a healthy growth, and it can

cover its debts with ease.

The minimum return required from a company with little or no debt, such as

technology companies, is equal to :

WACC = CE = (Risk Free Interest) + (Market Risk Premium * Beta)

Where,

CE stands for the Cost of EquityMVE stands for the Market Value of Equity

So as of 11/10/06 WACC of Ebay is:

WACC = 4.58+(3.2*1.49) = 10.04%

Where:

Risk Free Interest, 10-year note, is equal to 4.58%

Market Risk Premium is equal to 3.2%

Beta = 1.49

As of 11/10/06 average Ebay growth rate in the past 5 years has been 78.31% in

earning, and 74.37% in cash flow. Provided that Ebay keeps its competetiveness, and its

financial statement is strong, you can conclude that Ebay growth is much larger than

what it is required from it, given the additional risk of holding it. You cannot conclude


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that investors have already bid its price to represent its current growth rate, or it will keep

up this growth rate in the long term. WACC can help you calculate the company fair

value. You can find the value of WACC, which is also called the cost of capital, in the

Rochdale Research report. This report is provided free of charge by Etrade to its

customers.

Some investment houses use WACC to derive the fair price of a company

stock. They use it with the company cash flow to come up with the company fair price,

also called intrinsic value. Knowing how much a company stock, you, as an individual

investor, can make sure that you buy the stock only at discount price, and not at its fair

price. When you have the fair price you can compare it to the most current stock price,

and decide if it is worth buying or selling the stock. In most cases, you do not want to

sell when the stock price is below the fair price and you do not want to buy when the

stock price is higher than the fair price.

Most of the models to approximate the fair values can be complicated and

daunting for an individual investor, because the numerous assumptions and variables

required when estimating an accurate fair value, especially if you want to use the cash

flow approach. Fortunately, you do not have to calculate yourself the fair price of a

company stock, you can look it up at www.morningstar.com--some public libraries

provide free access to the full content of this web-sitealso, if you have accounts with

etrade you also have access to Standard&Poor Analysis Reports and other reports with an

estimated fair price.

We decided not to include the calculation of the fair value of a company stock for

the main reasons are the simplest model permit too much discretional assumptions from


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the users, and the more robust models are too complex and require too many variables to

keep track of. While rebuilding the wheel may be a great endeavor, it is better use of

energy to that the model requires many assumptions that you need to make

To calculate the fair price of a company you need: discount rate (WACC),

represented by d in here, shares outstanding, perpetual growth rate (p)which is

assumed to be 3% and is the long term sustainable growth rate of the American

economy, current free cash flow growth (FCF), and numbers of years you want to project

future cash flow and its discounted value. From this variables you can come up with a

fair price value for the stock. Your first step is to estimate for each year FCF given a

growth rate (g). In calculating the Fair Value of a company, growth rate is the only

variable that you can toggle to create different scenarios, and come up with different

stock fair value, while all others you can infer them or acquire them from literature.

At the same time as you calculate the yearly FCF, you need to discount it, or

divide it by a discount factor to get the discounted rate. Now that you have set up the

necessary step you can start calculating the fair value (FV). The FV is equal to the ratio

between the sum of discounted rate and total equity (TE), and the number of shares.

For instance, if you want to estimate the FV of Ebay, first you calculate the

WACC, which is the discount rate (d), assume the perpetual growth rate to be equal to

3%, and get from any financial website the company current stock price, share

outstanding, free cash flow, and growth rate. We assume that we are estimating cash

flow for 10 years.

Current Stock Price $32.81 in November 10th, 2006

Share outstanding 1416

Free Cash Flow (FCF) $1,671.60

Perpetual growth Rate (p) 3.00%

Discount Rate (d) 10.72%


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Growth Rate (g) 20.00%

Number of Years (N) 10

YearFree Cash Flow Discount Factor

DiscountedRate

1 1671.60 1.11 1509.75

2 2005.92 1.23 1636.29

3 2407.10 1.36 1773.44

4 2888.52 1.50 1922.08

5 3466.23 1.66 2083.18

6 4159.48 1.84 2257.78

7 4991.37 2.04 2447.02

8 5989.65 2.26 2652.12

9 7187.57 2.50 2874.40

10 8625.09 2.77 3115.32

Where

FCF1 = 1671.60

For i between 2 and N (is assumed to be equal to 10 years)FCFi =FCFi-1 *(1+g)For i=3 FCF3 = 2407.10

DFCFi = FCFi/di

For i=3 DFCF3= 1.36

Now that we have the projected Free Cash Flow and the projected Discounted Free Cash

Flow we are ready to calculate the Company stock Fair Value

Discounted Rate (DR) = (FCF10 *(1+ p))/(d10*(d p) )

DR = (8625.09 * (1+0.03))/(2.77*(0.1072-0.03))soDR = 41654.52

Total Equity = DR + sum of all the discounted rate from 1 to N years)TE = 41654.52 + 22271.39TE = 63835.91

Fair Value per stock price = Total Equity/ Number of SharesFV = 63835.91/1416FV = 45.08


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This result is comparable to what Morningstar estimated as fair value for Ebay.

Morningstar estimated Ebay fair value to be 45.00. If you use the analysts estimated

earning growth of 18.6%, then Ebay stock fair price value will be 41.22. You can also

assume that the c

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Chapter 6:Simple Defence--Know Yourself

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