Thumb-tacked over my desk is a chart of the value of the Long-Term Capital Management Fund, which quadrupled from 1993 to 1997, but was wiped out in a matter of months in 1998. I keep that chart to remind myself what can happen to an investor who forgets that it's not what you make during a bull market that counts, but what you keep during a bear market. I just finished my worst year in 20 years of investing -- down 20% in 2002 and down 27% from the market peak in March 2000. However, I'm still in business, which is more than I can say for many of my peers.
Is the bear market of the past three years finally over, setting us up for the next bull run? The pending war with Iraq clouds the near-term outlook, but I have the equity portion of my portfolios fully invested at this point. Perhaps you're thinking of coming back into stocks or increasing your exposure. Before you forget the lessons of this bear market, here's a clip'n'save list of resolutions for your next investments. Let's take a closer look at each resolution.
1. Cash Flow Is King
In a healthy company, there's more money in the till at the end of each year. The healthiest companies accomplish this by producing profitable revenues, not through financial engineering. Of the three standard accounting reports (Balance Sheet, Income Statement, Statement of Cash Flow), only the Statement of Cash Flow "shows you the money." The three components of the report are:
Cash Flow from Operations (sales minus cost of goods and services sold).
Cash Flow from Investing (usually negative from investing in Plant, Equipment, buying other companies).
Cash Flow from Financing (positive if a company issues debt or equity, or borrows money).
The least risky companies are the ones that can cover cash flow needs out of operations. In the latest quarterly report of Microsoft
(MSFT)
for example, we see that $6.2 billion in cash from operations funded $0.9 billion in investments, while $3.0 billion was spent to buy up stock, leaving a net gain in cash of $2.3 billion (Microsoft has other risks, so don't buy the stock just based on the cash flow report).
I wrote about the statement of cash flow in detail in March 2000 and analyzed the riskiness of three stocks -- Budweiser
(BUD)
, Amazon
(AMZN)
and Revlon
(REV)
and here are the results:
Symbol
Riskiness
Mar 2000
Jan 2003
Gain (loss)
BUD
Low
$35
$49
40%
AMZN
Medium
$50
$20
(60%)
REV
High
$8
$3.5
(56%)
Source:
Although Amazon's stock did as badly as Revlon over the last three years, at least Amazon survived while its cash flow negative peers went out of business. Make sure as you add new stocks to your portfolio that they have the cash flow to survive the next downturn.
2. Beware the Paradigm Shift
A "paradigm shift" usually hits companies when their outlook is the brightest. When the personal PC shifted IT spending from mainframes to desktops, IBM
(IBM)
was the dominant maker of mainframes, seizing dominant market share over seven competitors and achieving a record market cap in 1988 (a new high wasn't achieved until 1997, by which time IBM had shifted most revenues to services rather than hardware). Companies like Digital Equipment Corp., which built mini-computers with proprietary operating systems, disappeared. Meanwhile, beneficiaries of the new paradigm like Microsoft and Compaq
(CPQ)
took off. Compaq was later the victim of another paradigm shift, from "build for inventory" to "build to order" -- Dell
(DELL)
was the primary beneficiary of that shift.
I recently sold my positions in Sun Microsystems
(SUNW)
and EMC
(EMC)
. I believe both are terrific companies, but sales of Sun's proprietary servers/operating systems are being pressured by cheaper Wintel- and Linux-based servers. My analysis is that the Sun servers are still the performance leaders, but not the price/performance leaders. EMC is in the same bind -- losing price/performance leadership to NetWork Appliances
(NTAP)
even though the EMC storage systems offer higher overall performance.
3. Nonsense Business Plans Make Nonsense Investments
Kozmo.com was an Internet era business which married one lousy business (bicycle delivery) with another lousy business (convenience stores), wrapped up in an Internet-based interface. The business strategy boiled down to "We're losing money on every sale, but we're making it up in volume." Briefly, Kozmo.com was valued at billions of dollars on the way to eventual bankruptcy.
When the next investment fad comes along, let your common sense prevail. If the business plan seems laughable, don't invest -- no matter how hot the stock is trading.
4. Accounting Problems? Goodbye
When a company restates its earnings, management is essentially saying that they have no idea how the company is doing. It also means that any quantitative screens that you use to select companies for further research are useless. Finally, it's rare that one restatement isn't followed by another -- and another. So, on the first announcement of accounting concerns, sell the stock automatically. This strategy would have protected you against some, if not all, of your losses in Enron, WorldCom, Global Crossing and Tyco
(TYC)
.
How can you predict when a company might have accounting problems? An imbalance in the Statement of Cash Flow, as described above, is one way. Another flag is when a company shows large increases in revenues and earnings on its Income Statement, but Accounts Receivable (from Balance Sheet) soars while Cash (from Balance Sheet) is declining year over year. Sunbeam achieved big revenue gains by "channel stuffing" -- filling distributors' warehouses with products that were ultimately unsold and returned, but recording the shipments as realized sales (thus, an increase in accounts receivable even though no cash was received). Subsequently, Sunbeam went bankrupt.
5. Diversify by Sector and Company
I wrote about this in detail in "Diversification Raises Returns, Lowers Risk -- Here's Proof". You should have a maximum of 25% of your assets in any one sector (e.g., technology, financial services) and you should never have more than 10% (preferably 5%) of your assets in any one company. Unless you're in senior management, this rule includes investments (e.g., ESOPs) in the company you work for. I automatically cut by half any position that rises to 10% of a clients account, and I rebalance my sector exposure every January (for details, see "Here's How to Play the Portfolio Rebalancing Act.")
6. Moderate Risk With Fixed Income and Dividend Stocks
I'm primarily a growth manager, but not all my clients -- for example, clients approaching retirement -- can afford the risks associated with a pure growth strategy. Typically, 25% of the stocks in my portfolios have "value" characteristics -- high dividends, low volatility, low price-to-book ratios. These companies include REITS (which are Real Estate Investment Trusts) and energy stocks. I also add in fixed income exposure, primarily through no-load, no-transaction fee mutual funds such as Monetta Intermediate Government Bond Fund and NorthEast Investor's Trust.
You should be careful with adding fixed income exposure in 2003 because the consensus is that interest rates will rise. High Yield Corporate Bond funds are attractive (high current yields) as are short-term investment grade funds (low interest rate sensitivity). You can also buy bonds in a "ladder" strategy (e.g., purchase five equal lots of government bonds maturing two, four, six, eight and 10 years out; when the first bond matures in two years, roll the proceeds into a new bond maturing in 10 years).
7. Cultivate Skepticism
After a year like 2002, it's obvious that no one, including myself, has a perfect record forecasting the future. Investment managers were overwhelmingly convinced of positive returns in the S&P 500 last January, but, according to Lipper, 96% of equity funds gave negative returns last year. So before you invest with a manager or fund based on a hot 1 year return, double check the three, five and preferably 10 years of returns. When I'm assisting clients in configuring their 401(k)s, I hardly ever choose a fund with less than five years of history, and certainly never pick something exotic like a sector fund.
Excessive compensation packages to management are often a flag of trouble, because managers are running the company to optimize their own positions rather than shareholders'. In April 2001, Forbes magazine reported that Michael Eisner topped the list of highest paid CEOs for the previous five years, even though net income of Disney
(DIS)
had declined an average of 3.1% per year. At that point, Disney stock had already fallen from a high of $45 to $35, on the way to the current $18.
Brokerage house research remains suspect. We don't rely on such reports ourselves, but if you read these reports, use them for background detail on the way to doing your own research. Concepts such as price targets are completely useless; instead, try to find companies that have a reasonable chance of growing revenues and earnings faster than the overall S&P 500 for at least five years. Beware triple digit multiples and triple-digit growth rates; these are rarely sustainable for more than a year.
Never ever invest in stock based on a tip, a chat room, a "cold call" or an e-mail solicitation. You might make better money shorting these companies, if you have the skill and stomach for short selling.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm was held positions in Dell and Amazon.com, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
The least risky companies are the ones that can cover cash flow needs out of operations. In the latest quarterly report of Microsoft
(MSFT)
for example, we see that $6.2 billion in cash from operations funded $0.9 billion in investments, while $3.0 billion was spent to buy up stock, leaving a net gain in cash of $2.3 billion (Microsoft has other risks, so don't buy the stock just based on the cash flow report).
I wrote about the statement of cash flow in detail in March 2000 and analyzed the riskiness of three stocks -- Budweiser
(BUD)
, Amazon
(AMZN)
and Revlon
(REV)
and here are the results:
