Your Advanced Homework: Dig into the Details
I compare the income statement to the cash flow statement. Are earnings rising noticeably faster than cash flow? If so, there are substantial amounts of accrual earnings. Real earnings may be grossly overstated. Over the past few years, is cash flow rising or falling? What is the enterprise value to EBITDA ratio and how does it compare to others in the industry?
Are earnings rising at a much faster pace than sales? If so, why? That is a huge red flag and needs to be investigated. My rule of thumb is that if I cannot figure out the disparity, I forget about the stock. Are there large one-time gains or charges that need to be considered? Does the company have a history of "nonrecurring" charges?
Once I have gone through the financials looking for flaws, I can construct a list of stocks that have real assets and earnings. I already know they trade at valuation ratios I am comfortable with from my screens. After that, I check insider buying, something I like to see. A pattern of insider selling in a stock that is already down is another red flag. If the stock is cheap, insiders should be reluctant to sell.
I also examine institutional activity, looking for names I know and respect. When I see that Seth Klarman is buying Linn Energy (LINN), I am more comfortable with my analysis. When I reviewed Winn Dixie (WINN) last year, Whitney TiIson's ownership of the stock was a confirming factor for me. Seeing that John Paulson, the most successful investor of the past two years, has a large position in Boston Scientific (BSX) makes me want to know more about the company.
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