Your Advanced Homework: Dig into the Details

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for readers. To subscribe to RealMoney, click here

There is more to doing the homework than just running screens and reading filings. Compiling a list is the starting point, not the finish line. You have to read and dig through the financial statements of the companies. You need to review management's thoughts on the business and the outlook for the next few quarters. Publicly traded companies have to file quarterly reports complete with financial statements. As a long-term value investor, I have to read them to know what I am buying.

I start with the balance sheet. I make no secret that I am one of the few remaining book-value-oriented investors on the planet -- a curmudgeon before my time. The first thing I like is intangible assets. Most screeners do not adjust for tangible book value. I back out any and all intangibles such as goodwill. I know this a valuable accounting tool but there is not way to immediately monetize goodwill so I subtract it.

The next question to consider is what are the assets? Is it oil in the ground or oil in a tanker? They are worth substantially different amounts. Is it property owned for decades in a metropolitan area? The value may well be understated. Are the assets primarily inventory, which may be outdated and difficult to sell? Are inventories rising faster than revenues? How much debt is there and what is it as a percentage of total equity and assets? Are the assets liquid?

How much cash per share does the company have? If they have a large portfolio of securities, do I understand what they own? That one single question kept me out of major banks starting in 2007. After better than two decades of trading and researching banks, I simply could not decipher what they owned and what the risks were.

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.

One area of homework I consider crucial is what Phil Fisher called "scuttlebutt": what others I respect are doing in the market. One way of tracking this is reading RealMoney every day. It was Doug Kass who pointed out Hatteras Financial ( HTS) last year as a major beneficiary of Fed efforts to lower mortgage rates. Today I see that Jonathan Heller has done a good review of Tecumseh ( TECUA), a stock I like on a valuation basis. I want to read the opinions of others, especially those that disagree with me.

Another part of scuttlebutt research is talking to people who are active in the markets. If my irritable bearish friend in Chicago is buying call spreads in Dow Chemical ( DOW) at twenty-some year lows, I am going to look into it. When four or five different smart people tell me education stocks cannot continue to grow at the expected pace, I am going to go back and look at companies like Apollo ( APOL) as potential shorts.

Doing the homework is critical. Dig into the numbers, be skeptical. Listen to what others are saying. Find someone who disagrees with you and argue your position to find the flaws you may have missed. Doing the homework helps you avoid many of the mistakes than can trash your portfolio.

Remember, do the homework now. There will not be time to do it when the market falls to more attractive levels.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Tecumseh to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

This was originally published on RealMoney on Feb. 4, 2009. For more information about subscribing to RealMoney, please click here.

At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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