Chapter 6:simple Defence--know Yourself

CHAPTER 6: SIMPLE DEFENSE KNOW YOURSELF Present and then methodology The purpose of section I was not to scare you away from investing, but to provide you with characterizations of human ingenuity—or at least the negatives of human ingenuity. Just like scuba diver need to know possible danger that their activity entails so do investors need to know possible traps that the market can entail. With this spirit we decided to show you how to, through simple and time-efficient “smell” tests, spot companies problems. Knowing what to avoid is an important step in becoming a good investor, but knowing oneself is as important to becoming and remaining a good investor. Knowing oneself is not only defined by ones risk tolerance, or ones investment time-frame, but also defined by one preferences, values, and confidence on ones knowledge. Opportunities in the market always exist, but it is up to the investors to find and capitalize on them. Over 10,000 public companies exist; you are bound to find at least one that is worth investing in. Even during recessions, and wars you can find some industries prospering due to these events. For instance, one industry that was profitable during great depression was the entertainment industry, more precisely the movie industry. Your choice investment strategy does not have to be based only on what professional may advice you or what www.nasdaq.com web site presents in its guru section, you can incorporate your own value, and flair. You can follow Ben Graham,

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Peter Lynch, O’Shaughnessey, 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 Women’s Equity Fund—that 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 1990’s PG&E contaminated the drinking water with toxic chromium— which when consumed by humans causes birth defect, and cancers—in 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 millioni. 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 million—over 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 crusade—62% 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: • • • •

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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

• • • • • • •

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 with breast 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 cancer—women 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

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ABT

AET

AMGN AZN

BIOM

BMY

DNA

ELN

FIMG

GE

GNTA

GSK

IMMU

IMPH

ISIS

JNJ

LLY

NEOL

OHP

PFE

PHA

RGIS

SGP

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 value—which 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.

Initial Price 2/1/06 GE LLY ELN AMGN SGP Total

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$33.14 $56.89 $15.90 $76.19 $19.15 $201.27

Table 2. Index Setup Today %Price Price Change 3/1/06 0.16 $32.76 -1.15% 0.28 $55.89 -1.76% 0.08 $12.99 -18.30% 0.38 $76.05 -0.18% 0.10 $18.36 -4.13% 1.00

Initial Weight

%Price ChangeWeighted -0.002 -0.005 -0.014 -0.001 -0.004 0.974

Table 3. Index Value Initial Cost of the index Initial Index Value Index Change 3/1/06 Index Value as of 3/1/06

$201.27 100 0.974 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, let’s 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 oil—we represent less than 5% of the world population and we consume around 22% of the world’s annual energy production—and 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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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 CSC

Position 2500

Buy Price 31.41

Sell Price 54.7

FLR HAL HUG

2000 4000 2500 Total

$28.01 $19.97 $22.89 $271,590.00

$88.08 $69.00 $46.22 $704,460.00

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%Change

74.15% 214.46% 245.52% 101.92% 159.36%

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QuickTime™ and a TIFF (Uncompressed) decompressor are needed to see this picture.

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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 benchmark—which 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 benchmark—it 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 nonfinancial ones and they are mostly in NASDAQ, you may prefer to compare your portfolio to Nasdaq 100—Nasdaq 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 index—such 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 5000—originally 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 beat—or 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 1990’s some technology companies with no products and little earning had their PE equal to 100, while the SP500 companies PE was in the 30’s. 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, 2005—almost 20% loss in value—with 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 investors 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 IRA’s, the investors are pressed to educate ones selves on the art and science of not only investing but also on the art of detecting obviously 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 the individual investors to salvage their money. Enron, and WorldCom financial troubles were apparent years before they declared bankruptcy. 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 these 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 Nick Heymann who worked at Prudential Securities detected the company troubles. The company was able to give the appearance that it was doing well by sending too much goods to stores and booking them as 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 at 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 company’s press releases that can influence these 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, a law suit, the number of clients is some of factors that can have a considerable influence on the company 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 numbers—financial statements, and financial ratios—and 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 balance sheet and cash flow. Unfortunately, a lot of investors during the 90’s bubble relied on only that to make 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 learn to detect problem companies before we decide to invest. We need to create line of defenses that consists of looking for red flags in the press releases, the business model, the financial numbers, and statements in 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 company’s CEO leave it suddenly after a short stay. Without Cash Flow Statement and Balance sheet investors and analysts cannot make an informed investment decision. In 2001, what triggered Wall Street Journal journalists, 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. Uzzi, Sunbeam’s well-regarded executive vice-president for world wide consumer products, and investor relations chief Richard Goudis quittediv. Chanos, a prominent short-seller, confirmed that professional

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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 resignations…That is usually a big red flag for us that something is a miss, particularly when it is abrupt and hasn’t been telegraphed for quarters or months end.”v CEO, just don’t leave million dollar jobs for no good reason except when they are fired or they are aware of some shenanigans. If a company released its earnings without balance sheet, or cash flow statement you should not be quick to make an investment decision. What triggered Chanos to analyze Enron was Enron releasing its earnings without a balance sheet, or cash flow. Credit rating downgrade is a big red flag. The main credit rating companies are Moody’s and Standard & Poor. They provide a reasonably independent objective assessment of the credit worthiness 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 is downgraded cannot get loans at a preferred rate that it was accustomed to, and can be forced to repay its 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 Moody’s and Standard & Poor. A rating that is below Baa, or BBB implies that the companies are speculative investment or junk. They are high risk and are in financial trouble. C, or D implies that the companies are in default--they cannot honor their 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 CEO’s who are in binge buying or selling, but in most cases, unless one has full knowledge of the company or the industry one cannot assess if the binge has a merit or not. A company will buy its competitors if it translates into higher slice of the market, or fire workers if the economy is slowing down or the goods are selling poorly. In early 1990’s Morgan Stanley, an investment bank, diversified into pig farming – investing in a venture located in Missouri and containing 2 million hogs. Morgan Stanley and its management had no previous experience with pig farms, and it showed. Just after it invested millions, and floated junk bonds to raise even more money, the feed price rose and a swine virus reduced substantially the number of pigs to the point that Morgan Stanley lost not only $190 million on the venture but could not repay $412 million in junk bonds that it floatedvi. Peter 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 CEO’s who went on buying sprees. They bought companies that added little to the company business for the only purpose to increase their company’s worth, and of course, earning. They bought companies using no cash and only

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shares, in the process, they increased their company net worth and the shareholder valuation—they entered the value of the new acquisition as goodwill and they did not record the expense in the earning. In short, the companies increased their assets, and their earnings were not affected. On the other hand you have CEO’s that love to restructure. Restructure for some CEO’s means 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 Sunbeam 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 Sunbeam’s 18 plants. He cut through not only the fat but 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 on the eve of a holiday or during the holiday hoping that the investors will not have enough time or will be too busy to react to it. For instance, to cover its bad news, Computer Associate (CA) decided to post a 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 company is either in financial trouble or is hiding something. Professional investors translate “pro forma”, “operating”, “as reported”, “normalized, or “core” as garbage in garbage out—Meaningless labels that add little knowledge to the investors. A prominent short-seller is looking at the company you are looking at, and short positions on the 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 inquisitive 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 public companies to publish financial reports: annual and quarterly reports called 10K and 10Q, respectively; in 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 financial number. In fact, you can find financial numbers of a company in www.NASDAQ.com, www.msn.com, www.morningstar.com and even in www.nytimes.com. Unfortunately, some entries are subject not only to the industry the company is in, but some are too obscure to decipher their meaning. For instance, the entry “extraordinary items”, in the income statement is vague. What does this entry relate to? You have no alternative but to read the reports to figure out what it stands for. Reports go beyond explaining the 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 questions: Is the CEO truthful? Did the Auditors found anything that should make me suspicious of the company 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 of the company annual financial standing without graphs, fluff, or president statement. Annual report will 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 upbeat 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 the 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 90’s, to report any inaccuracy of the company accounting practice. As the auditors finding are only in the 10K, annual report, under the title “Report 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 control over financial reporting as of December 2, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by COSO. Also, in our opinion, Adobe Systems Incorporated maintained, in all material respects, effective internal control over financial reporting as of December 2, 2005, based on the criteria established in Internal Control—Integrated Framework issued 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 company financial.

Our report dated March 28, 2005, on management’s 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 Company’s accounting for income taxes and a material weakness related to the calculation of the Company’s 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 maintain 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 allowance

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for doubtful accounts—estimated money that the company is owed and doesn’t expect to be paid back. 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 also 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 didn’t want to disclose but had to… they bury the bodies where the fewest folks find them—in the fine print.” You can look at the footnotes to have a better understanding of the financial numbers. Beside an explanation of financial numbers, footnotes can have information about a company’s 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? How 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 has 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 Vioxx 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 the

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company is a good investment, but its does not prevent that the amount may be insufficient to cover all the law suits. In this instance, no right answer exists. You can decide to invest or not invest depending 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 will your company. You should be worried if the company is following non standard accounting principle. If the company decide to recognize revenue when the goods are shipped, not when they are accepted you should be worried. In the 1990’s many companies were caught enhancing their income statement 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. For instance, a company will increase the depreciation of its computers from 3 years, which is the average age of computers, to 10 years. By doing so, it boosts the value of if income statement, and by the same token it gives the investors a shifted idea of the company performance. For instance, Union Carbide, a company that existed in the 1970’s and early 80’s, reported an earning increase by $217 million. One 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 statement.ix Another thing to look at is any entry called “extraordinary” entry also called non-recurring and located in the income statement. Some companies try to cover what is a usual business expense as a one time expense, also called one-time charge, and hence enhancing their revenue. Revlon, in the nineties 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 line—profit. For instance, Tyco bought 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 was 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 yourself a 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 flags 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 that 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 balance 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, us the individual investor, can detect the problems with ease. For a company not to fold, it needs to make money—preferably cash. A company can make and sustain profit but still be strapped for cash. In accounting 101 you learn that a company that has large assets but little or no cash is designed as a bankrupt one. Just like individuals, it can spend more than it can bring to the point that it cannot even pay for its basic necessities, such as leases or short-term debts. For a company to grow it need to have its profit and cash grow. The only way to assess if the company 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 because

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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 still be a bad investment. The media and popular publications have condition us to concentrate on companies earnings. If a company announces earnings that are better than expected some of us will interpret it as a sign that it 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 not 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 as it appears to be. Sometimes, looking at the cash flow alone will give you a clue that the company is in 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 increasing 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 better it is able to withstand economic downturn. You can think of FCF as the monthly money you put in your savings; Individuals who save monthly a percent of their income are better of at withstanding loss of job 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 approach

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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 FCF1. 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 1990’s and early 2000’s, is our first example. Etoy was a hot company that analysts called it the next ToysRUS—a clue that the company 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 one—2.83 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 cover 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 2000 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 get 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) CFO CE CFI FCF1 FCF2

2000 -174,435 -44,252 -26,842 -218,687 -201,277

1999 -23,930 -2,119 -2,720 -26,049 -26,650

1998 -2,127 -178 -448 -2,305 -2,575

As for Enron, if you look at its total cash movement between 1998 and 1999, you will notice that the company had a cash outflow of over $1 billion if you use FCF1, and over $4 billion if you use FCF2 (Table 6). However, if you expend your analysis from 1998 to 2000, you will notice that while the total FCF1 was an inflow of cash of over $1billion, the total FCF2 was still over $4billion outflow. In fact, FCF1 in 2000 was over $2billion, but FCF2 was just over half a billion. Looking at FCF1 from 1998 to 2000 you will have assumed that the company is replenishing its cash and has no financial troubles, but 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, has presented a bleak view of the company financial problems.

Table 6. Enron FCF FCF for Enron (In Millions) CFO CE CFI FCF1 FCF2

2000 $4,779 -$2,381 -$4,264 $2,398 $515

1999 $1,228 -$2,363 -$3,507 -$1,135 -$2,279

1998 $1,640 -$1,905 -$3,965 -$265 -$2,325

In case you are still not convince of the importance of checking FCF, we have decided to present one more example. WorldCom filed for chapter 11 in 2002, but the signs of its weak financial statement were apparent many years earlier (Table 7). While looking at WorldCom FCFs between 1998 and 2001

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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 of $3.9 billion. Subsequently, the Ex-WorldCom CFO confessed of moving WorldCom losses to the cash flow. Table 7. WorldCom FCF WorldCom FCF (in Millions) CFO CE CFI FCF1 FCF2

2001 7,994 -7,886 -9,690 108 -1,696

2000 7,666 -9,868 -14,385 -2,202 -6,719

1999 11,005 -8,716 -9,555 2,289 1,450

1998 4,085 -5,418 -9,433 -1,333 -5,348

Unfortunately, Looking at the balance sheet to find trouble would have provided you no strong 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 signal 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 the 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 earnings—which were positive and growing. 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 Cash Flow.

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Comparing receivable and inventory to sales can also show you that a company is in trouble. A company can have its inventory and receivable grow because it cannot keep up with competition. When 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 paid pronto. The fact is that sells or revenue, entries in the income statement, do not mean that the company received the cash, and the cash is in its bank. A company can have a positive income and have received little cash from it If the company receive cash for its products than the cash will be recognized as cash, but in the 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 credit—a short-term one nonetheless—and 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 the late 1980’s, and whose market value reached $250million in 1988, sales grew by 28%, but its inventory increased by 52%, and receivable by 54%--a sign that inventory was not selling and that receivable were not being collected. By June 30, 1988, sales were up 41%, but inventory jumped 100%, and receivables ballooned 187%1. This should have been strong enough signal to decide not to invest in such company. Peat Marwick, accounting company hired by Regina to conduct a full-scale investigation of the company’s accounting records, discovered that Sheelen, then Regina’s 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 company, 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, and receivable. Through his investigation he discovered that Sunbeam was giving lucrative terms to dealers 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 financial 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 year. Receivable turnover is the ratio between the annual sales and the average receivable within year. It is the number of times a company collect its receivable annually. When the inventory or the receivables increase faster than sales, the ratios will decrease. For instance, if inventory turnover change from 5 to 3 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 on 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 FCF. 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 shortterm debt and short-term assets. Although inventory, theoretically, can be changed to cash in shortterm, if its content is perishable or is obsolete—such as clothing—the 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 its quick ratio. We are all aware of important ratios such as short-term debt to short-term assets ratio, financial leverage, quick ratio, current ratio and even return on equity (ROE) and return on investment (ROI), but there are other ratios that are as important as important as these. You can find all these ratios already calculated in most financial web-sites. We would like to present one more ratio called quality of income 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 to 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 Equity MVE stands for the Market Value of Equity CD 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 Equity MVE 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-site—also, 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 Share outstanding Free Cash Flow (FCF) Perpetual growth Rate (p) Discount Rate (d)

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$32.81 in November 10th, 2006 1416 $1,671.60 3.00% 10.72%

20.00% 10

Growth Rate (g) Number of Years (N)

Year 1 2 3 4 5 6 7 8 9 10

Free Cash Flow

Discount Factor

1671.60 2005.92 2407.10 2888.52 3466.23 4159.48 4991.37 5989.65 7187.57 8625.09

1.11 1.23 1.36 1.50 1.66 1.84 2.04 2.26 2.50 2.77

Discounted Rate 1509.75 1636.29 1773.44 1922.08 2083.18 2257.78 2447.02 2652.12 2874.40 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))so DR = 41654.52 Total Equity = DR + sum of all the discounted rate from 1 to N years) TE = 41654.52 + 22271.39 TE = 63835.91

Fair Value per stock price = Total Equity/ Number of Shares FV = 63835.91/1416 FV = 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 company growth will vary year to year and choose a different growth rate for each year. Morningstar calculation of fair value take into considerations more variables than you, as an individual investor, has access to or can implement with ease, but this should not stop you from infer in it yourself. We believe it is better to have a general point of reference than to have none. Different approach of getting the fair value will result in different fair value. For instance, if you look at the Standard and Poor report for Ebay published in October 24th, 2006, you will notice that the report estimate a fair value close to 30.00; on the other hand, the September 13th, 2006 Rochdale Research report give a fair value of 35.00 to Ebay. The difference in results between different research firms is based on use of different models, and the time of the estimation. While both Morningstar, and Rochdale use the similar models to estimate the fair value, they use different measures: Morningstar uses free cash flow, Rochdale uses the value of the assets. In addition to the fair value, you may want to look at the project company stock price. Yahoo.com, Nasdaq.com, msn.com, to name a few, provide analysts estimate of future earnings, growth, and target price, or end of year price. This provides a simple approach to individual investors to make decisions on when to buy or sell a company stock. If the given stock is at $11.50, and it is estimated that its target price by next year will be $12.00 and no news altering the company fundamentals, you may decide to sell

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the stock as the return may look too small of the amount of time you are required to hold it. To estimate future stock price of a company—here we mean end of the year stock price, analysts rely on the PE, on the date of earning announcement, and future earning growth. PE, which stand for the ratio between the price and earning, is the most used ratio by investors. With PE, investors have a comparison base between different companies, industries, and sectors. In addition, they can see how much in the past other investors where willing to pay for such a company stock.

Hence, they can make a

decision on whether the company in question is worth investing in. We want to warn you that PE value, in itself, is not a good reason to invest in a company. A company can have a high PE—implying that investors are flocking to the company stocks—and still be a junk; it can have a low PE—implying that its is cheap— and still be a junk. Investors have to look at the company as a whole. Investors who held on tech companies with very high and unjustifiable PE lost a lot of money when these companies stocks price collapsed. These companies did not have the financial strength that justified such high PE, or the appeal to other companies to acquire them. We are aware of the existence of two major kinds of investors: growth, and value investors. Although value investors look for companies with low PE, and growth investors look for companies with high PE, both of them look for companies that are sound, and they both have a merit. What ever each camp may state, from the extended literature that we studies we came with the conclusion that neither have a superior advantage over the other. We have a period of time, when value investors will perform better than growth investors, and vice versa.

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A company can have a low PE because it is not financially sound, not because it is cheap, just like a company can have a high PE because people have been buy its stock for no reason but that MSNBC, or Bloomberg channel had its CEO as a guest on their show. In short, one cannot make a decision on buying or selling on one company ratio, one has to look at the company as a whole, and then decide if the PE is too high or too low. You may think that there is a one to one relation between the price and earning “presentation”. However, this is far form true. One can announce a decrease in earning but the stock will still rise, or one can announce an increase in the earning and the price will just dive. The reason for that is related to the investors’ expectations and of course the investment houses. If the investors’ expectations and the company announcement coincide then the price will just continue to follow its path; the stock price will not be affected by the news. On the other hand, if the investors expectations and the company announcements do not coincide then the price will either shout up (gap up) or shout down. For instance, LLY reported an EPS of 1.66 for the year 2004 compare to 2.58 a year earlier. With this information only, you will decide that the company should be shorted or sold, and the stock price to atrophy; however, contrary to your belief the stock opened higher, even though, it was far from the analysts estimate of 0.75 earning per share. The company short coming was not because of a lack of demand for its products; au contraire, its items where very much sought for; in fact, it sold 1 billion more in year 2005 than in year 2004, and it increased its cash from 3 billion to 5 billion. So what caused the company to have a decreased earning on its fourth quarter?

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LLY, in its SEC filing, stated that it used 0.43 of its earning for a planned repatriation of $ 8 Billion in overseas earning, 0.30 a share related to asset impairments and restructuring as it prepares to divest itself of manufacturing facility and equipment, and 2 cents of its earning in license of an insomnia compound from Merk KGaA (MRK.XE). Therefore, if these extra-ordinary items are excluded, LLY earning per share would have been 0.75, which is higher then the analysts’ estimate of 0.74. Investors have decided that LLY will have no problem recuperating that cost, and this cost will have no bearing on its future financial health. These extra-ordinary items are justifiable. Investors know that the expense related to license and repatriation are one time event, and the company will get If you find that the company is sound financially, then you can proceed at looking at PE, to estimate next year target price. Depending who you talk to, you get a different answer on which PE to use to estimate a target price. Some will use the current PE, defined as the ratio between the current price and the trailing 12-month earnings, others the average of the analysts estimated PE,others others the industry average PE, while others will use analysts estimated PE. Your estimate of target price will vary depending on your choice of PE. If you believe that a stock price is well priced at present then you can assume that using the current PE will provide you a more accurate assessment on where the stock will be in few months, if you assume that the company PE is too high or too low, then you may want to use either the industry average PE or the estimated future PEs. For instance, Ebay announced that its earning by the end of the year of 2006 will be 20% higher than last year. So if last year earning where 0.86, then the estimated

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earning by the end of 2006 must be 1.03. If the analysts PE estimate for Ebay is 33.252 by the end of 2006, then the target price of Ebay stock will be 34.31: where estimated price is equal to the product of the estimated earning by the estimated PE. With Ebay current price at 33.35 as of November 16, 2006, you will come to the conclusion that the stock is well priced, and at this moment it is not worth paying for it until compelling news, or announcements unveil. You will get a different target price if you use the current PE, instead of the estimated PE. The current PE, as of November 16, 2006 is equal to 45.00, so if the estimated yearly earning is 1.01 for the end of 2006, then the target price will be equal to 45.45. Using the industry average PE, which is equal to 46.103, you will get a target price of $46.56 per share. Now, if you compare this price with the current Ebay stock price, you will conclude that the stock is cheap and that it is a good buy. From Morningstar.com we found out that the fair price of Ebay as of November 2006 is 45.00, looking at the different estimated target price we can conclude that in the case of using the current and the industry PE the targeted prices are similar to our fair price, and the stock is cheap enough to buy and hold. If the fair price is at $45.00, the current price is at 33.35, and the target prices using the current and industry PE are around $45.45 and $46.56, respectively, we can conclude that the stock is a good buy. Some of you will notice that the target price using the analyst future estimated PE is much lower than the fair price of the company, $34.31 and $45.00, respectively. The fair price does not have to be the same as any target price: while the fair price is derived from the company financial statement and requires intense calculations, the target price is

2 3

www.nasdaq.com www.msn.com

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based on three main components: PE, in the case of current PE, it changes daily, earning growth, and present earnings.

We showed you how PE can be used and how different PE results in different target prices but we have not shown how malleable. PE is indirectly effected by the number of share a company issue. If a company decides to buy back some of its stocks from the open market, then its earning per share will increase, and its PE will decrease. On the other hand, if a company decides to issue more stocks to the market, then the earning per share will decrease and the PE will increase. For instance, if a company, like Ebay, decides to buy back some of its stocks the earning per share of the company will increase and the PE will decrease; the only way for PE to stay the same, the price per share has to increase to compensate for the increase in the PE. Earning can increase due to a decrease in tax rate imposed on the company, or an increase in efficiency in management. In addition, current PE changes daily, just like the price; high price results in higher PE, while a low price results in lower PE. The daily change of the current PE results in a daily change of the target price, and the current PE can be too high to be useful in estimating a target price, which explain the need to calculate the company fair stock price, which is based on how much is worth today. In all cases, PE, as simple and as available as it is, is not a good ratio to put ones all hopes on, but more like a sentiment thermometer of investors acceptance of a company. A company with a PE higher or lower than industry does not translate into a good or bad investment. One can have a higher PE and still be a bad investment, just like one can have a lower PE and still be a great investment. During the 1990’s many

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dot-com companies had PEs over 100; even though, they were lousy investment, some small companies may have low PE due to their size and SEC restrictions, which prevent large investment houses from investing in them. Finding if a company is in trouble, its fair value, its target price its relevance to you are all important component in choosing a good and a sound investment, but an investment has a value only when you tap in it, through line of equity if it is a real-estate investment, or you sell it. We all hope that our investment is a good investment, but the reality any investment has a risk, and we must mitigate the risks by putting some safety nests. Next section will present some exit strategies to lessen your losses and ripe you rewards.

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i

ADD Donald L. Cassidy, It’s not What stocks You Bu, It’s When You Sell That Counts, Probus Publishing Company, Chicago, 1991, p.86. iii Rebecca Smith, Emshwiller J. R., 24 Days:How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America, Harper Collins, New York, 2003 iv John A. Byme, “How Al Dunlap Self-Destructed: The Inside Story of What Drove Sunbeam’s Board to Act,” Business Week, July 6, 1998. v Martin Howell, Predators and Profits: 100+ Waysfor Investors to Protect Their Nest Eggs, Prentice, Hall, 2003, p. 49. vi Charles R. Geisst,Wall Street: A History from Its Beginnings to the Fall of Enron, Oxford University Press, 2004, pp 267-268. vii Martin Howell, pp. 110-111. viii Shenanigans, p29. ix Schilit, p.27. x http://www.suffolkacct.org/mmcinnes/GBEP/Word%20Files/The%20Regina%20Company%20(B).doc xi Byme. ii

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