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Breaking the Imprisonment of Investment Illusions
"The Ten Rules On How To Avoid The Next Enron"
The 11th Rule
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Purchase a copy of Security Analysis by
Graham & Dodd. The authors’ investment basics provide fundamental
principles that have stood the test of time since its initial
publication over 70 years ago.
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Be a customer. As a consumer you’re often the
best critic of a company’s prospects. Extend your “buying”
experience into your “investment experience.” Ask yourself: “Why
did I choose one brand over another?” Dell versus Compaq? Panasonic
over Sony? AT&T and not Verizon?
Ask yourself if you have had a positive customer
experience. Factor in anomalies but check with others. Chances are
that many people have had similar customer experiences. Positive
experiences usually lead to brand loyalty and, most importantly for
the company (and investors), revenues. Drawing on your motivations
as a customer and your interaction with a company are very telling
signs of a business’ vitality.
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What business is the company in? If this
question requires multiple paragraphs to answer and are not easily
understandable, be wary. Use the three-sentence rule: if a company
can’t explain its business in three sentences, wonder why.
The company’s name can be another telling point.
A name change is often made to divert attention from a controversial
product association or history. Altria Group is an impressive name;
it used to known as Philip Morris (cigarettes). Hard to imagine
that Exelon (nuclear energy) used to be Philadelphia Electric (Three
Mile Island). Xerox found out the hard way when it insisted upon
being referred to as “The Document Company” — What is the wisdom in
changing a household name. Companies having proud histories are not
quick to change their names (excluding mergers and/or necessary
renaming). Consider the implications of Coca-Cola, IBM or Microsoft
altering their names. Investors need to ask why a name is being
changed. Goodwill engendered by a solid name and the history
associated with it are rarely readily forfeited without an
underlying reason. Find out what that reason is.
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Identify a company’s “legal” not “divisional”
organizational chart. An organizational chart, with proper
corporate names, is imperative — a company can be in the headlines
every other day and an investor might not know it’s a member of the
corporate family in which they hold stock. A company’s 10-K filing
is generally the best source, though not always, for this
information. Just call the company’s investor relations department
and request one. The mere tone of the conversation can be
enlightening. If asked “Why?” reply with “Because I own shares in
your company” (That means you work
for me!). If investor relations transfers you to the
legal department, be polite yet firm. The first sign of trouble at
Enron was when it’s formal organizational chart began to look like
the Medici family tree.
When an organizational chart makes the New York
City subway map look easy, warning bells should ring. For example,
when Enron filed for bankruptcy in 2001, it listed a mere seven
business lines — not too complex and easy for management to
reference — notwithstanding the fact that those businesses were
distributed under 65 different corporate entities and divisions (And
even this count is subject to debate).
Companies that discuss themselves in terms of
business lines or divisions should be prepared to offer a legal
corporate organizational structure of their business entities.
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Keep track of insider buying and selling
activity. It should be monitored over time and evaluated properly.
It would seem to be a given that people, especially insiders, buy
shares in companies that offer increasing stock appreciation.
Conversely, insider selling is not a vote of confidence in the
company’s prospects.
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Competitors can frequently be the best
information source about a rival company. I was once grilling a
company very hard about construction delays and political discontent
when the CEO blurted out: “Well if you think we have it bad, I
suggest looking into (a competitor's) tribulations.”
I did and found a great new venue for information.
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Demand the latest analysts’ reports on a
company. Some analysts are reticent to document their opinions.
While not always suspect if they are not forthcoming, it should
cause one to ask some serious questions. And when a report’s
content and conclusions seem “mismatched,” something is usually
amiss. This was prevalent during the dotcom saga.
Don’t always be impressed by analysts sporting
CFA (Charter Financial Analyst) credentials. The CFA program is
designed to enhance the security analyst profession. However, I’ve
found it overly academic. I would prefer an analyst with a
bachelors or masters degree in liberal arts who has served a
three-year apprenticeship with a senior analyst (equivalent study
time required for the CFA). There is no substitute for a baptism by
fire, coupled with the broader based liberal arts perspective.
The rating agencies are also not immune from this dichotomy yet the
credit rating agencies are an under-utilized wealth of information.
The typical credit research report might suffer from an
inconsistency between content and conclusion. But these reports
often point to trigger events that could augur well (or not, as the
case may be) for a given company. For example, phrasing such as:
“We are waiting for a noteworthy event or the next quarter
performance” can offer valuable “directional” insights. Reports
from the rating agencies are not just credit opinions but also serve
as a public message to the company in question (the “effective”
constituency). Investors should take advantage of these hints.
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Too many diagnostic financial ratios can be
distracting. At some point all the numbers tell the same story. A
10-ratios’ tool can be a good investment indicator. The “fast
ratios” I use will be apparent if you read
Whitehall Financial Advisors LLC
comments over the course of time. (You can purchase them). When it
comes to numbers, though, keep in mind what the statesman Edmund
Burke (1729-1797) once said: “It is the nature of all greatness not
to be exact.” The tendency to torture numbers until they “confess”
can be overwhelming.
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“To infinity and beyond” (What
a lousy quote but it works.). It’s not about this quarter
or the next. Invest in a business not a quarterly statistic if the
key signals of financial health are in place. Quarterly earnings
can be off by a penny or even down. Worry when every quarter is
higher – perhaps too much “accounting” is at work. Unfortunately,
the expectation of increasingly higher quarterly or annual results
enslaves investors.
I am always amazed when a company reports earnings
that fail to meet Street estimates by pennies, causing a stock to tumble
by dollars. Just recently a fellow analyst was telling me how financial
results for a company fell pennies short of analyst estimates and the
stock fell by 11% and several analysts then downgraded it.
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Maintain adequate distance from management and/or
investor relations. The goal is to ask clear, informed and specific
questions—not make friends. Make certain inquiries are answered in
a decisive manner. Be careful of ambiguous phrases. For instance,
“soon” (I have never seen a calendar
with the date soon on it). Another one of my least
favorite answers is: “We’ll cross that bridge when we get to it” (What
if it’s not a bridge but a pier). Another: “We’re
continuing to study the subject” (It
implies that nobody knows what’s going on).
The most successful companies I have analyzed do
not whitewash events. The best investor relations person is the one
who answers: “Yes, it’s as good” or as “bad as it looks.” These are
reliable resources and their honesty sustains companies during
difficult times. Minimize discussions with companies. Sometimes
there is such a thing as having “too much” information. Stick to
the facts and avoid emotional attachments – it distorts objectivity.
If you’re looking for affection, get
a puppy — not a stock.
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The 11th Rule
“Interest means very
little when principal is at risk”
One of the questions I am asked most frequently
is how I uncovered the Enron house of cards several months in
advance. There is
nothing mysterious about it; I used the 10 “basic” fundamental rules
of security analysis which we have posted on our website
www.wfin.net under
the article entitled “The Ten Rules On How To Avoid The Next Enron.”
Since the principal did not explicitly relate to Enron, it was not
included as one of our “basic” investment tools.
Based on recent market conditions, notably the
credit freeze, we feel compelled to amending that list, adding an
11th rule:
“Interest means very little when principal is
at risk.”
This guideline was given to me by my mentor at
Standard & Poor’s
(...forget the year, it’s not important), Al
Copeland, a very wise and hardened analyst.
For Wall Streeters this rule is self-evident, for neophytes
it bears elaboration.
It simply means that when investors and lenders perceive that their
investments and loans are at serious risk, the rate of return
(interest, dividends) should be disregarded.
Certainly this is a variable underlying the current lending
seize-up at the interbank and retail levels.
The preservation of capital, regardless of the
rate of return offered, has been taken to heart anew by banks. This
principle is diametrically opposed to the conventional Wall Street
wisdom that “everything has a price” which, to investor dismay, has
been seriously challenged if not disproved.<
To anonymous: I give you the following Yiddish
proverb, “Truth is the safest lie.”
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