Do you spend time researching companies to invest in? Where do you start? It is imperative that you research companies before you consider investing in them!
Remember that investing in a company is equivalent to owning a part of it. Diligent investors may have an own 'style' of researching companies which could very well be different to mine but at the end of the day they all do plenty of background company research. To start with learn how to read a balance sheet and pay attention to the amount of money a company has in the bank and its levels of debt. In the tumultuous times we are experiencing when revenues are down and credit is hard to get cash in the bank is king. Find out what is the minimum the company needs to survive a slowdown. There are companies out there with net cash and you just have to find them.
The Altman-Z score comes in handy here as this shows the probability of a company entering bankruptcy within the next 2 years. The higher the Z score, the lower the probability of bankruptcy. An Altman score above 3 indicates that bankruptcy is unlikely; a score below 1.8 indicates that bankruptcy is a distinct possibility.
Anna Couling gives a few useful tips here on analysing a company's accounts: Pay close attention to the strength of the company's entire balance sheet which includes a look at a company's cash flow statement. This 12 month summary of a company's cash inflows and outflows should enable you to answer three critical questions: Where is the bulk of the cash coming from? Companies can boost short-term cash flow by borrowing or selling assets. However, there are only so many assets that can be sold and without a regular inflow on cash a company will soon run into trouble. The number to look for is cash flow from operating activities this shows how much cash is generated from the company's core business activity. A negative number is a red flag and always check back a few years to see if there is any pattern. Highly volatile operating cash flows can suggest trouble Enron was a classic case in point before it failed.
A firm can also boost operating cash flows by delaying payments to suppliers just before the financial year end so it would be a good idea of check the notes that support the the cash flow figure (usually placed a few pages back) and look for the number showing change in creditors. If this number has jumped without a corresponding rise in activity cost of sales in the profit and loss account, be suspicious. It is also worth comparing the firms operating profit to its operating cash flow. Big variations, or an operating profit not matched by a similar amount of operating cash flow are both warning signs.
Where does all the operating cash flow go? Analysts tend to quote free cash flow which should generally be positive and ideally consistent with past years, allowing for changes in activity. For instance, if sales have decreased 10%, free cash flow will probably have fallen as well and should be in proportion. Companies such as Tesco have to-date been able to expand aggressively by using huge free cashflows to buy freehold sites. However, in cases where a company is reaping high levels of free cash flow but isn't expanding or paying it back to investors as a dividend you should be concerned. And do consider the link between free cash flow and the equity dividend. If free cash flow does not cover the dividend by at least a factor of two, future payouts may be at risk.
Lastly, do take a look at the cashflows from financing activities section. Just as you would not extend your mortgage to pay for day-to-day living, a typical bankruptcy candidate will raise long term finance as new debt or equity and then use it to keep trading. So do compare the total amount the company has raised as debt or equity in the cash flows from financing activities section and the amount which is being spent on new assets in the cash flows from investing activities above it. A big mismatch with no explanation from directors is another warning sign.
For my part I network and research heavily and that is my style. I speak to the directors, target company competitors, fund managers, brokers, analysts and other researchers, you name it I will speak to them to try and find out what is happening in the market. Sometimes I even research/screen companies to invest in by meeting some of the employees at local bars. I do not trade on any sensitive information but I will get as close as possible to finding out essential information that is fair and reasonable for me as an investor and owner of a company. I occasionally have to remind a director that I own the company and they are employees...but that is rare. Anyone who has seen me asking questions at an annual general meeting will know that I am prepared to ask very awkward questions for the benefit of all shareholders. I may not be popular and some directors are wary of my investigative questioning but I do in the main report my findings for everyone. My actions are not those of a 'pump and dump' merchant.
Researching a company may take a little of your time but the results are often worthwhile. Share prices in some sector are often inter-linked and poor performance from one firm can forewarn us of negative developments in other shares in the same sector.
Below is a quick checklist for you to work through before you trade:
Speak to the girls on the checkouts in the supermarkets; they know what sales have been like! As far as retailers go a friend ex-retailer of mine once told me that if you wanted to know how many people are buying you need to look for carrier bags that people walking around have with them. I went to Westfield last friday. Great place. Huge number of people walking around (and eating in the 45 restaurants) but not many bags so they are clearly not shopping. BC is nowhere near as busy as usual for this time of year. Retail is brutal at the moment with very few able to buck the trend. One small high street chain I know was down 40% like for like last week. Only the fittest will survive. So carrier bags are a quick indicator we can all see without any spin or media hype. My wife has been saying for months that the shops are crowded but the checkouts are not - another indicator.
Recessions...Choose your sectors carefully. For instance the recession we are experiencing has been born out of broken banking which in turn has led to weaker consumer spending, the obvious red flag sectors will be: consumer cyclical, home building, construction, banks and retailing. History tells us that better performing sectors will be food, brewing, tobacco, utilities and healthcare.
High street retailers have traditionally suffered in recessionary periods. However, not all stand to suffer (or suffer equally) as shoppers are more likely to seek cheaper products so will resort to discounters like Tesco, Morrisons or TK Maxx. Retailers servicing the higher end of the market or offering luxury products are likely to suffer more as is the case with Marks and Spencer, PPR (which owns Gucci) or Whole Foods. Companies offering big retailer buys such as plasma screens are also likely to suffer more and people cut on the spending.
Let's take a look at the 2.5% questionable cut in VAT. The appetite for UK bonds is diminishing, the value of the £ has fallen dramatically against the $ and €, and will fall further due to the impending borrowing. Owners of manufacturing companies in the UK source numerous components from China, similarly most Vatable goods in the UK are made abroad and brought in, purchased in you have guessed it US$. So the costs of the goods to the retailer has already increased over the last 2-3 months by 25% and likely to be more expensive in the future due to the £12bn give away affecting the exchange rate further meaning that UK manufacturers are likely to suffer further.
When metal prices drop, as they have in recent times, then expect mining stocks to be marked down. Keep an eye on government legislation, had you spotted last year's new legislation on tightening up the Health and Safety Laws on men working at heights, you might have doubled your money had you invested in Latchways. When the US decided to 'liberate' Iraq, ask yourself who is likely to benefit? Firstly, those companies that make "body armour" and who are they? - Ceradyne a US ceramics company. Another benficiary has been the Portsmouth based Chemring who make pyrotechnic decoy flares - their share price has doubled! Look out for emerging new trends, e.g LNG (liquefied natural gas) we are on the verge of an explosion in demand for LNG - now check out Hamworth! Another example is Tanfield -electric hydrids, Mr Brown has applied yet another tax or levy to fuel which will help Tanfield. Think Fuel Cells, in particular solid oxide fuel cells- think Ceres Power, this year could see them move sharply! For sheer efficiency, innovative vision and customer satisfaction- think Toyota, Honda. For climate change think solar PV, hydrogen infrastructures, nuclear power and PEM fuel cells-now look at Q-Cells (Tech Dax) or Energy Conversion Devices (Nasdaq); for fuel cells, Johnson Matthey , Porvair; Linde Ag for hydrogen infrastructures, Toshiba for nuclear, and so forth.
A few other random thoughts on commodities. PVCS is on my radar because solar energy isn't going away (despite my view it's a red-herring in the UK, clearly that's not the case for half the planet). Just as a PC used to have 64k memory and cost £4k, so the cost the solar power will come down...and perhaps it could eventually be used in cars etc. The recession/depression will slow things down but the sun is going nowhere. Biofuels are a red-herring; they will be finished within 20 years as we realise the scale of devastation on the environment. Nuclear is good until Uranium runs out. So in the end the Northern Hemisphere will just put up a 'for sale' sign and move to the South...unless of course someone can figure an efficient method of moving the sun's power to The North. Even more ideas on researching stocks are discussed in this section.