Generation Y Investor » Education

Researching Stocks: Finding Shareholder Friendly Companies

Stephen Kline — Fri, 30 Oct 2009 01:26:24 +0000

This is the second of a series of posts dedicated to properly researching stocks. In my previous post, I examined how to calculate a company’s free cash flow. Today, I’m going to show you how to determine if that cash flow will be put to good use. The company you’re researching can be profitable, efficient and financially sound, however, if it’s not run in a shareholder friendly manner then it’s probably not worthy of your investment.

What’s a shareholder friendly company?

A business that is shareholder friendly always operates with the shareholder’s best interests at heart. They tend to be lead by competent managers who communicate openly and routinely reward investors. Businesses that exhibit these three traits are more likely to have favorable long term investment returns than their counterparts. Let us examine these traits in further detail…

Competent Management

The number one trait that shareholder friendly companies have is a team of great managers running the business. Determining whether or not management is competent can be a subjective process. After all, there are no hard numbers you can crunch to figure this out. Instead you have to look at other more subtle details like experience level and motivation.

Your initial step should be to research the company’s top executives. These are the folks leading the business and making all the major decisions. Are any of these individuals original founders of the company ? Have they been at the firm for 20 or 30 years? If so, then you probably have a group of managers who are knowledgeable and dedicated to the company. If the CEO or Chairman is new to the firm then do they at least have years of industry experience? There’s nothing worse than a CEO who doesn’t understand his own operating environment.

Once you check out the experience level of the management, you need to ensure their motivations are aligned with yours. Does the company have a high level of insider ownership? If so, you can be sure that those running the business want the stock to go up just as much as you do. Another thing to check out is the level of insider buying vs selling. Nothing inspires confidence more than when the CEO is buying shares on the open market. Conversely, if top management is dumping share after share one must question the company’s future prospects.

Open Communication

Your next step on your quest to find shareholder friendly companies is to look at how management communicates with investors. Shareholder friendly businesses go out of their way to be open and honest with investors. Listen to the latest quarterly conference call. Does management discuss bad news as openly as good news? Or do they try and dodge the tough questions when they’re asked? Is there any vagueness or attempt to hide important facts? If that’s the case, please recognize that Bernie Madoff and Ken Lay were the same way.

Rewards Shareholders

The last step in the process is checking to see if the company uses its cash to reward investors. This can be done either by paying dividends or buying back shares. Check out the company’s dividend history. Do they have a long history of paying dividends? If they pay a dividend, do they routinely increase the amount? The answer to these questions tell a lot about management’s feelings toward sharing the wealth.

In addition to checking the dividends, explore whether or not the company has a stock repurchase plan. You can find this information in the 10K and 10Q filings. If there is a repurchase plan, check here to see if the plan is actually decreasing the number of shares outstanding. Sometimes repurchase plans are enacted to offset share dilution caused by overly generous stock compensation plans. If outstanding shares are decreasing year after year it’s a great sign that management is committed to increasing the stock’s price.

As you can see, determining if a company is shareholder friendly can be an involved process. However, if you use this guide and answer the questions I’ve pointed out, you’ll be able to rest easy knowing your money is invested in rewarding enterprise. If you enjoyed todays post, please stay tuned to for my next post in the Researching Stocks series which should be out shortly.

Don’t Ignore Risk

Stephen Kline — Fri, 23 Oct 2009 21:19:30 +0000

I’m always reading articles and listening to “financial gurus” who tell individuals ***with extra money*** not to pay down low interest rate debt. Instead, the expert advises paying the minimum on mortgages and student loans so the difference can be invested in stocks. In theory, this will give the individual greater returns, as the stock markets historical average of 10% trumps prepaying the lower interest debt. On the surface this advice sounds logical, and perhaps even financially sophisticated; however, proponents of this method are completely ignoring risk.

By taking extra money and investing it in the stock market, one is forgoing a risk-free return on their money in favor of an investment that’s inherently risky. This isn’t necessarily a bad thing, provided that the investor understands that the potential for greater returns comes at the expense of increased risk to their hard-earned capital. Only by dialing up the risk do we up the potential for higher returns. This is the reason comparing the long-term return of stocks to the risk-free return of prepaying a loan is unwise. Instead, I suggest comparing the loan prepayment return to that of another risk-free investment such as a treasury bond or CD. When you make an apples to apples comparison you’ll see that prepaying the loan isn’t such a bad choice.

Remember, most of the truly disastrous financial mishaps in history were caused as a direct result of ignoring risk. If risk was accounted for properly on Wall Street and Washington we wouldn’t be in our current situation. Always be sure that you understand the risks before making a financial decision.

***This post is referring to individuals who are already fulfilling their financial obligations (i.e.: they have no high-interest debt, have an emergency fund, and are already contributing to retirement accounts.) Thus they are asking what to do with additional free cash from earnings or perhaps even a windfall such as an inheritance***

How Not To Invest For Retirement

Stephen Kline — Thu, 22 Oct 2009 23:00:55 +0000

Successful investing isn’t easy. In addition to having a basic level of financial competency, successful investors must also exhibit a high degree of discipline and emotional control. Without all three of these characteristics an investor’s returns are likely to disappoint. After all, one can be as financially astute as Warren Buffett or George Soros; however, if he or she lacks the emotional control and poise to go against the herd then they’ll never have great success.

As a case study, I bring you the story of The Simkin family: Getting back on the retirement horse

“Jason and Patty Simkins, both 40, have saved next to nothing for retirement in the past year. They were rattled by the rocky market, which caused the value of their portfolio to tumble 40% at its low point.”

“So when Jason switched jobs last fall… he neglected his new 401(k). Saying, “I didn’t want to throw money into it if it was just going to be lost.”

“But now they’re disappointed to have missed out on additional gains from the market’s rebound.”

“Realizing they need to catch up on retirement (and, with two kids, save for college), they’re ready to put a toe back in the water.”

I think all of us can relate to The Simkin’s story. Last year as the markets were being pummeled day after day, even the most iron-willed of us surely contemplated exiting the markets, or at the very least stopping our ongoing contributions. The problem with this, as the Simkins indicated, is that they’ve consequently missed out on the juicy 60% returns the market has put in since bottoming. Now, only after this enormous rally, are they looking to restart their retirement plan contributions. This my friends is not the modus operandi of successful investors.

Instead, I offer the following plan to passive retirement investors…

First, familiarize yourself with the concept of asset allocation. Once familiarized, develop a diversified asset allocation that coincides with your risk tolerance and time horizon. (note: you’re probably less risk tolerant than you think)

Second, contribute to your retirement accounts using a dollar-cost averaging plan. This entails investing a fixed amount of money on a monthly or per paycheck basis. These contributions should match the asset allocation you created in step one.

Third, every quarter check up on your portfolio and revisit your asset allocation. Are your current holdings in-line with your plan? If not, rebalance your portfolio so it isn’t too aggressive or conservative.

Finally, once every year you need to reexamine your risk tolerance and time horizon. If they’ve changed, chances are you need to modify your asset allocation.

There you have it. Following these simple steps will give you a disciplined financial plan that you can implement in an emotionless manner. Give it a try and your odds of being a successful long-term investor are high.

Researching Stocks: Calculating Free Cash Flow

Stephen Kline — Sat, 17 Oct 2009 01:16:30 +0000

Today is the first of a series of posts dedicated to properly researching stocks. As you’re probably aware, it’s always important to do proper research on a company before purchasing shares of its stock. Buying a stock without doing your homework is akin to jumping into the cockpit of a plane without proper training. In either situation, you’re bound to get hurt.

What is free cash flow?

Free cash flow is one of the greatest ways to measure the profitability of a company’s business. Put simply, free cash flow is the money that a business has left over after paying employees, expenses, debt, taxes and capital expenditures. Free cash flow is often used to measure profits because it is harder to manipulate than earnings per share or net income. It is also excellent at communicating the degree to which a company can reward its shareholders via dividends and share buybacks.

How do you calculate it?

In order to calculate the free cash flow of a company you need a copy of their statement of cash flows. Luckily this information is easy to find and can be accessed in the firm’s 10-Q and 10-K filings. You can also find this quickly at Yahoo Finance. I’ll now run through an example with one of my current investments…below is the cash flow statement for Heinz (HNZ)…

Once you have the statement of cash flows handy, calculating free cash flow is an easy task. The formula goes like this…

Free cash flow = Cash flow from operations - Capital expenditures

Here’s what Heinz’s free cash flow has looked like over that past three years…

How can you use it?

Once you’ve calculated the free cash flow of a potential investment you want to look at a variety of things. First, is the number positive or negative? And is it increasing over time? Or decreasing? Any company worthy of your investment dollars should have a strongly positive number that is increasing over time. Obviously companies can have a bad quarter or year once in a while, so you’ll need to use your discretion here.

Next, compare the number you calculated to the amount the company pays out in dividends and stock buybacks. If the company is paying more out in dividends and buybacks than it’s generating in cash flow you may have a problem. Ideally you want to see that the business has excess cash flow that it can use to increase dividends and buybacks in the future.

Finally, look at the total amount of long-term debt on the company’s balance sheet. Assuming that the company’s cash flow remains the same in the future, calculate how long it would take for the company to pay off all its debt. The quicker they could pay off their debt the better. This is going to give you an idea of the business’s financial strength and ability to weather a downturn.

If your potential investment passes the free cash flow test than it’s certainly deserving of further consideration. Stay tuned for my next post in the Researching Stocks series where I’ll be showing you how to determine the shareholder friendliness of a business’s management. After all, what’s the point of investing in a business with great free cash flow if the company’s management isn’t going to share the wealth?

Benjamin Graham’s Advice For Young Investors

Stephen Kline — Tue, 25 Aug 2009 01:25:58 +0000

I’m in the process of re-reading The Intelligent Investor and found some words of wisdom from Ben Graham to young investors. In his chapter entitled, “The Defensive Investor and Common Stocks” Graham states…

Let us not ignore human nature at this point. Finance has a fascination for many bright young people with limited means. They would like to be both intelligent and enterprising in the placement of their savings, even though investment income is much less important to them than their salaries. This attitude is all to the good. There is a great advantage for the young capitalist to begin his financial education and experience early. If he is going to operate as an aggressive investor he is certain to make some mistakes and to take some losses. Youth can stand these disappointments and profit by them. We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgement on price versus value with the smallest possible sums.

This is some great advice if you ask me. I’m a big proponent of investing on your own, and think that everyone should always start out small. For my own investments I have a two pronged approach… For my retirement accounts, I follow Graham’s advice in that I don’t try to beat the market. Instead, I use a portfolio of index funds that I rebalance whenever my asset allocation is out of whack. This conservative route for my retirement accounts is then balanced out by my discretionary portfolio that is comprised mainly of individual dividend paying stocks. I like this system because I know my retirement funds will never receive less than the market return and yet I can still try to outperform the market by picking my own stocks with my discretionary funds.

How Long Will This Rally Last?

Stephen Kline — Sat, 22 Aug 2009 15:01:03 +0000

The markets have been in a sustained rally since hitting the March lows. Since that time, the S&P 500 has climbed more than 50% from the bottom. While we’ve seen some noticeable improvement in the economy since than, there are still many ominous signs that make me weary.

Firstly, second quarter earnings were largely viewed as a success. The majority of S&P 500 companies managed to beat analyst’s earnings estimates. This is a good thing. However, the majority of these earnings beats were due to cutting costs rather than better than expected revenues. All in all this isn’t necessarily a bad thing, provided that top-line revenues begin to increase in the upcoming months. If revenues don’t begin to increase, than one had to question how long firms can continue cutting costs to drive earnings.

My second reason for being cautious right now is the high degree of bullishness on the housing market. Recent data has indicated home sales have increased significantly month over month and many have claimed that the housing market is beginning to bottom out. This bullishness seems unwarranted to me because only the low priced homes are seeing an increase in sales/price (think foreclosures). The mid to high end of the housing market is still stagnant and prices have nowhere to go but down.

Another reason to be bearish on housing is the first time homeowners credit. Towards the peak of the housing bubble our country saw the greatest percentage of Americans in history own their own home. Put in a different perspective, we had the fewest percentage of potential first time buyers in history because everyone who wanted a home had already purchases one. Yes there is a good portion of people right now who were/are looking to purchase a home. However, most of these people are rushing to close on homes right now in order to take advantage of the government credit.

At first you may think this is a good thing. But in reality all the first time buyers credit is doing is front-loading all the potential demand for housing that’s left (aka stealing from future demand). I wouldn’t be surprised to see housing take another leg down starting in November/December after the credit has ended and demand from first time buyers wanes. (Note: A similar argument can be made about the cash for clunkers program front-loading demand for new vehicles).

My final reason to question the extent of this rally is that it’s being fueled largely by hedge funds and institutional buyers who are being forced to buy stocks because they were under invested at the bottom. When you’re running a hedge fund or mutual fund your investors are always comparing your returns to those of other hedge funds and mutual funds. Therefore, if you were sitting in cash and missed the huge rally since March you’re going to desperately try and catch up to your peers who have benefited from the rally.

So despite some improvement in the economy since the lows, I still feel the need to advise caution. I wouldn’t recommend selling all your stocks and hiding under your bed. Just as I wouldn’t recommend jumping full steam onto this rally. Make sure you have a proper asset allocation that matches your risk tolerance. Also, take a look at your current asset allocation and make sure it’s inline with your target allocation. The big rally of the past few months may have caused your portfolio to become over-allocated towards stocks. If this is the case, rebalance your portfolio by selling some stocks and buying bonds or redirect new contributions into your fixed income investments.

Above all, remain vigilant and cautious about this or any other rally in the stock market. Remember, risk goes up as stock prices increase. Don’t become complacent.

Three Finance Rules From Warren Buffett

Stephen Kline — Sat, 11 Jul 2009 02:16:02 +0000

In a recent interview Warren Buffett was asked for his “top three pieces of advice for average Americans who want to grow their savings and keep their money safe.” Here’s what he said…

If it seems too good to be true… it probably is
Always look at how much the other guy is making when he is trying to sell you something.
Stay away from leverage…. Nobody ever goes broke that doesn’t owe money.

You can view the whole interview here…

U.S. Could Lose AAA Rating

Stephen Kline — Fri, 22 May 2009 14:25:59 +0000

Here’s a short clip that has Bill Gross talking about the possibility of a U.S. debt downgrade in the near future. A debt downgrade would increase the cost the U.S. has to pay to borrow money. It would also have a negative impact on the value of the dollar which would lead to inflation. I guess we’re going to have to pay for all this government spending somehow…

In the meantime, protect yourself by avoiding U.S. Treasuries like the plague. Look for quality dividend paying stocks that have significant overseas revenue. If the dollar continues to decline this will give these companies a currency exchange boost.

The Real Cause Of Tuition Inflation

Stephen Kline — Wed, 22 Apr 2009 00:24:20 +0000

Every Gen Yer knows that there’s been a steady increase in the cost of college tuition in recent years. This tuition inflation is one of the greatest threats to the financial security of our generation. Instead of graduating college with a degree and a clean financial slate students are being saddled with thousands of dollars in student loans. Some of these loans can take up to a decade to payoff.

The cause over the dramatic increase is often debated, but the guys over at the Freakonomics blog seem to offer a good explanation in this post.