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StockCentral :: Community
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Join in on the discussion with other like-minded investors in our community forums. Learn about the fundamental investing methodology and participate in educational workshops in the Investing forums, stay up-to-date on StockCentral news and make suggestions to the StockCentral team in Central Square, and discuss your favorite stock or recent market news in our A-Z ticker-based forums.
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Doug Gerlach
Cambridge, MA
http://www.iclub.com/
President, ICLUBcentral
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| 02/27/2007 10:44 PM |
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Today, we're going to turn to what is often the most complicated component of portfolio management:
5. Identify the low-quality stocks that may threaten your portfolio.
Conventional wisdom holds that stocks with "deteriorating fundamentals" should be sold. Unfortunately, many experts don't really go much further in explaining what those factors would be. But I'll review a few more concrete warning signs that you can consider in your evaluation.
The simplest way to define "deteriorating fundamentals" is if the company's recent performance is heading in opposite directions from the reasons that you made you like the company in the first place. Look at it this way: when you analyze the stock in Investor's Toolkit, you make certain assumptions about how the company's earnings, sales, and profits will grow. If the company grows at a slower rate in a recent quarter than you've projected it would grow over the next few years -- or, worse, if it grows at a negative rate -- how long can that trend continue before your company is no longer a growth company? This is why the Toolkit Defense Alerts screen highlights companies whose quarterly EPS, Revenues, or Pre-Tax Profits come in below your estimates -- to alert you to potential problems.
What other kinds of problems might be a sign of declining quality in the companies that you own? Let's start with an easy one.
If a company that you own is cited for fraud or "accounting irregularities," if the CEO or other officer is led away in handcuffs, or if you have any questions whatsoever about the honesty of company management, then the decision about selling that company shouldn't be hard -- sell the stock and move on. These are not signs of high quality, and you'll do better without these stocks. Even if the company brings in new management, you're still left with a company that has lots of problems and a management team that hasn't proven that they can drive the business forward (not to mention resuscitate it).
Another relatively straightforward reason to sell is due to significant changes in senior management. If several key executives leave en masse, that may be a sign that trouble is brewing beneath the surface. If a dynamic company leader leaves and there is no clear candidate to take his or her place, that could also be a sign of trouble. And, as in the last paragraph, indictments handed down against company executives are always a concern. While these changes may not be the sole reason that you dump a stock, they should be considered as clearly negative, and coupled with other factors may tip the balance and help you decide to sell.
One rule of thumb taught by Ralph Seger is to vigilantly watch the quarterly profit margins for the companies in your portfolio. The PERT graph and worksheet that he developed help you to keep tabs on the growth rate of a company's pre-tax profits. According to Ralph, a company that displays three consecutive quarters of slowing pre-tax profit growth is a candidate for selling; a company that has five consecutive quarters of declining PTP growth is an automatic sale (if you've waited that long). Ralph would rather err on the side of selling too soon than too late -- a disadvantage of holding on too long is that once you've discovered that the "temporary" problem is really not so temporary, you may have to hold on for several years before the company recovers. Over time, you'll also notice that a stock that's seen three quarters of consecutive bad news will take a beating -- but it's nothing compared to the trouncing it will take after more than a year of bad tidings. Selling sooner rather than later can prevent your portfolio from taking a trouncing too, and even if the stock recovers, you'd have likely invested in a company of higher quality and return in the mean time so you still come out ahead.
Another indicator of declining quality is the appearance of direct or indirect competition that stands to affect the company's long-term prosperity. This will most likely manifest in the company's declining profit margins as the company reduces retail prices, increases marketing, or cuts general and administrative expenses in the face of an aggressive competitor. Short-term, the competitive pressures can cause some pain, but if the company can't respond, then long-term agony will result. (This is a good opportunity for you to take a look at a possible new candidate for your portfolio, as well.)
Pharmaceutical companies in particular are subject to product cycles that are predictable and often troublesome. Drug makers make the bulk of their profits from products that are protected by patent and thus can't be sold by other companies. When those patents expire, however, any drug maker can manufacture generic versions of the drug, and the monopoly is put to rest. When you analyze these companies, you can find out when significant patents are set to expire, and if the company doesn't have lots of candidates in the long process of FDA testing and approval, then they'll suffer when sales plummet. Any company that's dependent on a single product may not be a good long-term candidate, anyway.
A company that can't control its raw material costs is another sign of diminishing quality. The price of coffee beans is a significant factor for a coffee bar chain; bad weather that decimates a year's crops can have a significant effect on that company's profits. You'll often see companies that depend on commodities engage in hedging, long-term contracts, and even ownership of the production of their required raw materials, all in order to exert more control over their own costs.
On a company's balance sheet, factors like increasing long-term debt, receivables, or inventories can be other signs of impending trouble. Declining cash flow is another potential hot spot. All of these require some research to determine what's causing the downturn and whether the nature of the problem is likely to be short-term or take longer to resolve.
It's important to be aware of all of these potential problems as you perform your regular portfolio reviews. Some things will only become apparent when you perform a quarterly update of the financials, while others will instantly be obvious as a problem, enabling you to identify quality issues before they become quality quandaries.
One final warning -- there is a flaw with the SSG in that the worse a company performs in the short-term, the better a value it will appear on the long-term oriented SSG. Once bad news hits, every other investor knows about the problem, and the stock's price falls. But on the SSG, the historical growth rates and current P/E ratios make the stock appear to be a screaming bargain, even though the future is certainly less sunny.
Once you've identified stocks that may be of lower quality than you desire, you don't have to worry about replacing those stocks; instead, you can simply get rid of them right away. There are always plenty of opportunities in the market, and holding onto uncertain, low quality companies can only hinder your portfolio's overall performance.
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Posting from ICLUBcentral world headquarters in the Harvard Square's historic College House, Cambridge, MA
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Danny Matthews
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| 02/28/2007 12:24 PM |
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One final warning -- there is a flaw with the SSG in that the worse a company performs in the short-term, the better a value it will appear on the long-term oriented SSG. Once bad news hits, every other investor knows about the problem, and the stock's price falls. But on the SSG, the historical growth rates and current P/E ratios make the stock appear to be a screaming bargain, even though the future is certainly less sunny.
This is a great point and goes to the saying that the SSG tells you 80% of what you need to know. Even though the SSG gives you a complete snapshot of the last ten years one needs to read the stories behind the numbers to really see why they are creating the "screaming" bargain. Great point...not me, you, thanks Doug. |
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Danny Matthews
Tuscola IL |
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R. Ann Bliss
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| 03/01/2007 10:08 PM |
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Doug:
I have heard the comment you made about the SSG before. There is a 'hot key' that will tell the investor what the return on equity has been for the last four quarters. That's Alt R. The numbers change in the 2B row. Is this not an indicator for current/quarterly information? That's kind of how I have been reading it.
Then, there is always the upper left drop-down that gives one the choice of seeing the PERT A information. There, the quarterly information is given on sales, PTP and earnings. Will either of these satisfy the quest for true info?
Great series. I'm eatin' it up. Thanks tons!!
Annie Bliss, LLIPS |
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