16 Ways of Looking at
a Stock Prospect
How a leading value investor
makes his picks.

 

By Christopher H. Browne | The time to buy stocks is when they are on sale, and not when they are high priced because everyone wants to own them. I have been investing for myself and clients for more than 30 years, and buying stocks when they are cheap—known as value investing—has for me been the best way to grow my money. Stocks of good companies on sale reaped the highest returns. They have beaten both the market and the more glamorous and exciting issues—growth stocks, in financial-world parlance—being chatted about at cocktail parties or around the water cooler at work.

Book value, cheap earnings, balance-sheet analysis—all these metrics are key to identifying good prospects. But if successful investing was as simple as a mathematical formula, everyone would have nothing but winners in their portfolios. There is some art to identifying the best prospects, and so you should analyze your list of companies in greater detail. Getting answers to these questions will give you a more in-depth knowledge of a company and its potential as a successful investment.

1. Can the company raise prices? For years, Philip Morris could raise the price of a pack of cigarettes pretty much whenever it wanted. At one point, Harley Davidson could price its motorcycles at a premium to its competitors because demand was so strong. Technology companies, however, are in a highly competitive environment that makes it difficult to raise prices (there is another computer company around every corner ready to lower prices). The same holds true for grocery businesses. The less competition in an industry, the easier it is to increase prices.

2. Can the company sell more? The simplest way to raise the bottom line is to sell more products or services. However, it is important to make sure that increased sales are not done through incentives or giveaways. In 2005, U.S. auto companies saw booming sales but they made little if any money off the increase in revenues. The friends and family pricing programs being offered to everyone hurt profit margins.

3. Can the company increase profits on existing sales? If it is not possible to sell more, is it possible to squeeze more profit out of what is already being sold? Many of the major media companies have been diversifying away from the mainline newspaper business as circulation flattens and ad sales decrease. Companies like the New York Times and the Tribune Company are looking to increase their presence in the more profitable online world to boost overall margins and revenues. Wal-Mart never hesitates to change suppliers if it will squeeze extra profit out of a particular product line.

4. Can the company control expenses? All too often, companies let expenses get out of control and it becomes necessary to make cutbacks to restore profitability. Every dollar saved, whether in the price of paper clips or healthcare costs, flows to the bottom line and helps to restore profitability.

5. If the company does raise sales, how much of it will fall to the bottom line? Often the cost of gaining revenue and market share can actually cause profit margins to fall or even reduce a company’s profits. This frequently happens in technology companies where the cost of gaining business may exceed the profit potential of the business. On the flip side, Wal-Mart and Harley Davidson are great examples of companies that have maintained tremendous revenue growth while holding or even increasing their pretax profit margins.

6. Can the company be as profitable as it used to be, or at least as profitable as its competitors? Often I will see a company where the profit margin falls well below previous levels. If this is due to a temporary problem, the company should regain its profitability. It may have stumbled due to management error, a new product that bombed in the marketplace, or expenses that temporarily got out of control. The reason for falling profits could be external—a rise in interest rates or, as I am seeing today, rising energy or raw material costs that cut into the bottom line of many companies. Once you determine the cause, you can decide whether the problem can be fixed and profits restored to previous levels.

7. Does the company have one-time expenses that will not have to be paid in the future? Often you will find situations where earnings are temporarily depressed by a one-time expense or charge. These could be costs associated with a merger or acquisition, or the closing of a factory. Other one-time charges include the costs of lawsuits such as seen with tobacco and firearms companies, or the closing of unprofitable divisions. If it is truly a one-time expense, one can assume that earnings will return to prior levels and the stock could rise.

8. Does the company have unprofitable operations they can shed? Getting rid of the money-losing operations in many cases is all the catalyst a company needs to see substantial gains in the price of its stock.

9. Is the company comfortable with Wall Street earnings estimates? Although I rely very little on the estimates when looking for stocks or estimating their value, I like to know if management is comfortable with the earnings estimates the Street is making. If they feel they are too high or too low, I know that missing the earnings will likely cause the stock price to fall, while exceeding the estimate will often cause the price to move higher.

10. How much can the company grow over the next five years? The confidence, or lack thereof, of management in its ability to grow the business gives me a good idea of how much the stock could be expected to rise from depressed levels. I want to know how the company intends to achieve that growth as well.  Growing revenues alone is not enough if those revenues aren’t generating additional profits.

11. What will the company do with the excess cash generated by the business? Every dollar of profit not given to shareholders in the form of dividends will be retained by the company. The proper use of the excess cash flow can add substantially to corporate earnings and increase profit in the years ahead, which bodes well for the stock price. Poor use of the money could result in falling margins and returns.

12. What does the company expect its competitors to do? The expansion plans of Lowe’s have a huge impact on the results at Home Depot. The growth plans of Wal-Mart are very bad news for major grocery-store chains. When one auto company decides to use incentives and rebates to spur sales, all of them have to respond in similar fashion or risk losing sales. If Pepsi introduces a wildly successful new drink concoction, Coca-Cola may have to spend some money to create a competing version or lose market share. As no man is an island, neither does any company operate in a vacuum. It has competition that is out to take away sales and profits.

13. How does the company compare financially with other companies in the same business? Does the competition earn the same returns on capital? Does the company have more or less debt than its peers? If it owes a lot more money than direct competitors, the cost of servicing the debt may prevent it from keeping up in the years ahead. How does the marketplace value the company? Why does Heinz sell at 20 times earnings when Kraft sells for just 15? What do other investors see that I may be missing?

14. What would the company be worth if it were sold? This question has become more and more important in the day-to-day business of evaluating stocks. Anytime I consider a stock, I look to see at what level of earnings and book value recent takeovers and division sales have occurred.

15. Does the company plan to buy back stock? I look to see if the company announced a buyback and check the quarter-over-quarter shares outstanding to see if it is actually buying stock. Not all announcements of intention to buy back stock are implemented. Further, many buybacks are done just to offset stock and option grants. I want to see if there will be a real reduction of shares outstanding.

16. What are the insiders doing? An occasional sale by an insider may mean nothing; consistent sales by many officers and directors are a clear indication that management thinks the marketplace has put too high a value on the company, and they are getting out while the getting is good.

By going through this checklist, I come away with a much better understanding of the companies that pass my initial tests for value. I can see which companies are likely to increase their stock price by growing their business and controlling expenses. I can determine the faith of management in the future of the company. The stocks that pass through these questions and have a favorable potential for growth are the ones that make their way into my portfolio.

Christopher H. Browne C’69 is a managing director of Tweedy, Browne Company LLC and president of the Tweedy, Browne Funds. This essay is excerpted with permission of the publisher John Wiley & Sons, Inc. from The Little Book of Value Investing. Copyright © 2006 by Christopher H. Browne. This book is available at all bookstores, online booksellers and from the Wiley website at www.wiley.com, or call 1-800-225-5945.

 


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