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Dozens of companies failed in
recent years, leaving their shareholders with nothing.
So it behooves us to do our
homework to ensure that we’re not holding the next financial basket
case. But the last thing most of us want to do is spend hours poring
over financial statements.
Here’s the good news: You don’t
have to.
I found that a few simple tests
would have helped investors avoid most, if not all, of the stocks
that went belly up. To develop the tests, I analyzed a bunch of
stocks, some in technology, and some not, that filed bankruptcy in
2001 and 2002. Then I compared them to stocks in the same industries
that survived and are still in business today.
Put away your calculator.
You can apply these tests using
readily available data -- and you don’t even need a calculator. I
call the stocks that pass these tests “bulletproof stocks.”
The bulletproof tests can be put to
work in two ways. You can check the suitability of specific stocks,
or you can use the bulletproof formula to come up with financially
strong candidates, suitable for further analysis from other
perspectives.
Before jumping into the tests,
let's lay the groundwork.
This is obvious, but worth saying:
All of the companies that I analyzed failed for the same reason.
They ran out of cash.
Some were recent startups that were
never profitable. That is, either their products cost more to make
than their customers paid, or they never sold much to begin with.
They started with tons of IPO cash, but failed when they burned
through their initial stash.
Others were long-established
companies that had built up high debt over the years. They failed
when the economy slowed, reducing their cash flow to the point where
it couldn’t cover the interest payments.
Don't get singed by the cash
burners. With that in mind, I
defined six tests that these cash burners can’t possibly meet. I’ll
describe each test, and I’ll use women’s clothing retailer
Christopher & Banks (CBK,
news,
msgs) to demonstrate the analysis.
We’ll start by looking at sales
data, which can be found on the
Company Report for Christopher & Banks.
Step No. 1: Selling pipedreams?
Many of the companies that went
bust had great stories to tell, but never sold much. So my first
requirement is that a company must be registering significant sales.
Otherwise, they must frequently raise new cash to meet expenses. How
much is enough?
Most public corporations count
sales in hundreds of millions, if not billions. I set the sales
minimum at $50 million to eliminate companies that can’t survive on
their own because they’re not selling anything.
You can see the last 12 months’
sales in the “Financials” section of the Company Report. Christopher
& Banks easily passed with $386 million in trailing twelve months (TTM)
sales.
Required: Minimum $50 million trailing
12 months' sales
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Step No. 2: Cash burners . . . not!
Operating cash flow is the money
that moves in or out of a company's bank accounts as a result of its
basic operations.
Negative cash flow, meaning cash is
flowing out, not in, at the very least signals that further
financial scrutiny is required. Simply by insisting on positive cash
flow, you significantly reduce your chances of picking a dud in
terms of financial health.
You can see a company’s operating
cash flow on its cash-flow statement, but because all we’re looking
for is positive cash flow, it’s easier to check the price-to-cash
flow ratio. The P/CF can only be positive when cash flow is
positive. You can see the P/CF ratio by clicking on “More Financial
Ratios” in the Fundamental Data section of the Company Report, and
then selecting “Price Ratios.” Christopher & Banks P/CF is 13.9,
signaling that Christopher & Banks’ cash flow is positive, so it
passes.
Required: Positive trailing 12 months'
operating cash flow |
Step No. 3: Shenanigans check
The positive cash-flow requirement,
in theory, eliminates cash burners. But some companies are creative
with their accounting, and cash flow alone is not a foolproof
indicator. Requiring that the company reported positive net income,
in addition to positive cash flow, helps to assure that the company
is, in fact, profitable.
The easiest way to confirm that the
company is profitable is by checking the Net Profit Margin figure in
the Fundamental Data section of the Company Report. Because profit
margin is net income divided by sales, the profit margin will only
be a positive number if the company reported positive net income.
Christopher & Banks, with a 10.8%
profit margin, passed.
So
far, we’ve determined that Christopher & Banks is recording
significant sales, is profitable and is producing cash, not burning
it. But passing those tests doesn’t mean that Christopher & Banks is
generating enough cash to service its debt.
Analyzing a company’s
debt-servicing ability is tricky business and doesn’t lend itself to
easy shortcuts. So I finesse the problem by sticking with low
debtors, so we don’t have to do the financial analysis.
First, we’ll check the company’s
cash situation vis-à-vis its immediate debts using both the current
ratio and the quick ratio, and then we’ll use the debt-to-equity
ratio to rule out companies with high long-term debt.
Required: Positive net income
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Step No. 4: No short-term cash crunch
Current ratio measures a company’s
working capital by comparing its current assets, namely cash,
accounts receivables (money due from customers) and inventories,
with its short-term debt. The ratio exceeds 1 when current assets
exceed short-term debt and is less than 1 when debt exceeds assets.
Requiring a 1.5 current ratio means that current assets exceed
current debt by at least 50%, evidence that the company isn’t facing
a looming cash crunch.
To see the current ratio, click on
“More Financial Ratios” in the Fundamental Data section of the
Company Report, and then select Financial Condition. Christopher &
Banks' 6.1 current ratio easily passes the test.
Required: Minimum 1.5 current ratio
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Step No. 5: Watch out for innovative
inventory counting
Working capital is called working
capital because it’s assumed that both of its non-cash components
(receivables and inventories) will convert to cash on a timely
basis.
But there’s always a chance that
the inventory figures are inflated with obsolete or unwanted
products that will never be sold. Quick ratio (QR) is similar to
current ratio, except that it counts only cash and accounts
receivables, not inventories. Requiring a 1.0 minimum quick ratio
assures that the company has enough cash to pay its bills, even
without considering inventory.
Quick ratio is listed right below
current ratio. Christopher & Banks’ 3.6 QR signals that it is flush
with cash and easily passes the test.
Since Christopher & Banks doesn’t
face any short-term cash problems, all that’s left to check is its
long-term debt.
Required: Minimum 1.0 quick ratio
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Step No. 6: Ax the high debtors
The debt-to-equity ratio compares a
company’s long-term debt with shareholder equity or book value.
Usually companies with D/E ratios below 0.5 are considered low debt.
But that figure can be misleading. Some companies list a portion of
their long-term liabilities in balance sheet entries that aren't
counted in the D/E ratio. Cutting the maximum acceptable D/E to 0.25
mitigates that problem.
You can see the D/E ratio on the
Company Report, which lists Christopher & Banks D/E as “NA” because
it doesn’t have any long-term debt. Needless to say, Christopher &
Banks passed this test, and thus, qualifies as a bulletproof stock.
Required: Maximum 0.25 debt/equity
ratio |
Try screening by industry.
I constructed a screen using MSN’s
Deluxe Screener that searches for stocks meeting all of the
bulletproof parameters. The bulletproof tests are very stringent and
err on the side of safety. Consequently, many financially strong but
high-debt companies, such as General Electric (GE,
news,
msgs), flunk the test. When I ran it, only 755 stocks qualified.
In my view, limiting the field to 700 or 800 candidates is a small
price to pay for avoiding the necessity of doing a detailed
balance-sheet analysis.
Because the screener can list just
200 stocks, you need to do your searches by industry. For example,
here’s a link to a screen listing bulletproof stocks in the
Applications Software industry. It's easy to change the Industry
Name parameter to see bulletproof stocks in other industries.
I’ve found that the bulletproof
test does a good job of eliminating bankruptcy candidates if their
bookkeeping is reasonably honest. However, it won’t protect you from
those that egregiously misrepresent their financial condition. Also,
the bulletproof tests won’t detect otherwise solvent companies that
file bankruptcy to avoid crippling lawsuits, such as those
associated with asbestos-related claims.
Passing the bulletproof test says
the company isn’t a financial basket case. That doesn’t mean that
you’ll make money owning its stock. As always, it's a place to start
your research. You still have to do your due diligence.
At the time of
publication, Harry Domash did not own or control shares in any of
the equities mentioned in this column.
Download 6-Step Quick Check Lists:
Click to download worksheet now:
Click to download extented worksheet now
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Technical Evaluations
to Eliminate
Bad Stocks
by: Paul Benkert |
The 6 quick test above is a great way
to remove stocks with questionable fundaments.
When you find a stock that passes all the above test,
then you need to do technical analysis to determine if
the stock should be added to your watch list.
A few technical test that I use to
evalute stocks are:
Technical Step 1:
Reward to Risk.
A Stock with a Reward to Risk of at least 2.00
or higher ensures that the stocks we choose have not
moved into overbought territory and still has plenty of
upside. This ratio is
explained in Tom Dorsey's book Point & Figure Charting
and is available to subscribers at
 Required:
Minimum 2.0
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Technical Step 2:
Price Objective. Price
Objective is a technical calculation to determine how
much upside a stock has in price. This number is
available for free at
This calculation is explained in
Tom Dorsey's book Point & Figure Charting and is
available to subscribers at
Required:
Should not be near or above the price objective
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Technical Step 3: Trend.
We are interested in stocks that are trending higher or
positive on their point and figure chart.
Negative trending stocks will lose you money.
Positive trending stocks tend to increase in value until
they reach or pass their Price Objectives.
Required: Positive trend.
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Technical Step 4: Support. Every
chart has either a support or resistance level.
Since we are interested in stocks that are trending
positive we need to know where the stock price currently
is relative to it's support number. Stocks that
violate (drop below) their support level are breaking
down technically and should be avoided for now.
Required: Above the support level.
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Technical Step 5: Relative Strength. Relative
Strength is a measure of a stock's price performance
compared to the market (usually the S&P 500).
Stocks prices with negative Relative Strength are
underperforming the S&P 500. Stocks with a
positive Relative Strength are rising in price faster
then the market averages. Required:
Oversold (OBw) |
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