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There’s No Magic Bullet
Posted by: David Chulak (IP Logged)
Date: February 14, 2012 09:43AM

No two stocks are identical. Walmart’s (WMT) market cap is larger than that of Target’s (TGT). Target has a lower price-to-book ratio and price-to-earnings ratio than Walmart’s. Walmart has a better return on assets and return on equity, but Target has better operating margins and net margins. Walmart, however, has less debt. The list goes on and on.

Investors are faced with choices such as this everyday and investing life would be much simpler if only the picture each company portrayed was much clearer and convincing as to which company each of us should invest in. Ultimately, investors must choose. There is no perfect check list, though I use one. There is no one metric or ratio to guarantee success, though I use many of them. In other words, there is no magic bullet that any guru, checklist, analyst, etc., can offer you so that you know that your stock will increase in price. Only time can do that, along with Mr. Market acknowledging what hopefully was a wise choice.

Every day, investors must make decisions and use their very best judgment. Many seek out that one magic bullet that will separate one stock from the other. If you like reading, you will discover that there are many more metrics or ratios for determining the quality of a stock you intend to investigate. Some are more important than others.

One of the most important and helpful devices is the actual study of the financial statements. I have a copy of Enron’s 2000 annual report and occasionally review it, almost as a study guide. Would I have seen the problems before the demise? I would certainly like to think so. Luckily, I never owned it and I
would like to believe that based upon their statements, I never would have. But what exactly are we looking for or what should you be looking for?

Search the Internet, read a book on investing or follow the Piotroski (F-Score) and you will discover that a key metric watched by investors everywhere is that operating cash flow exceed net income. But is it a magic bullet? This is only one of many metrics that an investor should use, but let’s investigate this one a little more closely. Those that have followed or used the Piotroski F-Score and done any back testing will see that operating cash flow greater than net income is one of the most important of the scoring. One of the reasons that this is important is because its more difficult to manipulate the numbers on the cash flow statement. Not impossible — just more difficult.



Above is a portion of Walmart’s cash flow statement. You will note that the top line of the cash flow statement begins with net income. The bottom line shown here is cash flow from operations and is how a statement should look in a perfect world. But alas, we don’t live in a perfect world and not all stocks have this clean of a statement.

Look at Hi-Tech Pharmacal’s (HITK) cash flow statement below. Hi-Tech just received approval by the FDA for an oral concentrate of Lorazepam. Lorazepam is an often-used drug for the treatment of anxiety and is probably used by more Wall Street analysts than I care to know about. Note that the last three years indicate that net income is greater than operating cash flow. This is known as a red flag and should be investigated thoroughly if you intend to invest in any stock with similar numbers.

It’s important to understand that this may only be temporary, but you should investigate fully before you dive into any stock where net income is greater than operating cash flow. Remember that cash flow is an adjustment to net income and considers such items as depreciation and amortization which alter the net income figure considerably. Depreciation and amortization don’t actually require cash outlays and therefore don’t alter cash flow, giving a clearer picture of the company’s position. This is one of the reasons why investors prefer to look at cash flow instead of net income. Further, if the spread of the larger net income is huge, it may indicate that earnings may be less than useful for consideration.



Many investors will choose to use free cash flow over operation cash flow which I don’t suggest because there is no “approved” definition of free cash flow and it may differ from various sources.

Companies take their cash and make up their inventories which are stored until sold. When sold, they typically, if not receiving cash, go into the column labeled account receivables until the customer pays. So looking closer at Hi-Tech for the last three years, let’s note a couple of things:



The annual growth rate of the revenues annually is 17.87% with a five-year rate of 39.41%. Not bad, so where do we look from here? Think about what we just stated regarding our cash going into inventories and account receivables. Take a look at the trend of their receivables.



Take note that the receivables are growing much faster than sales, another red flag.

These and many more are the types of steps you need to take when evaluating a stock. Be diligent and be careful.

Finally, don't necessarily conclude that this is a bad investment. Joel Greenblatt did not think so. Look at his record:



Happy investing!

Disclosure: I am long on WMT


Stocks Discussed: WMT, TGT, HITK,
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There s No Magic Bullet
Posted by: jaumepared (IP Logged)
Date: February 14, 2012 11:15AM

Nice work... thanks for laying it out so well. Maybe I am biased because I too am long WMT.
I don't follow or own HITK, but it seems to me that successful investors in that industry are able to successfully predict the value of the drug development pipeline. It is hard to analyze any but the largest of Pharma with anything but a predictive future on the commercial outcome of the "pipeline."



Stocks Discussed: WMT, TGT, HITK,
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There s No Magic Bullet
Posted by: pravchaw (IP Logged)
Date: February 14, 2012 02:07PM

Good article. If you look at Diamond Food "DMND" their earnings were growing faster than operating cash flow for 2010 - 11. It came out that they were shifting costs from "current period" to "future periods". This was showing up as increased earnings in the "current period". This high earnings in turn was inflating the stock price which management was using as currency for mergers and acqusitions. Once all this came out, the stock crashed from >$90 to >$20 over the last few months.


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There s No Magic Bullet
Posted by: Cornelius Chan (IP Logged)
Date: February 14, 2012 06:03PM

I have been wondering for awhile if I would have been burned by Enron. It is mucho difficult to find financials for that former utility co.

I only invest in companies that have a past 10 year dividend history and over 1B market cap. Did Enron have missing annual dividend payments just before their implosion?


Stocks Discussed: WMT, TGT, HITK,
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