I’ve had stocks upgraded and downgraded in the same day. Apparently different analysts are looking at the same exact information and coming up with completely different conclusions. So which one is correct? (Actually, I do understand that because I know that some very famous guru investors buy stocks I wouldn’t touch and I’ve bought some that none of them own. We have reached different conclusions based upon our research.)
I’ve had stocks go through an upper channel line and a lower channel line only to find out the person drawing the lines does it different than another person that draws lines. The first time I heard that my stock was “oversold,” I found myself wondering, “How can that be?”
There are only so many shares. If someone sells the stock, someone has to buy it. I thought Head and Shoulders was a shampoo, only to discover that it’s a chart pattern.
When it comes down to it, I’d actually prefer to know whether Bill Gates uses an iPhone or whether Mr. Tillerson buys gas at a Shell oil station. In reality, that would probably be more informative and would certainly give us something to talk about.
With that said, as investors, what is really important for us to look at? The various ratios that we love to talk about? Of course. Value investors don’t mind going to the cash flow statement. Some are less inclined to study the income statement or the balance sheet. If you look at the bottom of the GuruFocus 10-Year Financial page for any stock or the Guru Trade screen, you will see that quarterly and annual reports are available.
[ Enlarge Image ]
The quarterly and annual reports supply information that is not supplied in the statements above. Yes, it does duplicate some, but it has extremely valuable information that you are missing out on that may save you a lot of grief in the future. The bottom line is the bottom line. Read the footnotes in the reports. I know they are boring, but they are so indispensable. Let’s see why.
First, understand that even honest companies have liabilities (or assets) that are not on their balance sheet. These are called off balance sheet items that can only be found in the quarterly or annual reports. Very often, there are legal and valid reasons for not showing assets or liabilities on the balance sheet. There are also some transactions that are less clear and some that are outright illegal. Reading the footnotes will help you determine which you are dealing with.
As an example, let’s assume you own a company called My Company and you have a line of credit that you might decide to use for a future project with Chase & Fargo of America Bank. Banks often will require covenants when they lend the money, which might be a stipulation that you maintain a low debt to equity ratio (as an example) before they will lend you the money. So, now you’ve discovered a project or want to acquire a new piece of equipment and you want to borrow this money against your credit line. Then, you find out that you have been denied because if you make the purchase, you will exceed the debt to equity ratio required in the covenant. So, how do you do it? You need the equipment, but how do you get it?
A separate entity is created by My Company which buys the equipment and leases it back to My Company. Pretty cool, huh? My Company, though responsible for the entire purchase, doesn’t have to report the new liability on their balance sheet or count the new equipment as an asset, all the while, maintaining their credit line.
Off-balance-sheet financing is common, but it is also how Enron carried on for so long with so much smoke and mirrors. You are looking for these other entities and these types of transactions. The truth is that anyone could see this if they looked.
Let’s look at another example of off-balance-sheet items. Your company, My Company, is a retail company that does not purchase land and build their own stores, but finds locations for operations or stores through long-term leasing. When the lease comes to a conclusion, you can walk away from that lease and location or perhaps the owner of the building may not want you there any longer. Accountants do not have to look at these leases as assets because you don’t actually own them, nor are they liabilities until such time that you decide to renew the lease. These lease renewals can cost in the billions of dollars that will be taken from future revenue and are not shown as assets or liabilities on the balance sheet. You will only discover this in the footnotes.
Another off-balance-sheet item is pensions. They are not placed on the balance sheet because the money is placed in a separate entity or trust. Unless you’ve just not been reading the news, you should know that pensions are in trouble everywhere. At the beginning of this year, many companies, including Boeing (BA), Raytheon (RTN) and General Electric (GE) had huge unfunded pension liabilities and were injecting large amounts of cash to fund them. Ford (F) is expected to inject nearly $4 billion dollars for their pension shortfall. Over 65% of the companies with defined benefit pension plans that were in the S&P 500 were underfunded. Companies such as Lockheed Martin (LMT) and Boeing (BA) have been estimated to be injecting nearly 10% of their cash flow from operations into the underfunded pensions in 2012 alone. Below is from the 2011 annual report for Pepsico (PEP):
[ Enlarge Image ]
Note a couple of things. See the lines that give you a “fair value at end of year” along with a “liability at end of year.” This equals the “funded status” at the bottom line. The $(2,829) represents the unfunded liability for the pension program or nearly $3 billion dollars. This funding will come from the cold hard cash the company earns and is diverted from being shared with the shareholders, and none of this information is on the balance sheet.
Also, imagine if you will how the line that reads “fair value” at the beginning of year is calculated. It is based upon actuary tables, estimates, best guesses, etc., and you can also imagine how a company could somehow change some “fair value” in order to make the numbers appear better or manipulate them. Consider how a billion-dollar injection that comes off the balance sheet to pay for an underfunded liability on the off balance sheet affects other items. For instance, cash disappears from the balance sheet or assets diminish. These off-balance items can affect debt to equity ratios, amount of equity, etc., and must be considered in your decision making. There are many other items that could be discussed, but I cannot urge you enough to take the time to read those footnotes, check out these off-balance items and don’t be afraid to ask questions. They are not that hard to understand if you take the time. If the language is so vague that it is impossible to understand, it was probably intentional.
Also check out:
- Bill Gates Undervalued Stocks
- Bill Gates Top Growth Companies
- Bill Gates High Yield stocks, and
- Stocks that Bill Gates keeps buying
- Michael Dell Undervalued Stocks
- Michael Dell Top Growth Companies
- Michael Dell High Yield stocks, and
- Stocks that Michael Dell keeps buying