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Going Back to Fundamentals

June 04, 2012 | About:
David Chulak

David Chulak

29 followers
Today's market can often leave even the most ardent investor in a quandary of what action to take next. Anyone that is watching the Scoreboard at GuruFocus and the returns of the top guru investors will observe that several have shown drastic diminishing returns lately. So, what do you do? Do you sell in these uncertain times? Do you buy more? Is this what was meant by "buying at the point of maximum pessimism?" Is this what was meant by "blood in the streets?"

Often times, it's best to do nothing, take a step back and re-evaluate why you own the stocks you do. It might also be a time to evaluate your sell criteria for what you still own. If you are sitting on cash, now is the time to be building your list for when you are ready to add to your positions or create new ones.

Whatever your situation, this is the very best time to get back to basics or fundamentals. This is a time that we need to assess our skills, our investing or buy criteria, our sell criteria, etc., which help us make the finest of choices and preserve our capital as Graham admonished.

Sometimes, when talking with fellow investors, I am amazed at how complacent investors can become and how they will often settle for less than the best choice.

I want to take a look over the next month or so at several investing criteria that we all use, but have either forgotten their importance, their lack of importance or how they should be interpreted or used. Maybe they just have been tossed to the side callously. Sometimes we simply forget the meaning of the numbers. It's simple to require that your stock have a return on equity (ROE) of 15%, but why is that number so important? What's the big deal if I purchase a stock that has an ROE of 10%?

Why is ROA (return on assets such an important criteria)? Times aren't the greatest, so what's the big deal if margins are decreasing some — it should be expected, right? My stock had an F Score of 9, and it has dropped to 5. So what's the problem? The price has remained relatively stable.

The list goes on, and I want to cover many or most of the criteria in detail, along with examples, to clearly illustrate how they can and should be used or interpreted. Last, I want to specifically show which metrics or investment criteria best indicate potential financial masking of inappropriate or potentially fraudulent numbers. Some of them may surprise you.

Don't be lazy — keep reading. I know that you already know some of this, but this is time to re-evaluate what we think we know.

James Montier stated it well:

"As Graham notes: 'The purpose of balance sheet analysis is to detect… the presence of financial weakness that may detract from the investment merit of an issue.' In general, we have found that these risks get ignored by investors during the good times, but in a credit constrained environment they suddenly reappear on the agenda."

Montier continues:

"Investors tend to ignore balance sheet and financial risk at the height of booms. They get distracted by earnings, and how these cyclically high earnings cover interest payments. Only when earnings start to crumble do investors turn their attention back to the balance sheet."

It's time to do just that. Let us start with one of the simplest but often misunderstood criteria — the current ratio.

The current ratio is determined easily by dividing current assets by current liabilities. It offers a quick look at the company's ability to pay its short-term obligations or liabilities. More specifically, current assets include cash, cash equivalents, marketable securities, receivables and inventory. Current liabilities include notes payable and any short-term liabilities, typically due within 12 months.

Benjamin Graham in "The Intelligent Investor" specified the criteria for the defensive investor, stating that, "For industrial companies, current assets should be at least twice current liabilities – a so-called two-to-one current ratio."

The Benjamin Graham list put together before his death and published in the Journal of Portfolio Management included 10 criteria for stocks to be considered deep value opportunities. Again, the current ratio requirement was "greater than 2."

And yet, armed with this straightforward requirement, investors dismiss or ignore this criterion increasingly. Ignoring it is a hazard to your portfolio, but the truth is, just looking at the number doesn't really tell you the entire story. This is where investors get indolent. Equipped with the knowledge that the father of value investing required a minimum current ratio of two, we often don't stop to see the entire picture. The "two" is all we are looking for and that suffices for many of us. But what does it mean? What's the big deal if it's 1 or less than 1? What about if the ratio goes up to 5 or 6? Isn't that good? And the answer to these questions is — maybe.

Below are just some of the many incredibly good companies with current ratios less than the required minimum of 2. How can this be, and how do companies with current ratios less than 1 survive?

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One answer is the type of business. Graham himself excluded telecoms and energy companies because of their business structure. Others, with durable competitive advantages like Wal-Mart (WMT), can also operate with a low current ratio quite easily. Their ability to turn over their inventory faster than accounts payable become due allows them to maintain a lower current ratio and still remain liquid.

Companies with high current ratios, while appearing to be safer or better bets, can also be problematic. For instance, during a recession, inventory building up due to slower sales can increase the current ratio and distort the strength or the liquidity of the company. What about receivables? The inability to collect growing receivables can also cause a higher current ratio.

So where do we go from here? Too low isn't good. Too high may not be good. Even a current ratio of 2 may be a distortion of their liquidity. Once again, this is where investors get idle because they only want to look at the single number. Sorry, but it takes more work than just looking at one number by itself. So, you might ask, is the current ratio of any value? The answer to that is a resounding yes, but it takes work.

There are several points or rules we want to remember about this metric in order for it to be applied properly.

1. Financial auditors have discovered that the current ratio, when less than 1, becomes a red flag for potential fraud, requiring further detective work. The point is that there may not be any problem with the company having the low current ratio, but it should require that you discover why. We are talking Wal-Mart, right? I know, but we are also talking Enron, Qwest, WorldCom and Global Crossing, which all had extremely low current ratios. It's a red flag and should be treated as such. These were all big companies that many investors thought were successful and safe, and they purchased stocks without complete research.

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2. As Joseph Piotroski indicates on his F-Score, a current ratio that has increased from the year before is one of his famous nine points. It's the trend that matters. One number doesn't do it. You must discover the trend of the current ratio. Is it getting higher? If so, discover why. Is it because inventory is growing and not being sold? Are receivables not being paid? Is it lower? Why?

3. Understand that this ratio is best used as a comparison to the company's peers. If the stock I'm researching has a current ratio of less than 1 and its peers all have current ratios around 2, there is, potentially, a huge problem. Once again, this is work and yes, it takes time. Comparison of a stock to its peers is required work for any wise investor.

4. This ratio works best with service companies and manufacturing companies. There are several industries that tend to have either high or low ratios. Note this for future research. But if you find a stock that isn't in the range of its competitors, it's incumbent upon you to discover why.

5. If there is suspicion that inventory is causing some discrepancy in the ratio, you must still go further by discovering what method the companies under comparison use for determining their inventory value.

That is, do they use FIFO (First In, First Out) or LIFO (Last In, First Out)? Under FIFO, inventory is generally valued close to its replacement cost, while under LIFO, you may find undervalued or overvalued inventory. Either way, the point is that you must compare apples to apples to compare companies.

Benjamin Graham told us to use a current ratio of 2 or better, and I believe he meant it. I do not believe for a moment that he wanted us to just grasp the number from the websites he never saw and call it good. He fully expected full balance sheet analysis to determine whether the company being researched was liquid and safe in order to protect one's capital. No one ever said investing was easy.

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

Rating: 4.2/5 (22 votes)

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