Christopher Browne: 16 Questions

If you have followed Christopher Browne’s book, “The Little Book of Value Investing,” this far, you know he has walked us through a process in which we kept narrowing a field of investment candidates.

In chapter 14, he urged readers not to be satisfied with just the numbers, the metrics identified in analyzing the price of stocks and the key numbers on the balance sheet and the income statement.

To get to the qualitative, or softer side, of analysis, he recommended 16 questions, each of which would provide insight beyond the quantitative data.

1. Can the company increase its prices? As examples, Browne cited Philip Morris (now Altria Group (MO, Financial)) and Harley Davidson (HOG, Financial). In the not too distant past, Philip Morris could increase the price of cigarettes whenever it wanted, and Harley could do the same with its motorcycles. Generally, this ability reflects strong demand and limited competition.
2. Will the company be able to sell more units? As the author pointed out, “A 10 percent hike in units will increase gross profits by 10 percent if the gross profit margin does not change. Pretax income will go up by this amount if other costs do not increase.” For example, Johnson & Johnson (JNJ, Financial) shares dipped in the early 1990s over fears of health care reform, yet an aging population meant its products should sell in increasing volumes.
3. Can profits on existing sales be increased? Can the profit margin be improved by changing prices, rejigging the product mix or by reducing specific costs? Walmart (WMT, Financial) is a classic example of a company that relentlessly cuts prices without harming quality, and it keeps on squeezing and squeezing. Also keep tabs on the opposite side of the equation. Browne wrote, “I also keep a watchful eye out for companies that cannot control their most basic costs. Industries like trucking or the airlines have little control over fuel costs, and a cookie company cannot control the cost of sugar.”
4. Are expenses under control? Investors should check selling, general and administrative costs as a percentage of sales. Browne wrote, “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 health care costs, flows to the bottom line and helps to restore profitability.”
5. If sales increase, how much of that revenue will reach the bottom line? From another perspective, is it worth increasing sales if much of that new revenue will be eaten up by new costs? Companies in the tech sector got into deep trouble in the 1990s when they chased market share at any cost.
6. If profit margins are slipping, can the trend be reversed? This may happen because management made mistakes, a new product didn’t catch on or any one of a hundred other reasons. Can the cause(s) be identified and fixed?
7. Are there one-time expenses that will not happen again? If a stock is selling at a bargain price because of a one-time expense, there may be an opportunity. Browne wrote, “If it is truly a one-time expense, one can assume that earnings will return to prior levels and the stock could rise.”
8. Are there unprofitable operations that might be shed? Browne offered the example of National Education (now part of Harcourt General (HGNLB, Financial)). It had two profitable divisions and two that were posting losses. After management sold off the losers, the share price doubled.
9. Is management comfortable with the earnings estimates coming from Wall Street? While Browne did not rely on the estimates at all, he also knew that if the Street’s estimates were too high or too low, the share price would be pushed up or down by the market.
10. How much will the company grow in the next five years, and by what means? Is management confident it can grow its business operations and, if so, will it be positive or will it mean lower profit margins and lower returns on equity?
11. What will the company do with cash not returned to shareholders? The author advised, “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 are competitors expected to do? For example, when Lowes (LOW, Financial) expanded, it had a “huge” effect on the results of Home Depot (HD, Financial). Browne said, “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. Within the industry, how does this company compare with its peers? This takes us back to the balance sheet and income statement analyses, where we compared such fundamentals as return on capital and debt levels.
14. If it were sold, what would the company be worth? Browne said he first became interested in this issue in the 1970s, when some television stations were being sold for less than similar companies. While the industry standard at that time was 10 times cash flow, he was able to buy Storer Broadcasting for 5 times and that gave him a significant profit when it was later bought out by another company.
15. Will the company repurchase its own shares? He wanted to see if a company actually went ahead after announcing a buyback, and wanted to know why it was being undertaken. He cautioned, “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. Are the insiders buying or selling? Look for patterns; for example, infrequent sales mean little, but consistent sales by insiders suggest management thinks the stock is overvalued.

Browne reported that he found a lot of value in asking—and answering—these 16 questions:

“By going through this checklist, I come away with a much better understanding of the companies that passed 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.”

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

• Christopher Browne: What Is the Earnings Potential of This Stock?
• Christopher Browne: Tales That Are Told by the Balance Sheet
• Christopher Browne: Is This a Real Bargain Stock or Not?

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