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THE MOTLEY FOOL ONLINE SEMINAR
WHEN TO SELL: THE FOOLISH SELLING STRATEGY
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SEMINAR RESOURCES
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START PAGE
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ORIENTATION
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DOWNLOADS
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DISCUSSION BOARD INTRO
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DISCUSSION BOARD FAQ
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HOW DO I...?
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LESSON 2: COMPANIES GONE WRONG
Instructors: Bill Mann, TMF Otter (with Matt Richey, TMF Matt)
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In Lesson 1, we offered a list of red flags that trigger instant
sales. These things are pretty easy to spot, if you keep up with
current events surrounding the companies you hold.
Notice that we didn't spend much (meaning any) time discussing
Wall Street analyst upgrades or downgrades. This is for one
reason: We don't care what analysts think, and we certainly
don't put any credence in their deeply compromised ratings systems.
Sure, we read analyst research. After all, many analysts have
significantly more access to business management than we ever
will as individual investors, so they can have some valuable
insights. But if you want to watch a much better predictor of
company trouble than analyst rating systems, watch the bond
market (more on this later). "Strong buy?" Pfffffft.
In this lesson, we look specifically at signs that a company is
slipping. Investors need to remember one key point: For highly
valued companies, it only takes a small slip to lead to a large
share price decline. For example, a company priced at a multiple
of 30 times earnings is expected to grow faster than one that is
priced at 15 times. As a result, investors in the high-multiple
company are much more likely to be traumatized if its business
starts to show slowing growth (in earnings, sales, cash flows,
whatever). Thus, with highly valued companies in particular,
it's important to be vigilant in monitoring any slips. Even a
company that's growing nicely may be sending clear sell signals.
So let's look at a few instances where companies have started to
go wrong. Our goal here is to learn how to recognize the warning
signs of an impending stock collapse before it happens.
WARNING SIGN 1: SLOWING SALES GROWTH
Through 2000, Nokia (NYSE: NOK) could do no wrong. It was one of
the fastest-growing stocks in the '90s and the largest, best
capitalized participant in one of the hottest sectors of the
market: wireless telecommunications. In 2000, Nokia posted
revenue gains well in excess of 50% each quarter. Then, in April
2001, it hit a clunker -- 22% growth, followed by 5% growth the
next quarter. For investors in a high-multiple (high P/E)
company, this is rough. For most companies, a second quarter in
a row of dramatically slowing sales is enough. Get out. For a
barnburner like Nokia, one is enough.
Some words of wisdom: Keep companies in one of the hottest
sectors on a very short leash. Hot sectors cool off -- they
always do. Remember, railroads were once the hot sector, then
canals, car companies, radios, and so on. It ends. Be ready. If
you're expecting sales to continue roaring full-steam ahead and
they don't, it's time to position your finger on the sell
trigger. If sales growth slows unexpectedly, be prepared to give
a company one quarter to bring up its performance. But unload on
the second straight quarter of slowing sales, measured on a
year-over-year basis. (Always compare the quarterly growth on a
year-over-year basis -- a comparison of sequential quarterly
growth is a worthless measure. Seasonal effects can skew
sequential growth.)
WARNING SIGN 2: DIVERGENT SALES AND PROFIT GROWTH
By April 2001, Nokia had shed some 60% of its peak value. Signs
were surely evident in advance, right? Why, yes. Companies
growing top lines (sales) should generally be growing bottom
lines (earnings) at a similar clip. Even though Nokia's sales
were growing through 2000 at 50%-plus per quarter, at the end
of the year, net profit growth dropped suddenly from around 70%
to 40%.
Profits recovered slightly in the fourth quarter, only to
collapse in the first two quarters of 2001. The economics
changed quickly, and with a hyper-growth company, the stock
reacted just as fast. Even those not deeply versed in the
technology and economics of the mobile phone industry could see
signs that something was wrong.
WARNING SIGN 3: PLUMMETING CASH FLOWS
In 1999, Lucent (NYSE: LU) looked beautiful from an earnings
perspective, but horrible from a cash flow perspective. We look
at two numbers: operating cash flow and free cash flow. Free
cash flow can be low for growing companies, as they have
significant capital investment demands, but low operating cash
flow is inexcusable. Lucent's experiences are telling. In 1999,
Lucent's full-year earnings came out at a gaudy $4.7 billion,
based upon $38 billion in revenue. The company was on top of the
world, and it was, at the time, the largest telecommunications
equipment company by market cap, at $260 billion.
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But as Matt and I detailed in January 2000, big troubles were
afoot, lurking in the company's cash flow statement. On an
operating cash flow basis for fiscal 1999, the company lost
$276 million. That's a far cry from the $4.7 billion in
reported net income. And on top of that, Lucent had more than
$2.2 billion in capital expenditures. Thus, the difference
between Lucent's earnings and its free cash flow (operating
cash flow minus capital expenditures) was an amazing $7.3
billion, and not in a good way.
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The investor who picked up on this scary dichotomy could have
saved herself losses in excess of 98%. (As an aside, since 1999,
Lucent has gone on to restate its 1999 cash flow not once, but
twice, and in the most recent 10-K, the 1999 operating cash flow
is reported as a loss of $1.8 billion.)
And get this -- you'll see nearly the exact same thing on
Enron's old financial statements. Cooked books or no, they
weren't generating much cash. In fact, they were destroying it.
WARNING SIGN 4: WATCH THOSE BONDS
Remember what we said about ignoring analysts? Well, it's
because their information can be quite conflicted, and it's
almost impossible to tell if any one individual has your best
interests in mind. Fortunately, another group can give you the
same type of signals: investors who hold a company's bonds.
Bondholders buy a piece of a company's debt and are generally
paid interest on this obligation by the company. Watch the
current price of a bond, and it will tell you the current odds
bondholders are giving to that obligation being paid. I
recommend keeping a log sheet where you write down the price of
the bond. Download it here. If you see a drop, the bondholders
are growing pessimistic. You might even see this at the same
time analysts are shouting, "Strong buy!"
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I recommend the Yahoo! Bond Center. You can search on any company
and get a list of existing bonds. Find a bond with a maturity
between five and 10 years hence. Check the price. A bond priced
at 100 is at "par," which means that the bond's face-value
interest rate fairly compensates the investor for the risk. Some
bonds are priced above 100, meaning the interest yield will be
lower than face value. These are considered to be very low risk.
But some are priced below face value, even way below.
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As of this writing, WorldCom (Nasdaq: WCOME) bonds are priced at
18, which means that bondholders assume there's little chance
they'll be paid. Tyco (NYSE: TYC), for all of its recent
problems and high levels of debt, has 6.75% interest bonds, with
2011 maturity priced at 83. That's a discount to face, but not
one that alludes to an imminent default. Qwest (NYSE: Q) sports
a price of 85 on its 7.25% 2011 bonds, even closer to par than
Tyco. These prices don't indicate healthy companies, but they
don't insinuate imminent default or bankruptcy either.
WARNING SIGN 5: "IT JUST DOESN'T GET ANY BETTER"
For a brief time in 2000, Cisco Systems (Nasdaq: CSCO) was the
largest company in the world by market capitalization. This
should have been a warning. As I wrote in May 2000 when the
stock was around $57, Cisco's valuation of nearly $400 billion
implied that investors expected the company's earnings to reach
$34 billion in 2010. Yet no company had ever generated earnings
higher than $12 billion in a single year.
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As it turned out, I almost perfectly called the top for Cisco --
it has shed nearly $300 billion in market cap since that
article. Only those that decided it couldn't possibly get any
better achieved a sale near the high watermark. Cisco showed no
signs of a decline. For the quarter that ended Jan. 29, 2000,
Cisco turned in sales of $4.3 billion, as compared to $2.8
billion for the same quarter the year before -- a growth rate of
53%. The following quarter was 58% higher, then 62% higher, then
66% higher.
Only Cisco's stock price rise could beat these numbers. Imagine
a $385 billion company with a P/E of 156! The assumptions for
future growth were mind-bending, though at the time, in the
midst of the data revolution, they seemed plausible. As
investors, we must be on the correct side of probabilities.
Taking a portion of our Cisco investment off the table, at this
point, would've been a smart choice. Remember, Cisco's business
was fine in 2000, but the enterprising investor knows that a lot
has to be right for the situation to work out.
HOMEWORK
For this lesson, we ask you to do the same thing as we did after
Lesson 1. Pick a company -- maybe even the same company you
looked at last time -- to continue studying. For your company,
do the following:
- Track the year-over-year sales growth for each of the past four
quarters and three fiscal years. Is growth accelerating,
staying about the same, or weakening?
- Track the year-over-year net income growth for each of the past
four quarters and three fiscal years. Is net income growing
slower or faster than sales? Is there a trend to these figures?
- Track your company's operating cash flow for each of the past
three fiscal years. Is it lower or higher than reported net
income for the corresponding year? (We're not having you look
at quarterly cash flow because those figures can bounce around
due to the timing of payments. Annual cash flow data is much
more indicative of real cash flow trends.)
- If your company has long-term debt, go the Yahoo! Bond Center
and check the price of your company's bonds. (If you don't know
whether your company has any debt, just type your company name
into the bond center and see if any debt shows up.)
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- Finally, examine your company's market cap relative to its
current net income over the past year. What's the P/E ratio? Is
there reason to believe your company has every rosy scenario
already priced into its stock? (In the current bear market,
this is much less likely than it was a few years ago, but it's
still a question you should consider.)
To help you out, we've put together the Foolish Stock Information
Form to track all of your research and information about your
stocks. You can get to by clicking here. We've also outlined how
to find all of the information above, here.
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So dust off the old calculator, find your company's financials,
and get to work. Quarterly financial data is best found in
company 10-Qs, and annual data is best found in company 10-Ks.
You should be able to find all of this information using
financials from either the company website or at Fool.com on the
Quotes & Data area.
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FEELING A LITTLE LOST?
If you're new to using SEC filings, read this overview of
financial statements. Above all else, just do your best. Once
you've done what you can, report your findings to your teammates!
We've also put together an ongoing list of resources so you can
dive in a little deeper. You can click on the "Lesson Resources"
link in the right column or click here to find more resources to
help you better understand financial statements, general
investing equations, and stock options.
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Matt and I will be joining you on the boards with our own
analyses, so you can examine our processes.
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Fool on!
Bill and Matt
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LESSON PLAN
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Lesson 1: On Selling
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Lesson 2: Companies Gone Wrong
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Lesson 3: Gut Checks and Safety Valves
Lesson 4: When a Company Becomes Overvalued
Lesson 5: Report Card Part 1 - Business Prospects
Lesson 6: Report Card Part 2 - Valuation
Lesson 7: Panning for Panera
Lesson 8: The Report in Action - Johnson & Johnson
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