Editor’s note: This article was first published in June 2015; the statement that Buffett still did not invest in technology companies and the moat examples (Coca-Cola, Apple, Google’s near-monopoly in search) reflect that time. Berkshire Hathaway already held IBM shares then and began buying Apple in 2016.
Once again we turn to the bible of investing, Ben Graham’s The Intelligent Investor, where Graham himself, and later Warren Buffett, give us some guidelines for spotting warning signs in the companies we are about to invest in.
It all comes down to putting a future price on the value of a company’s shares, and therefore knowing whether we are buying them with the margin of safety that both Graham and Buffett always talk about.
What makes one company worth 10 times its earnings and another worth 20 times its earnings? Obviously, we are talking about the P/E ratio, which can be somewhat confusing: sometimes a very high P/E means the stock is far too expensive, while at other times an exceptionally high P/E indicates that the company may have enormous potential to appreciate.
*The P/E ratio is calculated by dividing the share’s market price by annual net earnings per share (EPS). So P/E = Share price / EPS.
According to Graham, how can we be sure we are not paying too much for a rosy future that could end up turning into a nightmare for the investor?
In the book, Graham set out the five elements he considered decisive:
- The company’s general long-term prospects.
- The quality of its management.
- Its financial strength and capital structure.
- Its dividend record.
Today investors have easy access to a company’s history, where they can see all of its past financial statements. Buffett advises looking at at least the last 10 years of those statements to see how the company has evolved.
Once we have the company’s statements, we should be able to answer two questions:
- What makes this company grow?
- Where do its profits come from, and where will they come from in the future?
Warning signs when investing in a company
Among the problems we can spot in a company’s history, Graham pointed out the following:
1. The company is a “serial acquirer”
An average of more than two or three acquisitions a year is a sign of potential trouble, according to Graham. After all, if the company would rather buy shares in other companies than invest in its own business, perhaps the intelligent investor would be more intelligent to invest in those other companies.
Graham warned about “bulimic companies”: those that gobble up large acquisitions only to end up “throwing them up” later.
2. The company is addicted to other people’s money
If the company keeps taking on debt or continually issuing shares to raise tons of outside money, it is a bad omen.
These huge contributions of other people’s money are called “cash from financing activities” in the cash flow statement of the annual report.
Graham warned that, thanks to these capital injections, a dying company can look healthy even when its underlying business does not generate enough cash.
3. The company has only one bullet in the chamber
When a company depends on a single customer or a handful of customers for most of its revenue, it is a risky company. That does not mean it cannot work, but history shows plenty of cases where, after the main customer ran into trouble, the supplier lost its value too.
Once we are clear about the sources of its revenue, profits and growth, we should study both the negative and the positive aspects.
Positive signs in a company
Among a company’s positive signs, Graham highlighted the following:
1. The company has a competitive advantage (a wide moat around it)
Graham compared a company to a castle. Some companies can easily be conquered by competitors who decide to attack them, while others are practically “unassailable”.
A company’s competitive advantage, or moat, could be:
- A strong brand identity. Coca-Cola, and even Apple, are examples of strong brands.
- A monopoly or near-monopoly on the market. In the search engine business, Google has an almost absolute monopoly, which allows it to launch other products very cheaply. Coca-Cola has a secret formula with no material value, but it gives the company a hold over consumers.
2. The company is a marathon runner, not a 100-metre sprinter
It is easy to tell whether a company is a marathon runner just by looking at its past income statements. If we take the last 10 years and see that its profits have grown steadily and firmly, we are looking at a marathon company.
If a company’s earnings grow at a long-term rate of 10% before taxes, that is sustainable growth. Companies that set themselves illusory targets may hit them for a few years, but afterwards, according to Graham, they will fall as hard as they rose: they would have run a perfect 100 metres, but the stock market likes marathon companies.
These astronomical growth rates are clearly what technology companies are delivering today, and perhaps that is why Buffett still does not invest in tech companies despite the high returns they have had over the last five years.
In other words, Graham preferred smaller but steady growth over astronomical take-offs in revenue, which does not mean those companies cannot be profitable for speculation.
3. The company sows and reaps
However good the company’s products and however powerful its brand, it must spend money on developing new activities.
Spending on research and development may hurt profit growth over the next few quarters, but it will be an important source of growth in the future. In other words, bad for the 100 metres but necessary for the marathon.
Last but not least: the quality of management
Most investors underestimate the importance of studying a company’s management team. If investors had studied Jenaro García (Gowex), they would have seen a precedent that would have put them on alert (see: Lessons from the Enron and Gowex cases that every investor should learn).
Graham said that management’s behaviour should be analysed. We should look back at what those executives said they were going to do, and whether they then did what they said.
If, as a rule, they have failed to meet their forecasts or always fallen short, we already know what to expect from the company’s next forecasts.
Graham also advised watching out for management’s self-interest: a company that pays 100 million a year to an executive who has not patented the fountain of youth shows, according to Graham, that it is run by its managers for the benefit of its managers, not its investors.
If a company reprices, reissues or swaps the stock options it has granted to its executives, stay away from investing in it.
Any established company that reprices its options, as dozens of high-tech companies have done, is behaving outrageously, and any investor who buys shares in such companies is begging to be fleeced.
The book gives the example of AOL, which, in a note practically hidden in a footnote of its annual report, said it had issued options on 657 million more shares, while saying nothing about it on the front page. That foreshadowed what later happened to AOL’s share price, and many investors never even found out.
This article is based on passages from Ben Graham’s book The Intelligent Investor, adapted and heavily modified.
See also: 5 books on investing and the stock market to read this summer
Featured image: Barry Marsh, Public domain, via Flickr.
