"The Little Book of Investment Knowledge"

Chapter 7:

Making Big Profits — What Successful Investors Look For

“Act like you own the company”

“I remember early in my investing career,” mused Tom, the most experienced investor in the Old Investors Club, “a friend of mine who had done very well said: ‘Act like you own the company.’

“I said: ‘Sure I’ll just waltz in and tell them to get those earnings up — and pay out more dividends while they’re at it.’

“But he said, ‘No, no, think about it. You’ve got the information about the company at your fingertips. Look it over, and figure out how you’d run the company. If you like the way they’re running the show, buy.’

“Of course it made perfect sense. Still does. If you think about it that way, you’ll look at a lot of things you might have missed otherwise.”

“Like whether the people running it are spending too much on their yachts?” piped up Terry the television announcer (pardon, “TV personality”).

“Well, yeah, as a matter of fact, you can figure that out, in a way,” said Tom. “And it does help.”

“I guess that’s the way Warren Buffett does it,” Terry said.

“Hey, if Warren Buffet likes a company, he can act like he owns it, because he probably will,” said Jennifer to a ripple of laughter that gave Hank, the lab, another unwelcome wake-up call.

“Ah, but you see,” said Tom, “Most people think Warren Buffett’s an expert on how companies should be run. No reason you can’t be, too.”

“The true story ... reading the annual report”

There’s nothing to prevent you from visiting a company you want to invest in and taking a tour. However, if you live in Yellowknife and want to invest in Nova Scotia based Emera Inc., don’t pass up the investment just because the cost of the trip would cancel out the potential gains in your portfolio.

Just access the firm’s annual report and financial statements on the internet.

Whether you pay a visit or only read the report, the company will tell you the happiest possible story. And why not? It’s the same thing we all do: our dinner guests don’t find the kids sprawled on the floor in front of the TV, or the laundry hamper abandoned in the front hall.

The true story is in the figures. They’ll either back up the company’s story or contradict it. These are the facts, nothing but the facts.

“The numbers game made easy”

Unless you’re a chartered accountant, your eyes may begin to swim when you see all those forbidding columns of figures. Here’s a way to hew all those numbers down to a reasonable and meaningful size:

1) On the balance sheet, look for long-term debt. Companies who spread out their debt maturities are in good shape. If only a small part comes due each year, they don’t have to drain the cash box to pay it.

2) Look at interest payments. Are the rates fixed or variable? Many companies wisely switch to fixed rates when rates are favourable. Also, if the company has leveraged itself for a takeover, check to see if the rate of return on equity is higher than the cost of debt.

3) On the income statement, look at the company’s operating margins. Compare the firm’s operating costs to its revenues and you’ll get a quick glance at just how efficient it is. Compare operating margins over the years. 15 per cent is a good number — it shows that a company can cover expenses and generate profits consistently.

4) On the cash flow statement, follow the prescription we outlined in Chapter 6. Make sure that cash flow (net income + depreciation + deferred taxes) covers dividend payments as well as plant and equipment costs.

5) Last, or first, but certainly not least, look at the CEO’s message. Read the mission statement, if the company is bold enough to have one. Is the vision realistic? Are the goals attainable? Do they have delusions of grandeur in the takeover field? The figures in the report will bear out or belie the message. But it’s also true that the ideas and attitudes of the people who run companies have a lot to do with the reason the figures are the way they are.

As you follow a company’s fortunes, you will instinctively decide whether the people who run it inspire healthy respect or nagging doubts.

The above was excerpted from The Little Book of Investment Knowledge.

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