Part 3

1. The Five rules for successful
stock investing – part 3
By Pat Dorsey

2. Chapter 7- Analyzing the company (Management)
• Evaluating the management is a critical component of analyzing a stock. Look for management teams that
act like shareholders, rather than hired hands.
• Here in this chapter it explains how to asses the management which people feel that its tough to assess and
often buys stocks without checking for the management. Here our goal is to find management teams that
think like the shareholders, executives that think they own a piece of business, unfortunately managers like
these are rare than we think.
• Management has given a few key pointers to look for assessing them :
• Compensation
• Character
• Operations
Let us review each pointer.

3. • Compensation – this is the easiest of the three area to assess. Because bulk information is contained in the single
document called the Proxy statement. In this form companies mail shareholders around the time of the annual meeting,
and it details how much executives are paid and what perks they get. There are certain pointers to look for in a company’s
Compensation plan.
• First and the most important, how much does the management pay? (This is detailed in the aptly named “Summary
compensation table”.
• Pay for performance - Executive’s pay should rise and fall based on the performance of the company. So, after reviewing a
company’s historical financials, read the proxies few years past data to see whether this has truly been the case or whether
the board of directors has cooked up some justifications for big bonuses even in bad times. Firms with good corporate
governance won’t hesitate to pay managers less even in bad times and more in good times, and that’s the pattern we want
to see as a shareholder. We should use our own judgement (if the amount that executives earn makes you cringe, it’s
probably too much).
• Other Red Flags - Aside from the big picture question of whether executives pay truly is linked to the company’s
performance, keep an eye out for the following issues when you’re assessing executives’ compensation
• Were executive’s given loans that were subsequently forgiven?
• Do the executive’s get perks paid for by the company that they should really be paying for themselves?
• Do management hog most of the stock options granted each year or do rank and file employees share in the wealth?
• Does management use stock options excessively?
• If a founder or large owner is still involved in the company, does he or she also get a big stock option grant each year?
• Do executives have some skin in the game?

4. • Character - Compensation is often a good litmus test for the character, there’s a strong relationship between management
teams that are in it for the money and management teams that treat shareholders poorly, however there are important
questions we should ask to get a handle whether a firm’s management deserves your trust.
• Find the answer to such questions.
• Does management uses its position to enrich friends and relatives?
• Is the board of directors stacked with management family members or former managers?
• Is management candid about its mistakes?
• How promotional is the management?
• Can the CEO retain high quality talent?
• Does management make tough decisions that hurt results but give a more honest picture about the co.?
• Running the business - As the shareholders of the company, we want mangers who can run the business well.
• Performance - Checking financial performance during the tenure of the management team is a first stop. Look for
higher ROE and ROIC, check reasons, ask questions regarding big jumps on the revenue.
• Follow through - When management identifies the problem and promises a solution, does it actually implement the
plan or does it hope you forget about it? The same goes for any new “strategic initiatives” that are announced. Have
the firm being updating the shareholders up to date for their strategies that worked and that did not.
• Candor – Generally, management teams will talk about parts about the business that are hitting on all cylinders, but
questions about a problem area are sometimes met with evasion or straight “we don’t disclose that”. So check
whether the firm provides enough information to shareholders to analyze the business.
• Self-confidence – Firms that do something different from their peers or from conventional method is applaudable.
Maintaining research and development spending during the industry downturn is another good example of self-
confidence
• Flexibility – Make sure the firm gives enough flexibility in the future, these include simple decisions such as not taking
on too much debt and controlling fixed expenses as well as many strategic decisions example, issuing equity when
stock is too high.

5. Chapter 8- Avoiding Financial Fakery
• In this chapter we will be studying about financial frauds and certain ways to detect, there are literally
dozens of techniques that are perfectly legal and aboveboard, but which have the effect of fooling an
observer into thinking that a firm has posted true operational improvements when all it has done is moved
some numbers around. We need to know aggressive accounting so we can know to avoid companies that
practice it.
• The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in
cash flow. That has it been able to convert its earnings into cash flow, If net income is growing quickly while
cash flow is flat or decreasing, there’s a good chance of trouble lurking.
• We will be looking at some red flags as long as we avoid the companies that bristle with the red flags we
won’t be caught owning them.

6. • Declining Cash Flow - We can do is watch cash flow overtime increases in companies cash flow from operations should
roughly track increases in net income. This usually means that the companies is generating sales without necessarily
collecting cash, that’s a red flag. If you see cash flow from operations decline ever as net Income keeps marching
upwards or if CFO increases much more slowly than net income watch out.
• Serial Chargers - Be wary of the firms that take frequent one-time charges and write downs. This makes historical
financials muddier because every charge has a long explanation and usually has various components that affect
different accounts. All of which needs to be adjusted if we want to look at comparable Year to year financial results.
• Serial Acquirers - Firms that make numerous acquisitions can be problematic their financials have been restated and
rejiggered so many times that it’s tough to know which ends is up. Aqusition increases the risk that the firm will report
a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch
often don’t spend as much time checking out their targets as they should.
• The Chief financial officer or auditor leaves the company - If the CFO leaves the company that seems all strange and
inexplicable you should be on your guard, its normal for CFOs to move around just like other executives, but if we see
CFO leave a company that’s already under suspicion for accounting issues, you should think very hard about whether
there might be more going on than what we see, same goes for auditor.
• The bills aren’t being paid. -We should track how fast A/R is increasing relatives to sales, the 2 should roughly track
each other, but if sales increases by, for example 15 percent while A/R increases by 25% the company is booking sales
faster than the co. is receiving cash form it’s customers. As a general rule it’s not possible for A/R to increase faster
than sales for a long time the company is paying more money (as finished goods) than it’s receiving (through cash
payments) from it’s customers. On the credit front watch out for “allowance for doubtful debt”, which is essentially the
company’s estimate of how much money it won’t be able to collect form the customers. If this amount does not move
in sync with A/R, the company will be artificially boosting its results or maybe its being optimistic about new customers
paying the bill.

7. • When reading an annual report watch out for the following pitfalls :-
• Gains from investments - If the firms you’re analyzing is using the gains or asset sales to boost operating income or reduce
expenses, you know you’re dealing with a company that might be less than ready in other areas as well. Companies can
also record the income “above the line” so that it is included as part of operating income and thus boosts their operating
margins. This is not accepted by the accounting rules, since it requires any piece of one time income to be separated from
income that comes from normal operations.
• Vanishing Cash flow - There’s one important caveat to the general rule of cash flow is a number to be trusted. You can’t on
cash flow generated by employees exercising options. If you’re analyzing a company with great cash flow that also has a
high flying stock price check to see how much of the cash flow growth is coming from options related tax benefits.
• Overstuffed Warehouses - When inventories rise faster than sales, there’s likely to be trouble on the horizon. When a
company produces more than its selling, either the demand has dried up or the company has been overly ambitious in
forecasting the demand. In any case, the unsold goods have to be sold either through discount or written off which is a big
charge on the earnings.
• To Expense or Not to Expense - Companies can also fiddle with their costs by capitalizing them. Operating costs such as
office supplies, office rents, so forth, are expensed because they produce a short term benefit. Ex. We pay rent only one
month or year at a time and the benefit we receive expires at the year end.
• Change is Bad - Firms can change things as basic as how expenses are recorded and when revenue is recognized (one of the
grey accounting areas) we will get all of this information in the “summary of significant accounting policies” if the firm
makes changes that materially increases revenue or reduces expenses, watch out. Unless these moves were required by the
accounting rule makers, the firm is probably trying to cover up deteriorating result.
Finding this kind of information will take some digging around in the footnotes, of a company’s annual report. Sometimes
expenses are capitalized, and if you find these ask some hard questions about how long the “asset” will provide the economic
benefit. Look at the useful life of the asset.