Per$onal Finance: Investment strategy might bear rethinking

Find a company with a strong product or promising idea, mix in top-flight management, throw in strong earnings and, voila, you have a good reason to buy the stock.<br><br>What a concept.<br><br>Many investors

Monday, April 24th 2000, 12:00 am

By: News On 6

Find a company with a strong product or promising idea, mix in top-flight management, throw in strong earnings and, voila, you have a good reason to buy the stock.

What a concept.

Many investors forgot that plain-vanilla advice and became so captivated with any company that stuck a "dot.com" at the end of its name that they paid for it dearly in the stock market's recent turmoil.

"The correction took everybody down," Mary Farrell, investment strategist at brokerage firm PaineWebber, said in an interview after a recent appearance in Dallas.

"They forgot that the rules of valuation haven't been repealed."

Finance experts said the stock market's debacle and subsequent uncertainty are painful reminders to investors that good, old-fashioned stock-picking principles do work.

"When it's all said and done, the fundamentals do matter," said Brian Mattes, spokesman and principal at The Vanguard Group mutual fund firm.

"You can't get by with just a promise or great idea. You need to make it work. You still need earnings because in the end, that is what really counts."

Many investors in the market's recent bloodbath expected too much from fledgling tech firms as well as the giants, analysts said.

"I would like to see people awakened by this crazy market get back to realistic values and realistic expectations," said Alan Goldfarb, a certified financial planner and director of financial planning at Axa Advisors in Dallas.

"What's killing the market are unrealistic values and unrealistic expectations."

It all comes down to financial common sense.

"If I have to spend $1.50 for every dollar of revenue that comes back, the only way I grow is that the capital markets keep having to finance me," said Brian Bruce, a finance professor at Southern Methodist University. "At some point, they [tech firms] have to transition to profits because if you don't have at least break-even or positive cash flows, the only way you can get money is to have the capital markets financing it."

The question is: How much patience do investors have?

"These stocks have risen because the market is betting that sales growth will eventually translate into growing earnings," said Amy C. Arnott and Olivia Barbee, senior analysts at Morningstar StockInvestor, an investment publication. "If you're an Internet investor, keep in mind that the market will only wait so long before it expects to see some black ink."

The tumble in stocks will cause investors "to think very carefully before they throw money at one of these dot.coms," Ms. Farrell said.

That's not to say that investors should dismiss technology stocks altogether.

"The thing to keep in mind is that the Internet is actually transforming the way we do business and the way we live, and there are many companies that are superb five- and 10-year holdings that will make money," said Jonathan Schoolar, a senior portfolio manager at Aim Capital Management in Houston, a mutual fund company.

But in the context of evaluating such companies, more attention should be paid to earnings prospects, investment experts said.

"It's back to basics," Mr. Schoolar said. "Find real companies that are making money and stick with them."

The trick is to not get caught up in the hype of a stock, he said.

"Bubbles don't begin irrationally, but they become irrational," Mr. Schoolar said.

"As investors experience success in a sector, more and more low-quality stuff comes out and valuations go to ridiculous extremes."

A cardinal rule is to invest in companies whose products and services you know and understand.

Pay attention to trends around you.

For example, Ms. Farrell likes the stock of Home Depot because stressed-out baby boomers are spending heavily on home improvement.

Numbers are also important in studying a stock. These are the areas you should look at:

What does the company do?

"This sounds like pretty basic information, but it can be tough to find," Ms. Arnott and Ms. Barbee said. "Most companies offer more than one product."

The shareholder letter in a company's annual report is a good place to look for the information, Ms. Arnott and Ms. Barbee wrote in an article.

"Digging into the company's lineup can give you a better sense of the competitive forces that will drive its results," they said.

The company's growth rate.

Ultimately, stock prices are driven by earnings growth.

"A company can often fatten its bottom line through cost-cutting, but ultimately, revenues have to increase if earnings are to maintain an upward match," Ms. Arnott and Ms. Barbee said.

If sales are increasing, that's a good sign. Growth in earnings means that the company is making more than enough to offset its costs.

"For established companies, look at quarter-by-quarter earnings, which often are provided in the annual report [and are also available at www.morningstar.com]," the Morningstar analysts said. "The more consistent the company's results, the better."

Young companies will often have revenue growth but no profits.

Profitability measures.

These will tell you how efficiently a company has used its resources. "Return on assets [net income divided by total assets]" tells you how well a company has translated a dollar of its assets into a dollar of earnings.

For example, a company with a return on assets of 20 percent has translated each dollar of assets into 20 cents of earnings.

Another profitability yardstick is "return on equity [net income divided by shareholders' equity]." This percentage number tells shareholders how effectively the company is using their money.

Return on equity and return on assets enable you to evaluate the profitability of companies of different sizes.

"Although two companies might have the same net income of $1 billion, looking to see which has a larger return on equity or return on assets will point you to the company that has most efficiently used its resources to generate that $1 billion," Ms. Arnott and Ms. Barbee said.

Cash figures.

Earnings and "cash flow" aren't the same thing.

You could earn lots of money but still run into cash-flow problems if your employer pays you only twice a year.

The cash flow figure in a company's annual report tells you how much money the firm brought through the door.

Because of quirks in accounting, a company's reported earnings often differ from cash flow.

"A company that recognizes revenues before actually receiving payments or that delays recognizing expenses for which it has already cut checks might be reporting healthy-looking earnings without generating much cash," Ms. Arnott and Ms. Barbee said.

The company's debt.

Firms are similar to consumers. They can use debt strategically or they can take on too much and get hurt.

Using debt efficiently can give a company flexibility to build new plants, pay for research and make it through a short-term cash crunch.

"Too much borrowing can suck away cash that could be put to use more productively," Ms. Arnott and Ms. Barbee said.

There's no hard-and-fast rule that tells you how much debt is appropriate for a particular company because debt levels vary among industries, they said.

One way to see if a company is overextended is to compare its debt with its competitors.

Is a stock worth its price?

Here's where many tech investors got burned because they were paying enormous amounts of money for a company, whose earnings - or lack of - couldn't justify its stock price.

One of the most common measures to decide whether a stock is cheap is the "price/earnings ratio" or P/E. That's a stock's price divided by its earnings per share.

If calculated with the past year's earnings, it's called the "trailing P/E." If calculated with a forecast for next year's earnings, it's called a "forward P/E."

"Always use 12-month forward earnings to calculate the P/E and never [the] trailing 12-month P/E because what happened in the rear view mirror doesn't matter," Mr. Schoolar said.

The ratio is also called a "multiple" because it gives investors an idea of how much they're paying for a company's earning power. The higher the P/E, the more investors are paying and therefore the more earnings growth they're expecting.

Because many start-up tech firms don't have earnings yet, many analysts use a price/sales ratio to evaluate them. Some investors also use the ratio to spot undervalued companies.

Additionally, if a company's generating extra cash, that means it could use that money to invest in other things or that could make it an attractive acquisition target, said Don Hodges, portfolio manager of the Hodges Fund in Dallas.

"Sometimes, a stock for no reason at all drops precipitously and it will go down so much in price that you instinctively know that it's got more value than that," he said.

If you have most of your money in your company's 401(k) retirement savings account or a nonretirement mutual fund, you have professional money managers to crunch the numbers for you.

But that doesn't mean you can avoid doing your homework.

Look for a manager with at least a five-year record who's done a consistently good job.

If a fund has returns that are far out of whack with its peers, that's a red flag.

"If you're looking at a mutual fund that has out-of-body returns - returns that are just so far above average that they almost don't seem real, there's a real good chance that they aren't real," Mr. Schoolar said.

Pamela Yip covers personal finance for The Dallas Morning News. If you have a story idea, e-mail her at pyip@dallasnews.com.