Stock Investing

Institutional Investors And Fundamentals: What's The Link?


Many investors quickly learn to appreciate the significance of institutional shareholders - the mutual funds, pension funds, banks and other big financial institutions. These types of investing entities are often referred to as "smart money" and are estimated to account for as much as 70% of all trading activity. This professional stock buying is called institutional sponsorship and is believed by many stock watchers to send a strong message about a company's health and financial future.

However, investors with a fundamental approach need to understand the connection between a company's fundamentals and the interest the company attracts from large institutions. Institutional sponsorship, often driven by factors other than fundamentals, is not always a good gauge of stock quality.
The Dependability of Institutions
The argument that institutional sponsorship signals strong fundamentals makes a lot of sense. Big institutions make their living buying and selling stocks. Working hard to buy stocks that are undervalued and offer good prospects, institutional investors employ analysts, researchers and other specialists to get the best information about companies. The institutions meet regularly with CEOs, evaluate industry conditions and study the outlook for every company in which they plan to invest.

Besides, the institutions with large stakes have a vested interest in increasing the value of their shareholdings. Big institutional investors can exercise significant voting power and impact strategic decision making. These shareholders tend to promote value-driven decisions and create shareholder wealth by ensuring that management maximize the stream of earnings. Broadly speaking, research shows that high ownership concentration generally leads to better monitoring of management, leading to higher stock valuation.

Academic research suggests that institutional holdings pay off. In their study "Does Smart Money Move Markets?", which is published in the Spring 2003 edition of Institutional Investor Journals, Scott Gibson of the University of Minnesota and Assem Safieddine of Michigan State University, compare changes in total institutional ownership to stock returns over the each quarter from 1980 to 1994. During the 15-year period, stocks with the largest quarterly increase in institutional ownership (about 20% of all stocks) consistently posted positive returns.

William J. O'Neill, founder of Investor's Business Daily and creator of the CANSLIM stock selection methodology, argues in his book "How to Make Money in Stocks" (1988) that it is important to know how many institutions hold positions in a company's stock and if the number of institutions purchasing the stock now and in recent quarters is increasing. If a stock has no sponsorship, the odds are good that some looked at the stock's fundamentals and rejected it.

When the Dependability Becomes Instability
Of course, you can have too much of a good thing. O'Neil is careful to point out that while institutional sponsorship is attractive, a lot of institutional ownership can be a sign of danger. If something goes wrong with a company and all the institutions holding it sell en masse, the stock's valuation can tank - regardless of fundamentals.

Think of a stock as a swimming pool. The water level is analogous to the stock price, and elephants represent institutional investors. If the elephants suddenly start stepping into the pool (buy the stock), the water level (the price of the stock) will rise very quickly. But if the elephants get spooked and leap out of that pool (or sell the stock), then the water level (price of the stock) will fall rapidly.

Remember, institutions are not only investors but also traders. In principle, they will put money into stocks only after lots of fundamental analysis, identifying where the stock price should be and compare that to where it is. In practice, however, they often forego fundamental analysis for the signals emitted by technical indicators. Because their main worry is whether the stock price is going up or down, institutions will often concentrate on whether the price direction has any momentum.

A stock with a lot of institutional support may be close to the peak of its valuation, or full of elephants. When every mutual and pension fund in the land owns a chunk of a particular stock, it may have nowhere to go but down. Look at the meltdown of technology stocks in 2000 and 2001. Companies like Cisco, Intel, Amazon and others had an unprecedented amount of institutional sponsorship, but, as the subsequent collapse of their share price demonstrated, they also had unattractive fundamentals.

The legendary investor, Peter Lynch, thinks institutional investors make poor role models for individual investors. In his best-selling book "One Up on Wall Street", he lists thirteen characteristics of the perfect stock. Here's one of them: "Institutions Don't Own It and the Analysts Don't Follow It." Lynch brushes aside the notion that companies without institutional support carry the risk never being discovered: he argues that the market eventually finds undervalued companies with solid fundamentals. These companies are never out of sight for long. By the time institutional investors discover these hidden gems, the companies will no longer be hidden but fairly valued, if not overvalued.

Finding Out Who Holds the Institutional Sponsorship
It all comes down to the quality of institutional sponsorship. With a little extra research, investors can find out which institutions own the stock. For spotting companies with good fundamentals, you can determine if the stock is owned by funds with good track records.

One way to see if a stock has some institutional support is by checking its trading activity for block trades. A block trade, which is a single trade of a large number of shares, typically has a value of at least $100,000. Normally only an institutional investor has the money to buy such blocks.

Otherwise, visit Multex Investor, which provides a list of links to research reports online, some of which may identify institutional holdings. Many of the Multex reports are free.

Of course, the easiest way to find out if a company has some institutional sponsorship is simply to ask it. Often the company's investor-relations web page will provide a listing. Otherwise ask the company's representative if any of their shares are held by mutual funds, pension funds or other institutional investors. They should be able to tell you which institutions are shareholders.

Conclusion
Although logic and statistics show that institutional sponsorship is a good indicator of a good company, investors should be aware that institutional investing is not always driven by quality fundamentals. Before you depend on the assumption that smart money is the leader in judging fundamentals, make sure you determine whether the institutions are investing for the same reason you are.
Spot Quality With ROIC
Return on invested capital, or ROIC, is arguably one of the most reliable performance metrics for spotting quality investments. But in spite of its importance, the metric just doesn't get the same level of interest and exposure as, say, the P/E or ROE ratios. Admittedly, investors can't just pull ROIC straight off a financial document like they can with better known performance ratios; calculating ROIC requires a bit more work. But ROIC is well worth the effort for those eager to learn just how much profit and, hence, true value a company is producing.

Important mainly for assessing companies in industries that invest a large amount of capital - such as oil and gas players, semiconductor chip companies, and even food giants - ROIC is a telling gauge for comparing the relative profitability levels of companies. For many industrial sectors, ROIC is the preferred benchmark for comparing performance. In fact, if investors were forced to rely on a sole ratio (not a good idea, mind you), they would be best off choosing ROIC.

The Calculations
Defined as the cash rate of return on capital that a company has invested, ROIC shows how much cash is going out of a business in relation to how much is coming in. In an nutshell, ROIC is the measure of cash-on-cash yield and the effectiveness of the company's employment of capital. The formula looks like this:
ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital.
At first glance, the formula looks fairly simple. But in the complex financial statements published by companies, generating an accurate number from the formula can be trickier than it appears. To keep things simple, start with invested capital, the formula's denominator. Representing all the cash that investors have put into the company, invested capital is derived from the assets and liabilities portions of the balance sheet as follows:
Invested Capital = Total Assets less Cash - Short Term Investments - Long Term Investments - Non-Interest Bearing Current Liabilities.
Now, investors turn to the income statement to determine the numerator, which is after-tax operating profits, or NOPAT. Sometimes NOPAT is the same as net income. For many companies, especially bigger ones, some net income comes from outside investments, in which case net income does not reflect the profitability of operating activities. Reported net income needs to be adjusted to represent operations more accurately. At the same time, the published net income figure also may include non-cash items that need to be added and subtracted from NOPAT to reflect true cash yield. For the purpose of showing all of a company's cash profits from the capital it invests, NOPAT is calculated as the following:
NOPAT = Reported Net Income - Investment and Interest Income - Tax Shield from Interest Expenses (effective tax rate x interest expense) + Goodwill Amortization + Non-Recurring Costs plus Interest Expenses + Tax Paid on Investments and Interest Income (effective tax rate x investment income)

Interpreting ROIC
If the final ROIC figure, which is expressed as a percentage, is greater than the company's working asset cost of capital, or WACC, the company is creating value for investors. The WACC represents the minimum rate of return (risk adjusted) at which a company produces value for its investors. Let's say a company produces a ROIC of 20% and has a cost of capital of 11%. That means the company has created nine cents of value for every dollar that it invests in capital. By contrast, if ROIC is less than WACC, the company is eroding value; investors should be putting their money elsewhere.

The extent to which ROIC exceeds WACC provides an extremely powerful tool for choosing investments. The P/E ratio, on the other hand, does not tell investors whether the company is producing value or how much capital the company consumes to produce its earnings. ROIC, by contrast, provides all this valuable information and more.

Moreover, ROIC helps explain why companies trade at different P/E ratios. The market demonstrates this well. From 1999 to 2003, the S&P 500 average P/E ratio fell roughly from 25 to 15, so the S&P 500 was trading at a discount to its historical multiple - does that mean the S&P 500 was oversold? Some market watchers thought so, but ROIC-based analysis suggested otherwise. Although the P/E ratio diminished, there was also a proportional reduction in the market's ROIC. This makes a lot of sense: since 1999 companies had had a much harder time allocating capital to worthwhile projects.

Investors should look not only at the level of ROIC but also the trend. A falling ROIC can provide an early warning sign of a company's difficulty in choosing investment opportunities or coping with competitors. ROIC that is going up, meanwhile, strongly indicates that a company is pulling ahead competitors or that its managers are more effectively allocating capital investments.
ROIC is a highly reliable instrument for measuring investment quality. It takes a bit of work, but, once investors start figuring out ROIC, they can begin to track company results annually and be better armed to spot quality companies before everyone else does.


Analyzing Pension Risk


There is great debate about what, if any, risk is posed by underfunded pensions. Murky accounting and limited disclosure make it difficult for investors to evaluate this risk. In this article we will discuss the issues surrounding pension risk. In Evaluating Pension Risk by Analyzing Annual Costs we present a way for investors to evaluate pension risk.
Pension Risk Defined
From an investor's point of view, pension risk is the risk to a company's EPS and financial condition that arises from an underfunded defined-benefit pension plan. Before we define 'underfunded', it is important we note that pension risk arises only with defined-benefit plans.

A defined-benefit pension plan promises to pay a specific (defined) benefit to retired employees. In order to meet this obligation, the company must invest wisely so that it has the funds to pay the promised benefits. The company bears the investment risk because it has promised to pay employees a fixed benefit and must make up for any investment losses. Under a defined contribution plan, which is sometimes called profit sharing, the employees bear the investment risk because the company, rather than paying a fixed benefit directly to retired employees, contributes a specific amount to employees' retirement accounts, so any gains/losses of these retirement investments belong to the employees. While the number of defined-benefit plans has declined, the unionized companies have the greatest risk.
'Underfunded' means that the liabilities, the obligations to pay pensions under defined-benefit retirement plans, exceed the assets (the investment portfolio) that have accumulated for the purpose to fund those required payments. These assets are a combination of invested corporate contributions and the returns on those investments.

Under current IRS and accounting rules, pensions can be funded by cash contributions and by company stock, but the amount of stock that can be contributed is limited to 10% of the total portfolio. Companies generally contribute as much stock as they can in order to minimize their cash contributions, but this is not good portfolio management because it results in an 'overinvestment' in the employer: the portfolio is then overly dependent on the financial health of the employer for both future contributions and good returns on the employer's stock.

If over three consecutive years the value of the pension's assets is less than 90% funded, or if in any year the assets are less than 80% funded, the company must increase its contribution to the pension portfolio, which is usually in the form of cash. The need to make this cash payment could materially reduce EPS and equity. The reduction in equity could trigger defaults under corporate loan agreements, which generally have serious consequences (ranging from higher interest rates to bankruptcy).

That was the simple part. Now it starts to get complicated.

Shortfall Risk
Determining whether a company has an underfunded pension plan is as simple as comparing the fair value of plan assets, which includes the current value of the plan assets that the company estimates it will have in the future, to the accumulated benefit obligation, which includes the current and future amounts owed to pensioners. If the fair value of the plan assets is less than the benefit obligation there is a pension shortfall. The company is required to disclose this information in a footnote in a company's 10-K annual financial statement.

However, this simple comparison is a deceptive process because it is unlikely that the company will actually have to pay the full amount in a relatively short time frame. A company must place a current value on the benefits that won't be paid until several years into the future and then compare this number to the current value of pension assets. To put it another way, it's like comparing the mortgage on your recently purchased home to your savings account. The gap is currently very large, but you expect to make the payments from future earnings. What is the 'real' risk that you will default on your mortgage?


Assumption Risk
This is the risk of companies using assumptions to reduce the need to add cash to their pension funds. Because we are dealing with long-term obligations and uncertainties, assumptions are necessary for estimating both the accumulated benefits and the amount the company needs to invest to provide those benefits. These assumptions can be made in good faith, or they can be used to minimize any adverse impact on corporate earnings. There is the very real risk that companies will adjust their assumptions to minimize the shortfall and the need to contribute additional money to the pension fund.

For example, a company could assume a long-term rate of return of 9.5%, which would increase the funds expected to come from investments and thus reduce the need to add cash. This assumption, however, looks overly optimistic if you consider that the long-term return on stocks is about 7% and the return on bonds is even lower. And, it is reasonable to assume that the pension fund would have some bond holdings in order to meet the near-term payment obligations.

Another way companies can manipulate (reduce) the pension liability is to assume a higher discount rate. The accumulated pension obligation is the net present value of the future stream of expected benefit payments. A higher discount rate will result in a lower benefit obligation.

Investors need to review the assumptions in relation to current economic trends and expectations in order to evaluate the reasonableness of these assumptions. We will discuss how to do this in my next article.

The Bottom Line
The risk of underfunded pensions is real and growing. An underfunded pension and an aging workforce is a very real risk to companies and investors, but, the shortfall and assumption risks are very hard to evaluate

Wall Street Post Spitzer


What hath Spitzer wrought?

The much-ballyhooed Wall Street settlement is supposed to punish the perps and fix research, but it will probably do neither. The settlement will most likely decrease market efficiencies and thus increase costs of both issuers and investors. However, some good will come from the harsh glare of publicity that accompanied the process: here are the good, the bad and the ugly sides of the settlement.
The Good: Tough Love on Wall Street
The good thing about Mr. Spitzer's efforts is that it undoubtedly accelerated a necessary examination of Wall Street practices. While these practices themselves have been around since the first traders gathered, excesses served as a function of the last bubble, leading to the corruption of research staffs, the demolition of the Chinese Wall and, most importantly, the loss of investors' trust.

If left ignored, Wall Street might have never underwent this cleansing process. Wall Street has always been a closed club whose oversight actions are implemented at glacier speed, and often with a wink. Generally, it is an outside force that encourages change, and this time it was New York State Attorney General, Mr. Spitzer, who forced the issue into the glare of public scrutiny. There may be differing opinions about why he chose this issue and how efficient the results may be, but Wall Street will be better off because investors are now more informed about how Wall Street works.

The Bad: Ineffective Effort and Wasted Money
The settlement will more than likely increase costs for both sides of the Street (issuers and investors). The need to comply with all the new regulations arising from the dotcom crash (including Sarbanes-Oxley) is increasing corporate expenses across the board, which will reduce earnings and raise the cost of products and services. Investors will interpret these costs as increased brokerage fees and other hidden charges in banking and insurance rates.

If you think that is bad, just wait until you see what the lawyers do! The documents released with the settlement will provide a cornucopia of material for class action lawsuits that will do more to line lawyers' pockets than to redress past wrongs. The cost of director and officer insurance rates will therefore rise, which in turn will further erode corporate earnings.


The Ugly: The Street Remains Broken
It is hard to believe that $1.4 billion is about to be wasted on ineffective provisions. Many may think that this money will provide restitution, objective research and protection for investors, but it will probably do none of the above. Here is a summary of the SEC's press release and some comments on how we see the potential end results:
•$775 million will be paid as "restitution" to investors hurt by tainted research - Half will go the SEC, NYSE and NASD while the remainder will go to the states. The amount is a joke compared to the trillions lost by investors and the billions in fees that the brokerages earned. It is also doubtful that individual investors will see much, if any, of this money, because it will be held by regulators to recoup their costs and by states to help offset budget deficits.
• $432.5 million earmarked for independent research - While the intent is noble, this is not likely to result in more objective information for investors. From what I have discerned, each brokerage firm will have an employee in charge of finding an independent firm to publish research on the stocks the firm follows. This addition of independent will not add any new information; adding ten analysts to the current crop of 38 analysts covering, say, Cisco will not uncover anything new
• $80 million will go to a yet undefined investor education program - While this has potential to do some good, its success will be determined only by those who administer the funds.
• The above settlements amount to a total of $1.288 million, leaving about $112 million unaccounted for. Most of this amount appears to involve the separate $100 million settlement reached with Merrill Lynch and may be in addition to the other restitution fines, but the use of the funds was not clear in the SEC's release.

I think the most unfortunate thing is that funds earmarked for research will do little to bridge the information gap on Wall Street - this plan's weakness is that it will increase the number of analysts following companies that already have too many analysts! How much new information can be provided by adding more reports on big-cap stocks?

The plan instead should call for an independent administrator or committee of practitioners and regulators to establish an analyst cooperative. The coop would select qualified analysts to provide one new report for each of the firms currently covered by Wall Street, thus reducing redundancy and wasted effort. In addition, the analysts, who would be independent contractors, would be incented to provide research on orphaned stocks, which have little or no analyst coverage. If these analysts then provided good investment ideas, meaning these stocks appreciated, and were accurate with their EPS forecasts, these analysts would receive a bonus on top of a standard report fee.

The Bottom Line
In every post-bubble market, it is deemed necessary to fix the system with new regulations and to punish the wrong doers. Whether regulations actually fix the system or just present temporary obstacles to creative financiers remains to be seen. The key fact is that Mr. Spitzer helped to accelerate efforts and educate investors. It is unlikely, however, that there are any innocents left on Wall Street, at least in this generation of investors.
Investors Need A Good WACC


During the dotcom era, there were predictions of the Dow Jones index soaring to 30,000. But this was a time when the market lost itself to the hype. When investors, along with their valuations, come back down to earth from such heights, there can be a loud thump, reminding everyone that it's time to get back to fundamentals and take a look at a key aspect of share valuations: the weighted average cost of capital (WACC).
Understanding WACC
The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect. WACC, in other words, represents the investors' opportunity cost of taking on the risk of putting money into a company.

To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying for debt, any cash left over that is not returned to shareholders in the form of dividends is kept in the bag on behalf of shareholders. If debt holders require a 10% return on their investment and shareholders require a 20% return, then, on average, projects funded by the bag of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.

If the only money the bag held was $50 from debt holders and $50 from shareholders, and the company invested $100 in a project, the return from this project, to meet expectations, would have to return $5 a year to debt holders and $10 a year to shareholders. This would require a total return of $15 a year, or a 15% WACC.

Securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.

Investors use WACC as a tool to decide whether or not to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company's return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

WACC serves as a useful reality check for investors. To be blunt, the average investor probably wouldn't go to the trouble of calculating WACC because it is a complicated measure that requires much detailed company information. Nonetheless, it helps investors know the meaning of WACC when they see it in brokerage analysts' reports.

Calculating WACC
To calculate WAAC, investors need to determine the company's cost of equity and cost of debt. Here's a breakdown:

Cost of Equity
The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn't mean no cost of equity exists. Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price theoretically satisfactory to investors. On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): Re = Rf + Beta (Rm-Rf). But what does that mean?
• Rf – Risk-free rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.
• ß – Beta - This measures how much a company's share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share price moves in the opposite direction to the broader market.

For public companies, you can find database services that publish betas of companies. Few services do a better job of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta estimation service, this site describes the process by which they come up with "fundamental" betas. Bloomberg and Ibbotson are other valuable sources of industry betas.
• (Rm – Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP) represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become more risky.

The EMRP frequently cited is based on the historical average annual excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will in most cases be lower than the arithmetic mean. Both methods are popular but the arithmetic average has gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease company's risk profile of the company. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment and they vary from company to company.
Cost of Debt
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated.

As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).

Finally – Capital Structure
The WACC is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value (equity + debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value (equity + debt). The WACC is represented by the following formula: WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.

A company's WACC is a function of the mix between debt and equity and the cost of that debt and equity. On one hand, in the past few years, falling interest rates have reduced the WACC of companies. On the other hand, the spate of corporate disasters like those at Enron and WorldCom have increased the perceived risk of equity investments.

Be warned: the WACC formula seems easier to calculate than it really is. Just as two people will hardly ever interpret a piece of art the same way, rarely will two people derive the same WACC. And even if two people do reach the same WACC, all the other applied judgments and valuation methods will likely ensure that each has a different opinion regarding the components that comprise the company value.

Working Capital Works

Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund operations, reinvest and meet capital requirements and payments. Understanding a company's cash flow health is essential to making investment decisions. A good way to judge a company's cash flow prospects is to look at its working capital management (WCM).
What Is Working Capital?
Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. Among the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength.

Take a simplistic case: a spaghetti sauce company uses $100 to build up its inventory of tomatoes, onions, garlic, spices, etc. A week later, the company assembles the ingredients into sauce and ships it out. A week after the checks arrive from customers. That $100, which has been tied up for two weeks, is the company's working capital. The quicker the company sells the spaghetti sauce, the quicker the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. If the ingredients sit in inventory for a month, company cash stays tied-up and can't be used to grow the spaghetti business. Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. Working capital also gets trapped when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.

The better a company manages its working capital, the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that will generate suitable returns for investors.

Not All Companies Are the Same
Some companies are inherently better placed than others. Insurance companies, for instance, receive premium payments up front before having to make any payments; however, insurance companies do have unpredictable outgoings as claims come in.

Normally a big retailer like Wal-Mart has little to worry about when it comes to accounts receivable: customers pay for goods on the spot. Inventories represent the biggest problem for retailers, who must perform rigorous inventory forecasting or they risk being out of business in a short time.

Timing and lumpiness of payments can pose serious troubles. Manufacturing companies, for example, incur substantial up-front costs for materials and labor before receiving payment. Much of the time they eat more cash than they generate.

Evaluating Companies
Investors should favor companies that place emphasis on supply-chain management to ensure that trade terms are optimized. Days-sales outstanding, or DSO for short, is a good indication of working capital management practices. DSO provides a rough guide to the number of days that a company takes to collect payment after making a sale. Here is the simple formula:
Receivables/ annual sales/365 days

Rising DSO is sign of trouble since it shows that a company is taking longer to collect its payments. It suggests that the company is not going to have enough cash to fund short-term obligations because the cash cycle is lengthening. A spike in DSO is even more worrisome, especially for companies that are already low on cash.

The inventory turnover ratio offers another good instrument for assessing the effectiveness of WCM. The inventory ratio shows how fast/often companies are able to get their goods completely off the shelves. The inventory ratio looks like this:
Cost of goods sold (COGS)/Inventory

Broadly speaking, a high inventory turnover ratio is good for business. Products that sit on the shelf are not making money. Granted, an increase in the ratio can be a positive sign, indicating that management, expecting sales to increase, is building up inventory ahead of time.

For investors, a company's inventory turnover ratio is best seen in light of its competitors. In a given sector where, say, it is normal for a company to completely sell out and re-stock six times a year, a company that achieves a turnover ratio of four is an underperformer.


Computer giant and stock market champion, Dell, recognized early that a good way to bolster shareholder value was to notch up working capital management. The company's world-class supply-chain management system ensures that DSO stays low. Improvements in inventory turnover increased cash flow, all but eliminating liquidity risk, leaving Dell with more cash on the balance sheet to distribute to shareholders or fund growth plans.

Dell's exceptional WCM certainly exceeds those of the top executives who do not worry enough about the nitty-gritty of working capital management. Some CEOs frequently see borrowing and raising equity as the only way to boost cash flow. Other times, when faced with a cash crunch, instead of setting straight inventory turnover levels and reducing DSO, these management teams pursue rampant cost cutting and restructuring that may later aggravate problems.

Cash is king, especially at a time when fund raising is harder than ever. Letting it slip away is an oversight that investors should not forgive.

The End of Wall Street Research

It amazes me that so many small-cap companies continue to ignore the individual investor and futilely focus their IR efforts on getting the attention of institutions. You would think these small caps would wake up to the fact that Wall Street doesn't care about any company that does not offer an investment banking deal. After all, that's why 60% of the publicly traded stocks lack research coverage.

Institutional Attitudes
Wall Street's limited attention on small-caps is not surprising since the large institutional investors now run Wall Street research, which caters to institutional demands for big commissions on the large trades. These commissions are the only way the large brokerage firms can pay for their research departments.

John Bogle, the founder of Vanguard Funds, typifies the institutional mind set. He audaciously claims that there is no liquidity crisis on Wall Street, and at the annual National Investor Relations Institute (NIRI) conference in 2003, he wondered how anyone could claim otherwise if trillions of dollars are traded on the markets every day. It is true that trillions of dollars are traded in the market, but that volume consists of only 20 stocks! The majority of publicly traded stocks are caught in liquidity limbo: they have good fundamentals but not enough trading volume for large institutions to take notice.
The Impact of Individuals
But what should you expect from a man like Bogle, who feels that every investor should buy only index funds and not play the "loser's game of individual stock picking"?

If we followed Mr. Bogle's advice, the individual investors would not have acted as savvy as they did when they sold all their holdings of Enron and WorldCom faster than Bogle's portfolio managers did! The individual investors were able to avoid the crash in these (and other) stocks because their choices are not limited by what Wall Street was selling. Individual investors have a competitive advantage because they can invest in the smaller-cap stocks that have long-term investment potential, and these investors are not overly concerned if they do not beat a specific index.


For two main reasons individual investors have a larger impact today than ever before. First, the Internet provides the individual with the power to do their own research and make their own trades. Second, individuals become more educated every day thanks to the information provided in the financial press and investment-related websites. These forces have eliminated the individual investor's dependency on large Wall Street brokerage firms.

The more pro-active companies are realizing this and are starting to provide information directly to individuals, and this effort is appreciated. In a survey conducted by Researchstock.com and Investopedia.com, we found that individual investors want information, even if it has been paid for buy the company. (To see the survey results, click here.) The overwhelming majority of survey participants felt that companies that engaged legitimate fee-based research firms to provide reports on their companies were making a positive statement about their firm's long-term investment potential.

The Bottom Line
I think we are watching the end of Wall Street research. I don't think Wall Street itself will end, but the information it produces is becoming more irrelevant to the majority of investors, which are individuals. Wall Street analysts, longer free to look for the best ideas, are chained to selling yesterday's winners only because of the liquidity.

The foundation of the next bull market will be individual investors and proactive companies, both of whom are circumventing the old Wall Street. Independent research firms and legitimate fee-based research will bridge the information gap and be the force of creative destruction that will result in a new Wall Street.
Governance Pays


If corporate collapses like Enron, Global Crossing and World Com have taught us anything, it's that investors can't afford to ignore the issue of corporate governance. When conducting fundamental analysis, investors need to keep a close eye on the way that companies keep management in check and ensure financial disclosure, board independence, and shareholder rights. Recent studies suggest that the benefits of scrutinizing governance extend beyond simply avoiding disasters. Good corporate governance can increase a company's valuation and boost its bottom line.
What Is Corporate Governance?
Corporate governance is a fancy term for the way in which directors and auditors handle their responsibilities towards shareholders and other company stakeholders. Think of it as the system by which corporations are directed and controlled. Typical corporate governance measures include appointing non-executive directors, placing constraints on management power and ownership concentration, as well as ensuring proper disclosure of financial information and executive compensation.

Surprisingly, corporate governance has been considered a secondary factor impacting a company's performance. That is, as opposed to a company's financial position, strategy and operating capabilities, the effectiveness of governance practices was largely seen as important only in special circumstances like CEO changes and merger-and-acquisition (M&A) decisions.

But recent events prove that governance practices are not merely a secondary factor. When the company's share price tanks because of an accounting scandal, the importance of good governance practices become obvious. Corporate disasters show that the absence of effective corporate controls puts the company and its investors at tremendous risk.

What the Studies Prove
For years, investors ignored corporate governance because academic research found no clear causal link between governance and financial performance. But that is starting to change. A paper by Harvard and Wharton business professors entitled "Corporate Governance and Equity Prices" concludes that investors that sold U.S. companies with the weakest shareholder rights and bought those with the strongest shareholder rights earned an additional return as high as 8.5%.

The study analyzes 1,500 companies and ranks them based on 24 corporate governance provisions. Those companies with the lowest rankings were less profitable and had lower sales growth. Moreover, the returns on these companies lagged far behind those of higher ranked firms. The paper also shows that for each one-point increase in shareholder rights, a company's value increased by a whopping 11.4%.

Meanwhile, a study produced in 2000 by global consultancy McKinsey found that 75% of the 200 institutional investors it surveyed regard board practices as important as financial metrics for assessing companies. The study showed that companies that moved from the worst to the best governance practices could expect a 10% increase in market valuation.

Investors Are Starting to Take Notice
Amid all the hand wringing about corporate governance, investors are getting help in steering clear of mis-governed companies and finding well-governed ones. Governments, stock exchanges and securities watchdogs are coming up with new rules and regulations that try to put a stop to some of the worst cases of corporate failure. Proposals at the New York Stock Exchange and the SEC that push for more boardroom independence and greater financial expertise in audit committees certainly accelerate improved practices and reassure investors.

At the same time, a veritable cottage industry has sprung up among ratings agencies and consultants issuing corporate governance ratings. Investors can turn to Standard & Poor's Corporate Governance Score and Institutional Shareholder Services' Corporate Governance Quotient. Both of them report and grade public companies' governance practices. In addition, the Investor Responsibility Research Center, along with corporate governance watchdogs like the Corporate Library and Governance Metrics provide governance performance ratings.
While new regulatory proposals and rating systems are valuable to investors, they are no guarantee that companies are well run. Investors need to evaluate corporate governance for themselves. Here is a quick list of key issues for investors to consider when analyzing corporate governance:
• Board Accountability - Boards of directors (BODs) are the links between managers and shareholders. As such, the BOD is potentially the most effective instrument of good governance and constraint on the top managers. Investors should examine corporate filings to see who sits on the board. Make sure you seek out companies with plenty of independent directors who have no commercial links to the firm and who demonstrate an objective willingness to question management choices. A minority of independent directors make it difficult for the board to operate outside the sphere of management influence. Do directors own shares in the company? If not, they may have less incentive to serve shareholders' best interests. What are directors' attendance records at board and committee meetings? Finally, does the board adhere to a set of published governance principles?
• Financial Disclosure and Controls - Investors should insist that corporate structure includes an audit committee composed of independent directors with significant financial experience. Ideally, the committee should have sole power to hire and fire the company's auditors and approve non-audit services from the auditor. Persistent earnings restatements or lawsuits challenging the accuracy of financial statements provide a clear signal to investors that financial disclosure and controls are not functioning properly. Top management compensation should be determined by measurable performance goals (shareholder return, ROE, ROA, EPS growth), and, if possible, the compensation rate should be set by an independent compensation committee and fully disclosed.
• Shareholder Rights - Be wary of companies with dual-class stock. Class A and B shares can place major constraint on shareholder rights, enabling insiders to accumulate majority power by virtue of owning vote-tilted class B shares. Voting should always be routine through mail, telephone and Internet, and shareholders should have the right to approve major transactions, including mergers, restructuring and equity-based compensation plans.
• Market for Control - Management power can become entrenched by strong takeover defense provisions, such as poison pills or the issue of blank check preferred preferred stock. These mechanisms protect against hostile takeovers and subsequent management change, but investors should cheer poison-pill plans only when fully trusting and supporting management.

Be aware also that directors - especially executive board directors - have a habit of granting generous stock options to top managers. While stock options offer management an incentive to perform well, overloaded stock-option accounts create the possibility of unwanted share value dilution. The more stock options management owns, the bigger the drop in share value will be when these options are exercised.

Because the quality of corporate governance determines how a company allocates shareholder rights and aims to maintain the value of shares, investors should vigilantly analyze and evaluate the governance of their current and potential investments

What Is The Impact Of Research On Stock Prices?


While the above question is a valid one, it is hard to answer.
Can the Benefits Be Measured?
On a quantitative basis, you could perform a regression analysis to determine the correlation between changes in a stock's price and the publication of a research report. However, you would need to filter out the effect of "noise", the impact of news releases, competitor news releases, economic reports, as well as other macro-economic factors. After all that work, the results may not show statistical significance, which means that you would not have found any direct relationship between the movement in a stock's price and the issuance of a report. In addition, the results can be manipulated by a change in the length of the time period being studied.

On a qualitative basis, it has been proven that having more information about a company in the marketplace is better than less information, but the return on the investment in research is nevertheless hard to calculate. On the other hand, objective information in the marketplace about a company reduces the "halo effect" on that company if its competitor announces unexpected bad news. With objective information, the market can evaluate the impact of the news event on both companies.

While quantifying the benefits is difficult, most of the value of research lies in the un-quantifiable benefits provided to investors:
• Comparative operating and valuation data on a company.
• Earnings estimates and target valuations based upon reasonable data included in the report.
• A reliable source of independent third-party information on a continuous basis so that investors can track performance and evaluate an investment.

The benefits of research coverage are not immediate, and the decision to invest in stock research is generally a long-term process. It takes time for investors to familiarize themselves with a stock and get comfortable with a new company and its investment potential.

Research, however, provides the market with more information and increases market efficiency, but it is hard to determine exactly when a report will convince an investor or a fund manager to buy a stock. It could be near the publication date or months later, but it will be the third party report that helps provide the information on which that investor makes his or her decision.

However, investors should beware of "research" reports that advertise how the stocks these reports followed rose immediately after publication of the report. While it may be true that the stock rose after the report was issued, there is generally no way to prove beyond a reasonable doubt that the report was the sole reason why the stock rose. If you see such a claim, check the long-term trend of the stock's price and see if it fell back after a few days or weeks.

The Bottom Line
Although the total return on the investment in research is hard to quantify, the information provided via third-party research has tangible value. Objective research provides information to the market to reduce uncertainty. Even though the nature of the stock market prevents us from isolating any one of the many variables that affects a stock price, no one can disagree that in the long run, greater available information means greater market efficiency.

Buying Into R&D

Research and development (R&D) is fundamental to a company's long-term success: R&D fuels new products, market share, high margins and rates of growth. In hard times, however, companies can be tempted to cut back on the expenses devoted to the scientific and technological work that underlie new products, processes and services - these expenditures can be among the most capital intensive part of a company's cost structure. But investors should take note: firms that cut R&D too much are in danger of saving today to the detriment of growth tomorrow.
Importance of R&D
Granted, in an economic downturn fewer products are sold as the demand for them weakens, so some overall cost cutting makes sense. But investors should recognize that when the cycle turns upward, companies with new products coming out of the development pipeline are better positioned to profit than those companies that slashed R&D in the previous recession. In addition, big R&D budgets are normally an indicator of ample financial resources, so a telling sign of a company in trouble is earnings growth through severe cuts in R&D.

R&D isn't just important for high-tech industries. Consider Procter & Gamble's leadership in detergents and disposable diapers, or Gillette's edge in shaving. Putting a premium on real growth rather than trying to boost earnings through cost cutting, each of these two companies rose to the top on the strength of R&D investments that rival those of any Silicon Valley firm.

That said, R&D by itself doesn't guarantee a good investment. Some companies see a payoff from spending heavily on R&D. Apple Computer, for instance, devoted large amounts to R&D during the company's unprofitable years of 1996 and 1997, but Apple saw earnings skyrocket with the 1998 launch of its successful iMAC product line. In stark contrast, some companies can continue to suffer spiraling losses even after investing a great deal money each year to R&D. For example, in 2003, telecom equipment maker Lucent Technologies was still facing losses even though it was throwing more than $4 billion a year into R&D since 1998.

Measuring R&D
Financial expert/writer, Kenneth Fisher, touts the price-to-research ratio (PRR), which is the market value of the company divided by its research-and-development expenditure over the last twelve months. Fisher suggests buying companies with PRRs between five and 10 and avoiding companies with PRRs greater than 15. By looking for low PRRs, investors should be able to spot companies that are redirecting current profits into R&D, thereby better ensuring long-term future returns.

Technology investment guru Michael Murphy offers the price/growth flow model. Price/growth flow attempts to identify companies that are producing solid current earnings while simultaneously investing a lot of money into R&D. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the shares outstanding to get R&D per share. Add this to the company's EPS and divide by the share price.

Measuring R&D Effectiveness Is Key
Unfortunately, while the Fisher and Murphy models both do a great job of helping investors identify companies that are committed to R&D, neither indicates whether R&D spending has the desired effect - the successful creation of profitable products. When evaluating R&D, investors should determine not only how much is invested but how well the R&D investment is working for the company.

Companies often cite patent output as a tangible R&D success measure. The argument goes that the more patents filed, the more productive the R&D department. But, in reality, the ratio of patents per R&D dollar tends to represent the activity of a company's lawyers and administrators more than its engineers and product developers. Besides, there is no guarantee that a patent will ever turn into a marketable product.

One way, however, to perceive the proficiency of R&D is to calculate the percentage of sales that come from products introduced over a period of time, say the preceding three years. For the calculation, investors need annual sales information for specific new products. If lucky enough to get that kind of data from company reports, investors can do the calculation this way:
New product sales (previous three years) / Total sales (previous three years)
The resulting percentage gives investors a sense of R&D success as well as R&D output and offers a useful metric for comparing R&D performance with peer companies.


Investors should also pay attention to R&D expenditure/sales. According to Michael Murphy, good growth-flow companies spend at least 7% of their sales revenue on R&D. On the other hand, what is deemed a healthy R&D/sales ratio depends on the industry and the company's stage of development.

Pharmaceuticals, software, and hardware companies, for instance, tend to spend a lot on R&D while consumer product companies typically spend proportionately less. In 2003, Johnson & Johnson, for example, reported spending about 10 cents per sales dollar on R&D, but drug company Pfizer spent 15% of expected sales on R&D; software giant Microsoft spent 16%; and network-equipment maker Cisco Systems spent 18%. For smaller, early-stage software and biotech companies the number can easily stretch as high as 80%.

Conclusion
By closely analyzing R&D spending, investors can identify those companies that are able to keep on top of product cycles with innovations, squeeze profits from those innovations, and pour money back into R&D to secure future growth. Measuring the amount spent on R&D, however, is not enough: investors need to determine how well the company is making use of its R&D expenditures and producing competitive products.
Core Earnings Measure Up

Let's face it, numbers in earnings reports mean pretty much what company accountants want them to mean, neither more nor less. That's why investors looking at fundamentals must determine on a company-by-company basis what earnings are really saying. Wouldn't it be great if there were a standard measure that could make earnings evaluation easier, clearer and more meaningful?

Standard & Poor's, the ratings agency, tries to solve the problem with a new earnings metric: core earnings. While the core earnings approach gives investors a first glimpse of what truly "clean" earnings might look like, it also creates its own set of challenges.
Problems with the Traditional Metrics
Investors have lost faith in the three major categories of earnings: reported earnings, operating earnings and pro forma earnings. We've seen in the past that the traditional measure, the GAAP-based reported earnings, leaves companies with plenty of room for creative accounting and manipulation.

Operating earnings, which leaves out one-time gains and expenses from the bottom line, is meant to make the numbers comparable across companies. Unfortunately, many Wall Street analysts now have their own criteria for what should be excluded, so analyzing and comparing companies using operating earnings can be awfully difficult. Meanwhile, the definition of pro-forma earnings - which treats significant corporate transactions "as if" they never occurred - has become so broad that it can hide almost anything from investors.