Finding Diamonds in the Rough
An old Wall Street adage tells us that the trend is your friend. And when it comes to evaluating potential small-cap investments this certainly rings true. Trends tell us where the company has been, and lend insight into where it is going. They can also help us determine what should be the fair value of a company’s stock, and our price target on shares. We can use two different types of analysis to evaluate trends: fundamental analysis and technical analysis.
Fundamental analysis focuses on data that can be found in a company’s financial statements, and also includes economic factors like the state of the economy and interest rates. If you like this type of analytical work you’re in good company – two of histories best-known investors, Warren Buffet and Peter Lynch, were staunch believers in the method.
By contrast, technical analysis is a discipline that seeks to forecast the future direction of a company’s stock based on past market date like share price and the daily volume of shares traded. I like this method as well. In fact I use it extensively when evaluating a potential investment since it helps to understand market behavior. I’ll talk more about this in a future issue, today I want to focus on fundamental analysis.
Here in SmallCapInvestor Daily I want to help you find profitable investments. But I also want to give you the tools that will help you locate the diamonds in the rough yourself. So today I’m going to run through eight key metrics that you should consider when performing fundamental analysis on a potential investment. You’ll also find these measures, along with many other small-cap investing tips in my book, The Small Cap Investor: Secrets to Winning Big with Small Cap Stocks.
1. Revenues: Reported revenues are the heart of every business. If the company can’t sell products or services, there isn’t really much more you need to look at. Look for companies with increasing revenues and a steady or increasing rate of sequential growth. The diamonds are those that are growing sales at a faster rate than the competition.
2. Net Income: This is what’s left over after paying all the bills. Just like revenue, look for constant growth, and an increasing rate of growth. But note that at some point net margins (net income divided by total revenue) will level out because a company can only make so much per dollar in revenue. Some companies, like Wal-Mart (NYSE: WMT), have amazing internal controls and as a result incredibly consistent profit margins. As a general rule, I steer clear of companies that are not profitable because, well, if the company can’t make money, why do I want to invest my hard earned dollars?
3. Growth: Revenue and Net Income: You want to see growth in both of these income statement lines trending upward together. For instance, if a company is reporting 30% growth in revenues, you want to see similar growth in net income. Of course, small-cap stocks that are growing rapidly will need to use cash from operations to fuel growth, and this will cut into net income. So growth in net income doesn’t need to follow revenue growth perfectly. It’s a good sign if they generally trend together, and you’ll want to understand why if they don’t.
4. Gross Margin: This is the amount left over after subtracting cost of goods sold (COGS) from total revenues. It’s expressed as a percentage of total revenues and tells you how much the company makes per dollar in sales. Check out a few competitors to use as a benchmark since gross margins vary widely by industry. Bigger is better.
5. Current Ratio: Working capital is the lifeblood of every organization, and this ratio tells you how well a company can cover short-term obligations. The current ratio (current assets divided by current liabilities) should be consistent every quarter, or at least every year if the company has cyclical sales. Again, benchmarks vary by industry so competitor comparisons are a must.
6. Debt Ratio: This ratio tells you how much leverage a company has relative to its assets. Used with the current ratio, it help understand the financial risk a company has, and is found by dividing total debt by total assets. As a general rule, a debt ratio of 1 differentiates higher risk (above 1) companies from lower risk (below 1). You don’t want to see a trend of increasing debt to assets over time, especially in periods of increasing interest rates.
7. Executive Compensation: It’s an old story: a small company starts to succeed, revenues and net income rise and the stock takes off. Then a peculiar thing happens – earnings growth subsides, maybe even falls a little. The reason? Top executives are giving themselves big raises, bonuses, even stock options. I’m all for incentives and healthy paychecks, but as investors we need to be sure we’re not just lining executive pockets. Look at trends in the Selling, General and Administrative (SG&A) line on the income statement and for stock options compensation policies in the financial notes. If the company is just funneling money to executives steer clear.
8. Dividend History: Dividends return profits to shareholders and along with stock price appreciation help to raise an investments total yield. Most young companies won’t pay dividends since the money is best used to fuel rapid growth. But some do and the dividends can be reinvested to accumulate more shares. Usually dividends are a sign that growth is slowing, but small-cap value stocks (value stocks pay dividends, versus growth stocks which usually don’t) still offer tremendous upside.
These are eight metrics that I use when evaluating each small-cap company I’m thinking of investing in. If you do the same, you’ll find you have a much better grasp on the company’s potential for growth. You’ll also be less likely to invest in small-cap lemons. In future articles I’ll discuss more fundamental analysis metrics including earnings quality and cash flow – two subjects that deserve in-depth discussion.
If you want a little more help finding diamonds in the rough, sign up for Small Cap Investor PRO and you’ll be among the first to receive my research reports, including fundamental analysis, on my favorite companies. Just click here to get started today.
