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Get Four
|  | OCTOBER 21, 2003
Management Tools for Investors In Value Leadership, Peter Cohan explains how a new way of looking at companies can help you decide if you want to buy in It's rare for one executive to both provide companies with advice on how to build their businesses and investors advice on how to build their portfolios. But Peter Cohan, an author and consultant in Marlborough, Mass., has made applying the tools of management consulting to investment analysis his specialty. His new book, Value Leadership: The 7 Principles That Drive Corporate Value in Any Economy, is primarily a management book. It emphasizes ethics and team-building (more than cost-cutting) as Cohan urges managers to follow his seven principles: Value human relationships, foster teamwork, experiment frugally, fulfill commitments, fight complacency, use multiple strategies, and give to the community. Cohan believes investors as well as managers can profit by looking for companies that follow the same principles he has identified (see BW Online, 10/21/0, "Picking the Market's Value Leaders"). He shows how to perform the exhaustive analysis it takes to come up with a company's "Value Quotient" -- a percentage between 0 and 100 that indicates how closely a company follows his seven principles. For example, Wal-Mart (WMT ) gets a 54, while J.C. Penney (JCP ) gets a 30. In the following edited excerpt, Cohan explains how to use the tools in Value Leadership to make investment choices: Value Leadership for Investors Value Leadership is useful for investors in any market. In up markets investors can profit by purchasing shares in Value Leader companies because they are likely to generate higher profits and earn higher returns. In down markets investors can identify companies that do not embody Value Leadership and profit by selling short these companies' shares. Profiting in Up Markets The more information investors have about the companies in which they invest, the less risk they undertake before committing their capital to a stock. In a rising market, such risks may appear not worth considering because the greatest perceived risk may be in not getting the maximum investment returns possible. It is precisely during such periods that investors should conduct detailed analysis to avoid purchasing shares at the top of an investment bubble. Investors should screen potential investments based on how well a company meets these criteria relative to others in their industry: • Market Share • Ten-year average return on equity • Revenues and profits per employee • Balance sheet strength • Ten-year earnings growth • Ten-year shareholder return A set of companies that beats its competitors on these six measures may make a good candidate for stock purchase. After conducting the quantitative screening, investors may wish to develop a Value Quotient (VQ) analysis of the companies that pass the initial screen. A small investor might be able to gather the data needed to conduct such an analysis through a combination of searching online databases and interviews with customers, employees, and possibly even executives of the company. Investors could then consider investing in the companies with both strong performance on the quantitative indicators and a high VQ. Once investors had purchased shares in such companies, they could conduct periodic VQ analyses. If the VQ performance was improving or remaining high, the trend might suggest that the investor should continue to hold shares of the stock. If the VQ was declining, that might suggest that the company's financial performance was likely to deteriorate in the future. Because there is likely to be a lag between the time that the VQ trend turns down and the time that the company's financial performance deteriorates, the VQ could be a valuable early warning indicator for investors to sell a stock. Profiting in Down Markets Investors had significant opportunities to profit from the bear market that began in March, 2000. Among the companies whose stock prices plunged were many whose management did not embrace Value Leadership. One of the most useful ways for investors to identify this lack of commitment to Value Leadership came in the form of financial reporting that did not reflect the company's true economic performance. In short, companies whose stock prices dropped precipitously violated the principle "Fulfill your commitments." Investors can profit from the failure of companies to adopt Value Leadership, particularly in a down market. Surging stock prices reward any management behavior that can keep them surging. During the boom years from 1995 to 2000, for example, managers overlooked Value Leadership as a costly anachronism. Instead, they manufactured financial statements that would create the perception that their companies were meeting performance expectations that were in fact beyond the capabilities of the underlying economic reality of the business. When stocks started to fall, managers were out of sync with the change in the market. A few continued to act as though they could restore their deflated stock prices by continuing to manipulate reported financial results. These managers -- perhaps unwittingly -- created investment opportunities for investors willing to study their financial statements. In many cases these financial statements provided clues of underlying gaps between what the managers were saying publicly about their businesses and their actual economic performance. Many books have been written about how to analyze financial statements to look for such gaps. But in down markets many investors get out of stocks altogether or simply ignore the stocks in which they've invested. Few take the time to read published financial statements. Available at no cost on the U.S. Securities & Exchange Commission Web site, these statements are a treasure trove of details that can help investors pinpoint gaps between what the management says about the company and its underlying economic reality. Although managers can manipulate these financial statements, a careful reader can identify signals of future trouble that could create opportunities for short sellers. Although a comprehensive list is beyond the scope of this book, here are some of the analyses you can use to pinpoint the specific opportunities: Compare earnings press releases and conference call statements with financial statements companies file with the SEC. Investors with Internet access can listen to conference calls between company managers and analysts that deal with past results and future expectations. Sometimes, the tone of these conference calls is far more optimistic than reported financial results. Analyze goodwill, net loss, debt, and cash trends. Companies that have grown by making acquisitions tend to accumulate huge amounts of goodwill on their balance sheets. Goodwill is the difference between the price an acquirer pays and the book value of the acquired company. Accounting rules require companies to adjust downward the goodwill on their balance sheets if its market value declines. Although such write-offs are noncash charges, they generally result in the reporting of huge net losses that reduce the company's shareholders' equity. If such companies carry heavy debt loads, the resulting decline in shareholders' equity can increase the company's debt-to-equity ratio. In many cases banks require borrowers to maintain a debt-to-equity ratio below a specific threshold, so such dramatic increases can cause borrowers to default on their credit agreements, requiring immediate repayment of their loans. At the same time, investors should examine whether a company's cash balances are dwindling. If the company's cash balances are dropping fast, investors may be able to estimate how much time will elapse before the company runs out of cash by dividing the cash on the balance sheet by the company's net loss. Look for opaque reporting of liabilities. Some companies use accounting rules regarding the reporting of unconsolidated subsidiaries and lawsuits to confuse investors about their true liabilities. Companies might create off-balance sheet subsidiaries that borrow money that gets siphoned to the company. Yet for accounting purposes, the debt does not get reported to investors on the company's balance sheet. Or companies might downplay in their financial statements the financial impact of a lawsuit filed against it, only to surprise investors with a far worse impact than that previously reported. Uncovering such gaps between financial reporting and economic reality can involve complex analysis. Nevertheless, the underlying impetus for the gap is a management team that violates the concept of Value Leadership. In an ideal world, such a gap would not exist. In the real world, investors can profit from the gap by shorting the stocks of companies that create the gap. The stock market offers discerning investors a chance to profit from bringing the stock prices of companies that violate the concept of Value Leadership into line with their underlying economic reality. 
BW MALL
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