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The 10-Minute Test
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With literally thousands of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren't. Now that you know the tools of in-depth fundamental analysis, I want to give you some tips on narrowing down the field. Apply the following tests to any stock that you think might be a worthwhile investment, and you should be able to decide in IO minutes whether it warrants much of your time.

In fact, I'll bet that asking the questions in this chapter "will allow you to eliminate at least half—if not more—of the stocks you run across from consideration. Throwing out less-promising stocks early in the process will leave you more time to investigate and value the ones that really might be great investments.

Two caveats before "we start: First, these rules of thumb are starting points, no more and no less. There are exceptions to every guideline I list in this chapter. These shortcuts aren't designed to cover every possible situation—but if you apply them, they will eliminate poor investments more often than not.

Second, although the following list of questions might seem daunting at first, you can answer all of them using a compilation of 10 years' worth of financial data that's available on Morningstar.com.

Does the Firm Pass a Minimum Quality Hurdle?

Avoiding the junk that litters the investment landscape is the first step in our 10-minute test. Companies with minlscule market capitalizations and firms that trade on the bulletin boards (or pink sheets) are the first ones to rule out. Also avoid foreign firms that don't file regular financials with the SEC—even some large foreign firms issue only brief press releases each quarter and pub­lish full financials only once per year.

Finally, recent initial public offerings (IPOs) are usually not worth your time. Companies sell shares to the public only when they think they're getting a high price, so IPOs are rarely bargains. Moreover, most IPOs are young, un­seasoned firms with short track records. The big exception to this rule is firms that are spun off from larger parent companies. Spinoffs are often solid companies with long operating histories that the larger firm no longer wants to manage, and the stocks can often be attractively valued as well.

Has the Company Ever Made an Operating Profit?

This test sounds simple, but it'll keep you out of a lot of trouble. Very often, companies that are still in the money-losing stage sound the most exciting— they're investigating a novel treatment for some rare disease, or they're about to offer some exciting new product or service, the likes of which the world has never seen.

Unfortunately, stocks like this will also blow up your portfolio more often than not. They usually have only a single product or service in the pipeline, and the eventual viability of the product or service will make or break the company. (Going by the statistics of how many start-ups fall, break is a more likely occurrence than make.) Unless you're looking for an alternative to lot­tery tickets, take a pass on any firm that hasn't yet proven it can earn a buck.

Does the Company Generate Consistent Cash Flow from Operations?

Fast-growing firms can sometimes report profits before they generate cash—but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are Returns on Equity Consistently above 10 Percent, with Reasonable Leverage?

Use IO percent as a minimum hurdle. If a nonflnancial firm can't post ROEs over IO percent for four years out of every five, for example, odds are good that it's not worth your time. For financial firms, raise your ROE bar to 12 percent. Don't forget to check leverage to make sure that it's in line with in­dustry norms. A 15 percent ROE generated with minimal leverage is a much higher quality result than one generated using lots of leverage.

One exception is that cyclical firms—companies whose results vary strongly with the general economy—may have wildly varying results from year to year. However, the best will make money and post decent ROEs even when times are tough.

Is Earnings Growth Consistent or Erratic?

The best companies post reasonably consistent growth rates. If a firm's earnings bounce all over the place, it's either in an extremely volatile industry or it's regularly getting shellacked by competitors. The former is not necessarily bad as long as the long-term industry outlook is good and the shares are cheap, but the latter is potentially a big problem.

How Clean Is the Balance Sheet?

Firms with a lot of debt require extra care because their capital structures are often very complicated. If a nonbank firm has a financial leverage ratio above about 4—or a debt-to-equity ratio over 1.0—ask yourself the following questions:

Is the firm in a stable business? Firms in industries such as consumer products and food can withstand more leverage than economically sensitive firms with volatile earnings.

Has debt been going down or up as a percentage of total assets? One thing you don't want to see in a highly leveraged firm is even more debt.

Do you understand the debt? If a quick glance at the IO-K reveals questionable debt and quasi-debt instruments that you can't wrap your head around, move on. There are many fine companies out there with simpler capital structures.

Does the Firm Generate Free Cash Flow?

As we know, free cash flow is the holy grail—cash generated after capital expenditures that truly increases the value of the firm. Generally, you should prefer firms that create free cash to ones that don't and firms that create more free cash to ones that create less. As I discussed in Chapter 6, divide free cash flow by sales, and use j percent as a rough benchmark.

The one exception—and it's a big one—is that it's fine for a firm to be generating negative free cash flow if It's investing that cash wisely in projects that are likely to pay off well in the future. For example, neither Starbucks nor Home Depot generated meaningful free cash flow until 2OOI—yet there's no question that they had been creating economic value (and shareholder "wealth) for many years before 2OOI. That's because they were plowing every cent they earned right back into their businesses because their management teams believed that they still had many high-return investment opportunities for the cash they were generating.

So don't automatically write off firms with negative free cash flow if they have solid ROEs and pass the other tests in this chapter. Just be sure you believe that the firm really is reinvesting the cash wisely.

How Much "Other" Is There?

Companies can hide many bad decisions in supposedly one-time charges, so if a firm is already questionable on some other front and has a history of taking big charges, take a pass. Not only are charge-happy firms more difficult to analyze because of their complicated financials, but numerous charges hint at a management team that may be trying to burnish poor results.

Has the Number of Shares Outstanding Increased Markedly over the Past Several Years?

If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. The former is a red flag because most acquisitions fail, and the latter is not something you want to see because k means that your ownership stake in the firm is slowly shrinking as employees exercise their options. If shares outstanding are consistently increasing by more than around 2 percent per year—assuming no big acquisitions—think long and hard before investing in the firm.

However, if the number of shares is actually shrinking, the company potentially gets a big gold star. Firms that buy back many shares are returning excess cash to shareholders, which is generally a responsible thing to do. Just be careful that the company isn't going hog-wild with share repurchases even as their shares keep zooming ever upward because stock repurchases are a good use of capital only when the company's shares are trading for a reason­able valuation. You don't want to see a company buying overvalued stock any more than you want to invest in overvalued shares yourself.

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