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If the firm does pass these tests and it looks as though it's worth a detailed examination, here's how to proceed. This research process will take much longer than IO minutes, but it's worth the effort for an idea that passes the initial hurdles:

Look over the io-year summary balance sheet, income statement, and statement of cash flows on Morningstar.com or another Web site. Look for trends, and make notes of anything that raises an eyebrow and deserves further Investigation. This process should give you an initial road map for investigation.

Read the most recent IO-K filing front to back. Pay special attention to the sections that describe the company and its industry, the sections about risks and competition, any mention of legal issues (sometimes labeled "commitments and contingencies"), and the "management's discussion and analysis" section. The latter is where the firm explains, in reasonably plain English, "why the most recent year's financial results "were what they were. Write down anything you don't understand or which you want to investigate further. You don't necessarily need to read every page of the IO-K—sometimes firms include scores of pages of mind-numbing detail about leases, for example—but you should at least skim every page to make sure there's nothing buried in the text that you do need to know. Be on the watch for any sections that describe loans, guarantees, contractual obligations, or the like. If the firm is going to owe someone a large amount of money in a few years, you need to know about it.

•  Read the two most recent proxies (form DEF-14A, in the SEC's jargon).
Look for reasonable compensation that varies with corporate financial
performance and a reasonable options-granting policy. Check to make
sure the board of directors isn't packed with individuals with close ties to
management.

•  Read the most recent annual report, as well as the past two years' reports, if
possible, to get a feel for the company. Is the letter to shareholders candid
and frank, or does management gloss over problems with jargon? Ignoring
problems won't make them go away, after all. In addition, does the firm
present industry information to give you context for evaluating it? Does
the report look as though the firm spent way too much money on it?

•  Look at the two most recent quarterly earnings reports and IO-Q filings to
see whether anything has changed recently. Look for signs that business is
getting better—or worse—as well as for anything major that has changed
since the last IO-K. If it's still available, listen to the most recent quarterly
conference call. (Companies often archive these on their Web sites for
some time after the quarter is over.) Does management get defensive or
evasive when analysts ask tough questions, or does it respond with
straightforward answers?

•  Start valuing the stock. Look at the stock's valuation multiples relative to
the market, the industry, and the stock's historical valuation ranges. If the
firm has low reinvestment needs, low risk, high returns on capital, or a
high growth rate, be prepared to accept a higher price-to-earnings ratio.
Do at least a very rough discounted cash flow valuation—think about
how much free cash flow the firm is likely to generate next year, how fast
it will grow, and add the discounted value of these cash flows to a perpe­
tuity value. If your estimated intrinsic value is very different from the
market price, check your assumptions. Are you being too pessimistic or
too optimistic? If you recheckyour assumptions, the stock still looks un­
dervalued, and your multiple-based analysis didn't scream "sell," you
might just have uncovered a great investment.

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