The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues—a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.

Your best bet is to compare a company with its closest competitors to see which is able to do more with less and to look at SG&A as a percentage of sales over time.

Companies have gotten into the habit of rolling many costs that really are part of doing business into charges,

If it bounces around from year to year, the firm may be generating earnings by playing with tax loopholes rather than selling more goods or services.

Although net income is the number you’ll most often see companies tout in their press releases, don’t forget that it can be wildly distorted by one-time charges and/or investment income.

it’s the diluted number that you’ll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk

But because the “changes in working capital” entry is often the biggest cause of differences between net income and operating cash flow, this is an area that you’ll want to pay attention to—hence our detailed analysis.

There are excellent reasons not to invest in even the best-looking firms.

It’s critical to investigate the sources of a company’s growth rate and assess the quality of the growth.

There are a host of reasons for this. For one, acquisitive firms have to keep buying bigger and bigger firms to keep growing at the same rate—and the bigger a target firm is, the harder it is to check out thoroughly, which increases the risk of buying a pig in a poke.

buying other companies takes time and money.

If executives are spending all of their energy looking for ways to make the firm bigger, rather than better, the wheels are sure to come off the cart eventually.

It makes the company more difficult to understand.

Bottom line: If you don’t know how fast the company would have grown without acquisitions, don’t buy the shares—because you never know when the acquisitions will stop.

A big difference between the growth rate of net income and operating income or cash flow from operations can also hint at something unsustainable.

In general, any time you can’t pinpoint the sources of a company’s growth rate—or the reasons for a sharp divergence between the top and bottom lines, as was the case with Big Blue—you should be wary of the quality of that growth rate.

We need to know how much economic profit a firm is able to generate per dollar of capital employed because it will have more excess

profits to reinvest, which will give it an advantage over less-efficient competitors.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

For any business that can’t charge a big premium for its goods, tight inventory management is critical because it keeps down the amount of capital tied up in assets, which helps pump up return on assets.

Look at the kind of business the firm is in. If it’s fairly steady, a company can probably take on large amounts of debt without too much risk because there’s only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments.

In general, any nonfinancial firm that can generate consistent ROEs above 10 percent without excessive leverage is at least worth investigating. As of mid-2003,

First, banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a nonbank.

ROEs above 40 percent or so are often meaningless because they’ve probably been distorted by the firm’s financial structure.

However, I think it’s reasonable to say that any firm that’s able to convert more than 5 percent of sales to free cash flow—just divide free cash flow by sales to get this percentage—is doing a solid job at generating excess cash.

A company that can earn a high return on its shareholders’ money is worth more to those same shareholders.

Although they’re not earning much in the way of profits right now, folks are investing in their businesses because they expect these companies to be very profitable sometime in the future, which is when investors will be rewarded.

You’d be taking a lot less risk investing with the older businessman than you would with the young entrepreneur—though that entrepreneur might just pay you back many, many times over.

If these firms still have profitable reinvestment opportunities, they should be spending all the cash they generate on expansion.

Essentially, ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing:

ROIC uses operating profits after taxes, but before interest expenses.

The bottom line about financial health is that when a company increases its debt, it increases its fixed costs as a percentage of total costs.

When business is bad, however, the fixed costs of debt push earnings even lower.

Calculate the ratio for the past five years, and you’ll be able to see whether the company is becoming riskier—times interest earned is falling—or whether its financial health is improving.

This ratio is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.

Constructing a convincing bear case is especially important for those who like to buy high-quality companies that have hit temporary speed bumps, because what looks like a speed bump may very well be a roadblock on closer inspection.

But some executives think they have a license to print money just because they manage a huge company, no matter how poor a job they’re doing, which is why you need to determine whether their pay is tied to the firm’s operational performance.

In any case, I think it’s a negative sign when the targets are changed but the potential reward stays the same, because it indicates that the board is unwilling to stand up to the CEO and punish him or her by slashing the bonus when performance slumps.

Another sign of poor compensation procedures is paying managers for actions that make the company bigger, but not better.

Generally, firms with more equitable distribution schemes perform better over the long run.

If so, the firm probably did an acquisition, and you should check to see whether management paid a reasonable price and whether the acquired firm wound up adding to shareholder value.

self-confidence that shows management is more concerned with beating competitors over the long haul than beating its quarterly earnings guidance.

To invest successfully means you need to buy great companies at attractive prices.