Bulletproof
Stocks
Stocks
That Won't Go Broke
It’s easy to get excited
about a company’s growth story and forget the
basics; such as does it have the financial strength to overcome the
inevitable obstacles it’s bound to encounter.
Dozens of companies have
failed in recent years, leaving their shareholders with nothing. But a
company doesn’t have to go bankrupt to ruin your day. Just the possibility
is enough to send your stock into a tailspin.
Fortunately, you don’t
have to scrutinize financial statements to avoid such problems. I’ve
analyzed dozens of stocks that failed and compared them to firms in the same
industries that survived without a scratch.
Fail-Safe Checklist
Based on that research, I devised a simple checklist for avoiding
potential default candidates. I call stocks that pass these tests
“bulletproof stocks.” You can apply these checks using data readily
available on many financial sites. Best of all, you won’t need a calculator.
My checklist is designed
to rule out companies that could fail because they ‘re not generating enough
cash to cover their interest payments. It won’t detect firms that use
bankruptcy to shield them from litigation such as those being hit by
asbestos-related lawsuits.
The checklist consists of
six tests that, taken together, pinpoints profitable companies with plenty
of cash and low enough debt so that bankruptcy isn’t an issue. Flunking any
one of the six disqualifies a stock.
I’ll demonstrate the
process using women’s clothing retailer Chico’s FAS.
Smart Money’s Key
Statistics report contains everything needed to do the checks. On Smart
Money’s homepage (www.smartmoney.com),
start by entering Chico’s ticker symbol (CHS) and select
Key Statistics.
#1) Real Sales
Companies make profits by selling goods or services. So I start by ruling
out firms without significant sales.
Most public corporations
rack up hundreds of millions of dollars in sales, if not billions. I’m an
easy grader here, requiring only $50 million or more in sales over the last
12-months (TTM or trailing twelve-months).
Smart Money listed Chico’s
TTM revenues (sales) at $1.2 billion, so Chico’s aced that test.
#2) Real Cash
Some companies report positive earnings, but when you count the cash, you
find that they lost money. Operating cash flow is the cash that moved into,
or out of, a firm’s bank accounts resulting from its main business.
Positive cash flow is a
necessity for financial strength. For the checklist, the amount is not
important. Just make sure cash is flowing in, not out.
Chico’s $224 million “Cash
Flow From Continuing Operations” passed that test.
#3)
Real Income
In theory, the cash flow check eliminates unprofitable firms. But some
companies can be remarkably creative with their accounting. Adding a
requirement for positive net income in addition to positive cash flow helps
to assure that the firm is, in fact, profitable. As with cash flow, the
amount of net income isn’t significant, as long as it is a positive number.
Chico’s $166 million TTM
net income meets that requirement.
So far, we’ve found that
Chico’s is a profitable company with significant sales. However, passing
those tests doesn’t mean that Chico’s is generating enough cash to service
its debt.
That analysis requires
delving into financial statements, which few of us enjoy doing. Instead, I
prefer to avoid the issue by sticking with profitable companies with
low-enough debt so that bankruptcy isn’t an issue.
The final three tests are
designed to identify those firms.
#4) Sufficient Working
Capital
Working capital is the difference between a firm’s current assets such as
cash, inventories, and accounts receivables (cash owed to firm by its
customers), and its current liabilities (bills).
Current ratio, which is
current assets divided by current liabilities, measures working capital. The
ratio exceeds one when current assets exceed current liabilities, and less
than one when they don’t.
I require a 1.5 minimum
current ratio, which means that current assets exceed liabilities by at
least 50 percent, signaling that the firm isn’t facing an immediate cash
crunch.
Chico’s 4.3 current ratio
easily meets that requirement.
#5) Reality Check
Using current ratio assumes that inventories will be converted to cash
before all the bills need to be paid. But sometimes the inventory numbers
are inflated with obsolete products that may never be sold.
Quick ratio is similar to
current ratio except that it only counts cash and receivables, not
inventories. I require a minimum 1 quick ratio, which assures that the firm
has enough cash to pay its bills, without considering inventory.
Chico’s 3.6 quick ratio
easily passes that check.
#6) Avoid Big Borrowers
The current and quick ratios measure current, but not long-term debt. What’s
the difference? For us, our utility bills are current liabilities, while our
home mortgage is a long-term debt. The final check uses the debt/equity
ratio (debt divided by book value) to measure long-term debt. Zero ratios
equate to no long-term debt, and the higher the ratio, the higher the debt.
Many analysts consider
firms with D/E ratios below 0.5 as low-debt. But some firms hide long-term
liabilities on balance sheet lines that don’t get counted in the D/E ratio.
To be on the safe side, I set my maximum acceptable long-term debt/equity
ratio at 0.25.
Chico’s, with a zero D/E,
had no problem passing that test, and thus, having passed all six checks,
qualifies as a bulletproof stock.
My bulletproof checks are
stringent and error on the side of safety. Consequently, many financially
strong, but high-debt firms flunk. When I checked last week, only around 800
U.S. listed stocks qualified.
For me, limiting the field
to 800 fiscally fit candidates is an acceptable tradeoff for avoiding doing
a detailed financial analysis. But passing the bulletproof checks doesn’t
mean you’ll make money owning the stock. Determining that requires further
analysis.
published
12/11/05 |
