Looking Beyond the Financial Statements

A Good Record Is Not Enough to Justify an Investment

If you are a long-time reader of the site, you know that accounting is the language of business. Just as you’d have trouble understanding the complexities of German culture on a visit to Bonn without the ability to speak the native tongue, you can never really know an enterprise until you can deconstruct the income statement, balance sheet, and statement of cash flows. That’s why I spend so much time explaining different financial ratios and complexities such as pension accounting to you – these topics aren’t that difficult to understand but they are vital to protecting your portfolio.

With that said, it’s important to look up from your annual reports, 10Ks, and proxy statements every once in a while and take a look at the world. It’s often tempting to take comfort in the statistics of the past even though history has proven they are merely guideposts, subject to competitive forces and becoming obsolete as a result of technological advancement (Wall Street’s blue chip stocks once consisted of horse and buggy manufacturers, street car companies, and railroads! Had you paid attention when the car was first invented, the earnings for these industries were still very good – yet the average teenager could have probably told you that the automobile was the way of the future. In other words, you have to know what information is worth knowing and whether it is relevant for the future.)

Here are a few things to think about when you are thinking about a new investment.

Demographic Trends

Are there any widespread demographic trends that bode well or poorly for the company? Retirement homes and health care services may experience a substantial increase in revenue as a result of the wave of aging baby boomers. Radio stations and broadcasting networks focusing on rapidly growing niche markets such as the Hispanic American population are likely to have an advantage over those catering to relatively stagnate populations listening to things such as country western, for example. Of course, a demographic advantage isn’t going to make a business successful in and of itself – that requires a good revenue model, high returns on capital, intelligent management, and ethical Board of Directors, and a product or service customers love.

Technological Trends

There are some companies that are doomed with their business model regardless of the current financial results – no matter how cheap the stock may appear or how impressive its past record has been. For example, it is my personal opinion that Blockbuster Video is just such an enterprise. With a powerful brand name that has long reigned as the dominant force in the video rental market, recent improvements in broadband speed coupled with the public’s demand for on-demand viewing (how many times have you sat around and thought, “Remember that movie from fifteen years ago? I’d love to watch that right now!”) does not bode well for the chain. It just won’t make sense for someone to deal with returning little plastic discs when, in the future, they can simply press a button, bring up an on-screen selection of virtually every movie ever created, and watch anything they want, day or night, by paying $0.99 charged directly to their credit card. I mean, ask yourself – do you really, truly believe that in ten years you will be renting videos?

On the other hand, technology may bear huge fruit for a company. Walt Disney is a perfect example. Years ago, when the VCR was invented, it became a way for the media company, which had hundreds of films in its vaults just gathering dust, to monetize decades of intellectual property that had been developed. Each generation, classics such as Snow White and the Seven Dwarfs, Cinderella, and Mary Poppins were re-released to great fanfare with very little incremental cost.

Management’s Integrity and Disposition

I know, I know ... we've said it before but it really is worth repeating. It is never a good idea to go into business with someone who makes your stomach churn. No matter how profitable the venture may appear (or turn out to be), the world is full of other opportunities. It makes no sense to risk your hard-earned money by entrusting it to someone who views you as nothing more than a faceless member of an ever-shifting mass of nameless investors.

The Firm’s Record on Capital Allocation

Remember Coca-Cola a few decades ago? The company had a short stint in shrimp farming and as owner of Columbia Pictures. Likewise, American Express siphoned off precious capital generated from its strong core charge card franchise into insurance companies and other financial services that cost shareholders big in the way of opportunity costs – the money would have been much better spent had it been used to repurchase shares or paid out as cash dividends.