Risk Management

1. Dependence upon key suppliers

Generally speaking, a reasonable management is going to want to keep inventory levels at optimum levels. In the ordinary course of business, it is unlikely for an executive to purchase more product components than necessary to complete a cash conversion cycle. This is perfectly acceptable, even preferable, as it keeps cash in the company’s coffers – and, thus, earning interest – rather than in that of its suppliers.

Apple Computer was in this position in 1999 when Motorola was the company’s sole supplier of the G4 PowerPC chip. Practically speaking, had Apple experienced a tremendous increase in demand for its product, all of those sales could be jeopardized by a problem in the factories of its supplier (strike, shortage, etc.) Thus an investor considering acquiring Apple shares would have been wise to examine the condition Motorola as well.

2. Dependence upon key customers

Several weeks ago, I was researching potential investments when I came across American Locker Group (ALGI). The company caught my eye because, despite relatively stable earnings, it was trading at a price-to-earnings ratio of four; an implied earnings yield of 25%. After delving into the 10K, however, it didn’t take me long to see why the market was discounting the stock heavily. One key customer, the United States Postal Service, accounted for over fifty-percent (50%) of the net sales for each of the previous five years. Investors were clearly worried about the impact the loss of this key contract would have on the company’s sales, profitability, and liquidity. It turns out the market was right. Several weeks later, management filed an 8K with the SEC announcing that it had, indeed, lost the contract. The lesson is a simple one: if a company’s future is too closely linked to the success of a single key customer, and the company does not have control over that customer, the investor should consider this in his analysis.

3. Dependence upon a single, key product

What differentiates William Wrigley and Hershey Chocolate from the Hula-Hoop and the Pet Rock? Endurable franchise value. If a company derives a substantial portion of its sales from a product with little or no staying power, any capital you commit to the venture can scarcely be anything other than speculative. When the market evaporates, you don’t want to be left holding the bag.

4. Management disposition

As I mentioned in Seven Questions that Can Help You Select Better Stocks, a simple, shareholder-friendly orientation can have a much bigger influence on your pocketbook than can a CEO with a 200+ I.Q. (If you have any doubt, consider Enron, Halliburton, and Long Term Capital. All were run by brilliant, respected men.) These questions can help you gauge management’s orientation toward owners:

Do the executives have a significant portion of their net worth invested in the stock? If so, does the ownership come from options or from outright, honest-to-goodness cash purchases?

A management team that will profit in proportion to shareholders is more likely to follow an investor-friendly course of action. Warren Buffett has long made known his intention to keep ninety-nine (99%) of his net worth in Berkshire Hathaway stock. By assuring his investors that he will suffer or profit in proportion to them, he has established a culture of accountability. This stance is especially admirable considering that Buffett paid cash out of his own pocket for every share of Berkshire he owns.

Does management have a history of repurchasing stock when it appears undervalued?

You’ve already learned that when the number of shares outstanding decreases, the remaining shares become more valuable. In fact, share repurchase have played a vital role in the performance of companies such as Coca-Cola and the Washington Post. In Coca-Cola’s 2003 10K statement, management disclosed that, “Since the inception of our initial share repurchase program in 1984 through the current program as of December 31, 2003, we have purchased more than 1 billion shares of our Company’s common stock. This represents 33 percent of the shares outstanding as of January 1, 1984 at an average price per share of $14.07.”

Have dividends increased regularly for at least the past ten to twenty years?

For conservative investors, this is an important factor in selecting an investment as a dividend payout can establish a “floor” to a stock price. Continuing with our Coke example, the same 10K indicates that 2004 marked Coke’s 42nd consecutive annual increase in the per-share dividend.

6 Warning Signs a Company May Be Headed for Trouble

If the company has engaged in mergers and acquisitions, do the deals appear sensibly priced?

Capital allocation is vitally important to the success of an enterprise. If an acquisition-hungry CEO convinces the Board of Directors to acquire another company at fifty-times earnings, the transaction has essentially doomed shareholders to earn two-percent, less than the historical long-term rate of inflation, on their capital. Instead of entering into the transaction, management would have been wiser to find an alternative use of the capital or pay it out to shareholders via dividends.

Is the company maintaining a responsible level of debt, or has debt relative to equity increased with little or no explanation?

If you notice a significant increase in the debt-to-equity ratio with little or no explanation from management, you may want to be concerned.

Are employee perks reasonable?

While under the direction of former-CEO Scott Livengood, Krispy Kreme [KKD] had reported earnings of $33.5 million in 2003. Yet, after he was forced out, the corporate turn-around specialist appointed in his place, Stephen Cooper, found that Livengood and several other executives at the company had access to a Dassault Falcon 900EX private jet. Cooper got rid of the aircraft; a move which is expected to save the company $3 million dollars per year. This expense essentially amounted to a ten-percent “jet” tax on Krispy Kreme’s shareholders. Had the company reinvested those funds into the business and managed to earn an average return on equity of only twelve percent per annum, this would have resulted in $52,646,205 additional net income over the course of ten years. The lesson: if a management team is regularly dining on filet mignon and sleeping in $5,000-per-night hotel suites on shareholders’ tab, the odds are substantial their priorities are out of line. (Note: The same test can reveal extraordinary fiscal responsibility: despite overseeing a company with half-a-trillion-dollars in revenue, Wal-Mart executives are known for their bus-station-like headquarters, and insistence upon sharing rooms at $50 per-night hotels. Here, management is truly looking out for the interest of shareholders.)

Are management’s communications open and honest?

As an owner of a business, you have the right to expect a management that is open and honest about the challenges the company is facing. If the CEO’s letter to shareholders sounds more like a public relations document, or if you have difficulty understanding the footnotes, reconsider your investment. At the very best, they don’t have a proper respect for your role as owner. At worst, they may have something to hide.

5. Large potential dilution

Dilution, either in the form of convertible bonds or preferred stock, or outstanding stock options can result in otherwise stellar-increases in earnings-per-share coming in substantially lower than anticipated. For this reason, it is extremely important that investors delve into the financial reports and attempt to uncover any potential source of share issuance. By factoring this into his valuation calculation, the investor can help ensure he does not overpay.

6. Presence of uncapped liabilities

An investor should be wary of acquiring shares in a company with uncapped liabilities that cannot be reasonably estimated (e.g., home builders with asbestos exposure or entities that utilize advanced derivative strategies outside of the regular course of business.) This bet-the-farm exposure can devastate an otherwise wonderful business. For the average investor, it is probably best to avoid these shares entirely as capital commitments are speculative in nature.