With all the recent investing disasters, I have been thinking about defensive investing. Here are some of my ideas on that:1) Avoid companies with large amounts of debt. This rule can be broken for special circumstances, but insure that they are special. For instance, a gas pipeline operator will carry debt to finance the pipeline. That is understandable. But, an insurance company should not have a lot of debt. As a general rule, only bad things can happen with debt. Someday, those pesky, ungrateful lenders will want their money back, and it is often at an inconvenient time. 2) Look for high quality earnings. The best companies are those where you have very little need for capital, and all of their earnings come home in cash. A money management company is a great example of this. 3) If you can't figure out how the company makes its profits, don't invest. This would have saved you from Enron. Who knows how Enron made ( or didn't make ) money on its trades. 4) If earnings are too good to be true, they are neither true nor good. The key here is experience. By following many companies, especially in the industry under consideration, the investor should be able to determine when earnings appear excessive. If you can't determine why the company is more profitable than it should be, avoid it. A key way of determining this is to compare the profits of the company to its role in the economy. If it is doing something that seems of little value to the economy as a whole, yet showing a huge profit for doing so, become suspicious.5) Avoid companies making a lot of acquisitions in a rush to get big. Tyco and WorldCom are excellent example of this, but there are many more. Good acquisitions are hard to make, and most acquisitions should never happen. They are usually more about the ego of management than about providing returns to shareholders. One of the best ways to evaluate management is to watch it for several years, and study its allocation of capital. If they build new factories, or buy companies just to get bigger, then avoid them, they are a Tyco or WorldCom waiting to happen. Since management usually likes to talk about its acquisitions, and gives its rational for them, I have found this to be one of the best methods to evaluate the quality of the management of a company.6) Avoid companies where the manages are paid huge amounts of money even when the company is not doing well.7) Buy companies that have a sustainable competitive advantage, or a moat. Moats come in all kinds of sizes and shapes, so you must learn how to identify them. Study the acquisitions of Warren Buffett; he is a master at identifying moats. 8) Buy companies that do not need to reinvent themselves every two years just to stay alive. Microsoft is one of the few companies that has been successful doing this. But Bill Gates himself said that Microsoft faces a major challenge every three years or so. If you must reinvent yourself, you do not have a moat, or a least a moat that does not require huge amounts of maintenance. 9) The three laws of moats:1) The width of its moat, the depth of its moat, and the size and ferocity of its resident reptiles is directly proportional to the profitability of a business enterprise. 2) When an enterprise with a properly functioning and sustainable moat is presented with a choice between generating higher current profits, or strengthening the defenses of its moat, the decision should always be made in the favor of the moat. 3) The ability to differentiate between moats that have an expandable life and utility and therefore deserving of maintenance expenditures, and moats that are failed or failing, is the beginning of wisdom. The first two laws come directly from Warren Buffett. The third law seems to logically follow the first two. A company that follows these three laws is showing good quality management. 10) Look at what a company does, not what it says. Words are cheap, actions are dear. 11) As a general rule, avoid companies that seem obsessed with providing and meeting earnings expectations. They are playing Wall Street, not Main Street. 12) Look for humility in managers. Is the company run for the benefit of management's' ego and desire for power, privilege and prestige, or is it run as a business enterprise? Look at what seems to motive the people at the top.13) Look for "one-time," "nonoperating," "extraordinary" charges. Some companies have "one-time" charges every quarter. Watch for the scams. Often these charges are neither one-time, nonoperating or extraordinary. Excess amounts of charges show a management that is either making a lot of bad mistakes, or is trying to manage its financial numbers.14) If the company is all about "me," make sure the "me" is worth being about. Buffett is, but few others are.15) Never underestimate the ability of bad managers to damage an otherwise strong and healthy company.16) We all know about a margin of safety in the purchase price of the stock, but is there a margin of safety in the operation of the business? Look at the attitude of the management towards business risk. The more risk in the business, the more those inevitable management mistakes are going to hurt. 17) Is the company in denial? As you read its annual report, do you have the feeling that management will be the last group to discover that it is a troubled enterprise?18) Avoid whiplash. If Strategy B, last year's road to glory and replacement for Strategy A, is now being replaced with Strategy C, don't wait for the new fix to end all fixes: Strategy D. 19) Is management ever at fault? Does management always blame others for the problems of the company, or does management take responsibility for its own actions and results. Don't tolerate behavior in the managers of the company that you would not accept from your teenage son. 20) Beware of noncash income. Does the company recognize large parts of its income before it receives the cash? Look at the footnotes to the financial statements for evidence of this. They will also show up on the balance sheet as intangible assets. 21) Beware of deferred charges. These can occur when expenses are not recognized even though the cash has been expended. Look at the footnotes and the balance sheet for these. 22) The problem with large amounts of deferred charges and intangible assets generated from the recognition of income before the receipt of cash, is that they have a tendency to disappear as "one-time," "nonoperating" or "extraordinary" charges; and we know how we feel about them. They may also indicate an aggressive accounting treatment. But also think about what they do to cash flow and income. Either the cash is spent but not expensed, or the income is recorded but not collected. In both cases, profits benefit when cash flow does not, resulting in low quality earnings. 23) Look at the footnotes for deferred and prepaid income taxes. They will show differences between income and expenses reported for tax purposes and book purposes. This is a place that may tip off aggressive accounting treatments. 24) Read management's discussion of operations in the annual report. Do they give a plausible explanation of why income, expenses, or sales increased or decreased, or are they vague and general?25) At least skim through all the footnotes to the financial statements, looking for unusual items. If there are accounts on the balance sheet that you don't understand, look to the footnotes for an explanation. The more confusing the balance sheet is, the more cautious the investor should be.26) Read the letter to the shareholders on several levels. Look for information, but also look for style and for what was not said. Does it sound like the CEO wrote it himself, or does it read like the work of a PR firm? Does the CEO sound like someone from this planet? I once read the letter to shareholders for a company that was reporting a billion dollar loss for the year, and not once was it mentioned in the letter. 27) EBITDA and pro forma earnings are large neon warning signs to the investor. Do not look away! If you ever see a company reporting EBITDARES, Earnings Before Interest, Taxes, Depreciation, Amortization, Rent, Entertainment and Salaries - go short.
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