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Foolish Eight Investing—A Methodology
Version 2


Here is version 2 of the Foolish Eight Methodology as I first posted on 6/24 in #2028. My commentary is in the first reply to this post. I've tweaked it a little bit, but the main change is that I have added a lot more questions and have categorized them.

I'm trying to make this a distillation of the best of what I've read on the subject of investing, so I've provided some page references where necessary so I can quickly refresh myself on a subject. A bibliography of all references is included at the bottom.

Disclaimer: Let me state that this is only my opinion. What follows is what I've written for my own personal use to judge companies. I post it here for commentary so that I can make it better and, of course, to contribute to the Fool community. I am neither accountant, stock analyst, or businessman; just a humble Fool trying to come up with a formal method to judge companies and their stocks.

Enjoy!

Step One: Get Foolish Eight Spreadsheet

A. Add new companies to Yahoo Foolish Eight portfolio
B. Read through the Yahoo Profile of each company briefly to get a feel for what they do.
C. Take a quick glance at their charts.

D. For purposes of considering a company that has dropped off the list I first rank the Fool 8 criteria in this order of importance:
1) Sales/Earnings Growth
2) Profit Margin
3) Cash Flow
4) Insider Holdings
5) Price Above $7
6) Daily Dollar Volume
7) Sales < $500
8) Relative Strength

Will still consider a company if 1 through 5 are still intact.
Relative Strength cutoff is 80. Don't mind if 6 & 7 go above limit.

Step Two: Additional Screening

A. EPS rank in Investors Business Daily >= 80. This is a mandatory screen. Source: IBD
B. EPS Estimates Positive: current estimates for profitable quarter. Source: http://quote.yahoo.com/
C. Positive Earnings Surprises: at least 4 out 5 quarters. Source: http://quote.yahoo.com/
D. EPS Estimates Revised Upwards: Consensus EPS Trend moving upward. Source: http://quote.yahoo.com/
E. Five Year Earnings Growth record: I want to see sequential growth of earnings over a period of 3-5 years and no losses. Source: www.zacks.com

A is mandatory. The others are not, but would like to see most of them pass before moving onto step three.

Step Three: Dig Deeper with Online Research

Here is a list for doing research in order to get the information needed in Step Four.

A. Take Notes: Before starting online research, create a Word document called ABC-Notes.doc (where ABC is stock symbol). While surfing the web you'll want a scratch pad for notes on the information you find about the company. This includes notes from SEC documentation readings as well as links to financial information on the Net.

B. Check Out Web Site: If the company has a web site, look it over. Look at products, investor relations, etc. Order a full investor package if their site has a request form.

C. Read latest 10Q/10K – Mandatory to read latest 10K and latest 10Q, at least. Take notes in a word processor of the interesting details. Cut & Paste excerpts. Read back a couple of 10K and compare the management discussion to latest 10K. Source: http://edgarscan.pwcglobal.com/ (a wonderful research site. in keyword box, use company name, not stock symbol.)

D. Search Web: Try to dig up any articles or news written about the company. Use financial search engines as well as normal search engines. Source: www.equityweb.com, www.yahoo.com

Get Five Year Income Statements, Balance Sheets, Cash Flow Statements. www.zacks.com, www.equityweb.com (see Financials, Marketguide for 2yr cash flow)

Run through the PEGulator at http://www.phillysites.com/foolratio/

Run through the MSN Investor Research Wizard. Source: http://investor.msn.com/research/wizards/SRW.asp

Visit Message Boards: Ask questions here first. Source: http://boards.fool.com/, http://quote.yahoo.com

Use the “scuttlebutt” method: Ask questions of those involved with the company. Competitors, customers, employees. (see CSUP, Chap 2)

Call Firm's Investor Relations, if needed.

Visit Company Headquarters, if possible, and meet with Investor Relations people.

With the data gathered, we move onto Q&A

Step Four: Due Diligence
With research from above available, here are just a few questions to consider.

Balance Sheet
Look for no debt. If any, what is the reason? (TMFIG p.155)
Is cash steadily increasing over the years? (TMFIG p.153)
How is Acct Rec growth in relation to Sales growth? (TMFIG p.153)
What's Acct Rec turnover (52 weeks/(sales/acct rec))? Better/Worse than industry? Improving?
How is inventory growth in relation to Sales growth? (TMFIG p.153)
What's Inventory turnover (52 weeks/(COGS/inventory rec))? Better/Worse than industry? Improving?
Does the company get to retain earnings? (BUFF p. 107)

Income Statement
Are gross margins improving or at least consistent (TMFIG p. 148)
What else can be done to improve gross margins?
Are net margins improving or at least consistent? (TMFIG p. 148)
What else can be done to improve net margins? (CSUP p. 36)
Is there consistent growth of sales over the five year period? Beyond five years?
Is there consistent growth of earnings over the five year period? (BUFF p. 102)
What is biggest contributor to increase in bottom line in past year?
What are the R&D expenses in relation to its size? Are they being cut at all as % of sales (TMFIG p. 149, BUFF p. , CSUP p. 26))
How are SG&A costs? What is growth in relation to sales growth?
Are they paying full income taxes? Any carry-forwards? (TMFIG p. 150)
What does share growth look like? (TMFIG p. 151)
How is COGS calculated (Avg Cost, LIFO, FIFO) (HTRAFR p. )

Cash Flow Statement
What is driving cash flow? (TMFIG p. 163)
Is Cash from Financing positive, suggesting company has needed influx of cash to stay afloat. How does this compare with cash balance?
How does Cash Flow from Operations compare with Net Income? If net is bigger could firm be massaging earnings? (WRPSRRF)

Financial Condition
Would you consider company conservatively financed? (BUFF p. 103)
Is this company doing any secondary offerings? Why? Will they need to? (TMFIG p. 151, CSUP p. 46)
Has the company made any recent acquisitions? Any in the works?
What does the SEC Doc's Liquidity & Capital Resources say about how firm will finance operations? (TMFIG p. 164)
How much does the company have to spend on maintaining current operations? (BUFF p. 108)
Is company free to use retained earnings in new businesses, expansion or share repurchases (BUFF p. 110)
Is the company deferring taxes to massage earnings? (WRPSRRF)
Are there any revenue that sticks out as being temporary or unsustainable? (WRPSRRF)

Financial Ratios
Flowie ((current assets-cash)/current liabilities) (RBRM p. 227)
Current (current assets/current liabilities)
Cash/Debt (1.5 min)
Debt/Equity (long term debt/shareholder's equity)
Return on Equity +12% (net income/shareholder's equity) (BUFF p. 104)
Return on Assets

Market Conditions
Do I care about this market? Am I familiar with their products? (RBRM p. 191)
Does companies products/services have sufficient market potential for continued increase in sales over many years? (CSUP p. 19)
Is this company in an emerging market? (RBRM p. 38)
Does business have an identifiable consumer monopoly? (BUFF p. 94, p. 101)
Is product a repeatable buy? How often do customers buy again? (BUFF p. 120 , RBRM p.214 , OUOWS p. 134)
Where is company positioned in its industry?
Name some competitors.
Is this a One-Trick-Pony? I.e., is all success based on one product that could run its course.
What percentage of sales does the firm's largest customer have?
What is their main competitive advantage? What sets them apart? (CSUP p. 43)
Do they have patent protection? If so, when does it expire?
What are the major risks listed by company in “Disclosures About Market Risk” section of 10K.
Is company free to adjust prices to inflation? (BUFF p. 113)
Will value added by retained earnings increase market value of the company? (BUFF p. 115)
Has company recently embarked on any possible “deworseifications”? (OUOWS p. 146)
Does this company have a niche? (OUOWS p. 134)
Can company develop new products that will further increase sales when current products have been exploited (CSUP p. 25)
How good is company's cost analysis and accounting controls? (CSUP p. 42)

Valuations
What's the market capitalization?
What's the P/E?
How does P/E compare to historical P/E?
How does P/E compare to Industry P/E?
How does P/E compare to Market P/E?
What's the PEG? (TMIFG Chap 17)
Is there a good reason to still consider if PEG shows it's “overvalued”?
If PEG shows “undervalued”, is there a reason it might be cheap?
What is Price/Sales?

Management & Staff
Who is the CEO? How long has he/she served? Is it the founder of the company?
How long has the current core management team been together?
Does management have a long-term outlook on profits? (CSUP p. 45)
Can you judge the sales force? Are they above average? (CSUP p. 31)
Does company have management of unquestionable integrity? (CSUP p. 50)
Does management talk freely when trouble occurs or “clam up”? (CSUP p. 48)
Does company have outstanding labor and personnel relations? (CSUP p. 38)
Does company have excellent executive relations? (CSUP p. 40)
Does company have depth to their management (CSUP p. 41)
How many employees does company have?

Stock Market
What are general market conditions? (HTMMIS Chap 7))
What's the institutional sponsorship? (HTMMIS Chap 6)
What % are insider holdings?
What's the stock's float?
What's the short interest?

Step Five: Buying
After the above questions have answers you should have a real good idea if this is a company that you want to invest in. Most of the questions have no right or wrong answers and there is no “point system” to grind out winners. At any point if the answers you are finding are raising red flags, then it may be time to move on to the next company.

At this point you have to use your own judgement based on all that has been learned in the proceeding steps as to whether the security under consideration merits your investment dollar.

Step Six: Selling
At a 15% loss do an entire re-evaluation of the company. If the story of the company remains the same, then possible time to add to position. If any other fundamental conditions have changed, consider aborting and cutting losses short.

If the fundamental story of the company changes for the worst it could be time to sell. (OUOWS p. 259)

If a company has a couple of disappointing quarters in a row that would be a sell signal.

Bibliography (all books refer to paperback edition, unless otherwise noted)
TMFIG - The Motley Fool Investment Guide, Tom and David Gardner
RBRM – Rule Breakers, Rule Makers, Tom and David Gardner (hardcover version)
CSUP - Common Stocks and Uncommon Profits, Philip Fisher
BUFF - Buffetology, Mary Buffet
OUOWS - One Up On Wall Street, Peter Lynch
HTMMIS - How to Make Money in Stocks, William O'Neil
WRPSRRF - “When a Rosy Picture Should Raise a Red Flag”, NY Times, Gretchen Morgenson (http://www.nytimes.com/library/financial/sunday/071899invest-acquire.html)
HTRAFR – How to Read a Financial Report, John Tracy

Ed May
Email:Edwardmay@msn.com
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