Investing: Pitfalls to avoid

1) Be wary of companies with large amounts of debt. This rule can be broken for special circumstances, but insure that they are special. The amount of leverage used to carry a gas pipeline would not be appropriate for an insurance company. As a general rule, only bad things can happen with debt. Someday, those pesky, ungrateful lenders will want their money back; and it will always be at an inconvenient time. With too much debt, a small operating problem can be ruinous.  
2) Look for high quality earnings. The best companies are those that have very little need for capital, and express all or most of their earnings in cash.
3) If you don’t understand how the company makes its profits, don’t invest. This would have prevented investing in 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 it can’t be determined why the company is more profitable than it should be, question should be asked. 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. If is reporting more income than the GDP of a medium size country, something is not right.  
5) Avoid companies making a lot of acquisitions in a rush to get big. Serial Acquirers are dangerous to your financial health. Tyco and WorldCom are excellent examples, 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, studying its allocation of capital. If it builds new factories, or buys companies just to get bigger, avoid it; it is a Tyco or WorldCom waiting to happen. Since management usually likes to talk about its acquisitions, and often gives its rational for them, I have found this to be one of the best methods to evaluate its quality.
6) Avoid companies where the managers are paid huge amounts of money even when the company is not doing well. They are not being run for the benefits of anyone but senior management, and it gets paid before you do.  
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) Look for 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) Look at what a company does, not what it says. Words are cheap, actions are dear.
10) As a general rule, avoid companies that seem obsessed with providing and meeting earnings expectations. They are playing Wall Street, not Main Street.
11) 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.
12) Look for “one-time,” “nonoperating,” “extraordinary” charges. Some companies have “one-time” charges every quarter. “Nonoperating” charges become standard operating procedures. And with some companies, “extraordinary” charges occur so often they become ordinary. This is a scam. Often these charges are neither one-time, nonoperating or extraordinary. Excessive amounts of charges show a management that is either making a lot of bad mistakes, or is trying to manage its financial numbers.
13) Beware of the “noncash” trap. Almost all “one-time,” “nonoperating” or “extraordinary” charges are noncash. When is the last time you saw cash go bad? So, a “noncash” charge may not require any decrease in the current cash balance, but it does mean that an asset has gone wrong. Do not fall for the “it is only a noncash charge so of no consequence” trap. Can an asset materialize on the balance sheet, at no cost to the company? Assets arise out of the expenditure of cash, the forbearance of another asset, the incurrence of a liability, or the issuance of equity. So, the asset that was wasted in a “noncash” charge once either represented cash, a claim on cash, a promise to pay cash, or the transfer of part of the ownership of the company. So which of those is of so little importance that you will easily dismiss it? All charges are important. All charges mean something. A company can “noncash” charge itself into sweet oblivion. Don’t fall for the “its only noncash” excuse.
14) Be cautious of companies where the CEO holds a controlling stake. And be especially cautious when voting control significantly exceeds economic ownership. 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. Look for companies for which the fewest number of things can go wrong. The more the number of things that can go wrong, the more likelihood that something will.
  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? There could be whole host of sins in management’s behavior: selective hearing, wishful thinking, fear, unrealistic expectations or emotional over-investment. Ask this question: Is this a board room, or a mental ward?
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? If so, intangible assets will be growing on the balance sheet. Those often ignored and forgotten accounting footnotes are a good source for the discovery of noncash income.
21) Beware of deferred charges. These are created when expenses are not recognized even though the cash has been expended. As with noncash income, look at the footnotes and the balance sheet for explanations and accounting.
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,” “non-operating” or “extraordinary” charges; and we know how we feel about them. They may also indicate the use of aggressive accounting. 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 even when cash flow does not, resulting in low quality earnings.
23) Compare cash flow and earnings. Do earnings consistently outstrip cash flow by a substantial amount? If so, why? But, don’t blindly trust cash flow statements. For instance, changes in current assets and liabilities are a part of operating cash flows. All a company needs to do to increase cash flows is sell some of its trade receivables, or defer payment on trade payables. This activity may boost the cash flow of the current year, but is not sustainable.
24) Study deferred and prepaid income taxes footnotes. These will disclose the differences between income and expenses reported for tax purposes and book purposes. This is one place that evidence of aggressive accounting treatments may be uncovered. Ask yourself: “How much income is being reported for financial purposes, but not being taxed?”
25) 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? “Current year’s income was up by 11%,” doesn’t cut it.
26) At least skim through all the footnotes to the financial statements, looking for unusual items. If there are accounts on the balance sheet that are unusual or unclear, the footnotes may provide an explanation. The more confusing the balance sheet is, the more cautious the investor should be.  
27) 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, yet not once was it mentioned in the letter. Who, besides himself, was he trying to fool?  
28) Three questions: Is management honest? Is management honest? Is management honest? Question managements’ take on the results and prospects for the company. If management is not being honest in its communications to investors; run.
29) Be skeptical of industry gurus. For instance, take George Gilder, a telecommunications guru. In February, 2001, Gilder wrote: “Despite the foibles of its management and its revolving CEOs, Global Crossing remains the worlds’ best-situated telecom company, achieving its complex and ambitious build-out faster than any previous venture. With its network mostly complete and with cash on hand, it now stands ready to harvest richly from the daring vision of its proponents and investors.” Less than a year later, in January, 2002, “the worlds’ best-situated telecom company” entered bankruptcy.
30) Be skeptical of managements’ claims for its future. Take Sentry Manufacturing Company, a former manufacturer of quartz crystals in Chickasha, Oklahoma. My decision to purchase the stock of this company was brilliant, an opinion shared by the Chairman of the Board of Sentry. Just listen to what he wrote in the third quarter report for 1976. “Due to the quartz crystal watch technology, I believe the quartz crystal industry offers the greatest potential and opportunity of any industry in America today.” Bully for me; I had invested in the one industry that “has the greatest potential and opportunity of any industry in America today!” Someday, books will be written about me! Songs will be sung!  My joy and confidence were short lived, however. The annual report for 1977 carried the following announcement: “All watch crystal operations were suspended due to Japanese crystal manufacturers buying the domestic market with help from their government and academic community. Sixty percent of the American quartz industry employment was lost during 1977. An American watch crystal industry doesn’t exist today.” So the industry that had the greatest potential and opportunity of any industry in America in the last few months of 1976, completely disappeared in 1977. Sometimes management has the cloudiest crystal ball of all – with me following close behind.
31) Insider buying and selling is just that: insider buying a selling. The managers of a company are sometimes the least objective interpreters of the company’s condition. And managers are not necessarily investors. Just because an individual can find a place in senior management does not mean that he can value a security.  
32) Sometimes it is “the balance sheet stupid.” Take Conseco. In 1997, Conseco was on top of the world. It earned $550 million. Its stock was soaring. But, its liabilities exceeded its tangible assets. For some companies, this would not matter. Some companies can operate on very little equity. But Conseco was not “some” company. It was an insurance company; a company whose existence was based on its “promises to pay.” Ruin followed Conseco, and in 2002 it failed completely.  
33) Is goodwill, good? Remember, goodwill only exists because the amount paid exceeded the fair value of the assets purchased in previous acquisitions. Goodwill don’t cook rice. It can’t be used to build factories or pay debt. It is neither good nor bad, it just is. Remember this when someone touts the book value virtues of a company carrying substantial goodwill.  
34) If a company runs off into new lines of business in which management is completely ignorant, be wary. They have convinced themselves that their brilliant business skills are transferable. Unfortunately, they usually aren’t.
35) Avoid wishful thinking. Don’t let the investment rational read like some version of the following: “If A occurs, followed by B, C and D, then there is great possibility of F occurring. If that happens, then G is sure to follow, especially if H happens.” If your reasoning for investing can be summarized as, “if we had some eggs, we could have some ham and eggs, if we had some ham,” you are engaged in wishful thinking.
36) Don’t fool yourself. Fool others if you must; fool others if you dare. But don’t fool yourself; that is the biggest sin of all.  
37) Pro Forma earnings may be a scam. There are many examples of companies that have consistently reported both good pro forma earnings and “one-time,” “non-operating,” “extraordinary” charges. Motorola and AT&T are two. Just like the wizard in the Wizard of Oz, management will implore the investor to “ignore those charges behind that curtain.” Pro forma earnings will grow and shine; and all the while, the company’s assets are slowly being destroyed by one-time charges. Ignore the bottom line at your own peril.
38) It is not the analysts’ fault and it is not the media’s fault. Do not blame them, regardless of how off base, inaccurate or conflicted they may be. And if it is being honest in its communications, it is not even management’s fault. If you substitute the judgment of someone else for your own judgment and it turns up a looser, do not blame them. Blame yourself. It was your decision. Take ownership of it. Learn from it. Get off your pity pot, and move on. Plus, at every available opportunity, remind me that I wrote this.
39) EBITDA is large neon warning sign to the investor. Do not look away! If you ever see a company reporting EBITDARES, Earnings Before Interest, Taxes, Depreciation, Amortization, Rent, Entertainment and Spitzer – go short.
40) Stick to your knitting. Don’t try to be all things to all industries. Find and invest in the industries that you can understand. This will most likely be an industry you actually like. Owning, following and studying a company for many years is more productive if you actually like what they do.  
41) You can not make money by buying something you do not want to own in order to sell it to some other person who doesn’t care to own it anymore than you do.
41b) Heed the Hierarchy of Values: Buffettesque Intrinsic Value (present value of future cash flows discounted at the long term federal rate), Fair Market Value (present value of future cash flows discounted at the rate you want to earn), Margin of Safety Value (Fair Market Value less an appropriate margin of safety) and Market Price, which could be higher or lower than any of the other three amounts. Buffett’s suggestion: buy at Margin of Safety Value.
42) Concentrate your holdings. There is no magic number of stocks to own. And at times, a basket of stocks in a specific industry may be the right strategy. Excessive diversification probably will only result in market results. Instead, just buy an index fund. The investor needs few enough stocks that he can sit around and daydream about them.
43) However, some diversification is necessary. There are some things that are not knowable. Has the CEO and guiding light of the company just lied to federal investigators and destined to spend some quality time in close, federal confinement? Despite all indications to the contrary, does the profitability of the company rest on the continuance of a criminal conspiracy? Has the company cooked the books so well that even someone as clever as you can’t discover it? If you own enough securities over a sufficient period of time, something like this will happen to one or more of your positions. I know.
44) Look at how the company views its role in change. Instead of being concerned with industry growth, are they asking if the industry will become commoditized and growth will not even be profitable? Instead of being concerned with the weaknesses of their major rivals and how to beat them, are they asking who else may become a competitor, maybe in some new and different way? Instead of concentrating on adding new and wonderful enhancements to their technologies, products and processes, are they asking if some new technological or social change will completely alter the rules of engagement? Are they concentrating on marketing strategies, or are they asking what their customers actually want? Instead of being consumed with fighting existing government rules and regulations, are they asking what kind of new government policies are likely, and how those changes will affect their operations?
45) Do not believe anything. Suspect everything. Be paranoid.  
46) This list will be expanded as public disasters and private losses (mine) continue to accumulate.      


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