I’m at my home office, reading through the annual report of a company with which many of you would have at least some familiarity based on normal shopping patterns. I’m absolutely baffled that such mediocrity can exist and it makes me angry that the average investor would not be able to uncover it by flipping through a Wall Street brokerage report. Let me discuss just a few of the finer points; you might want to look out for them in your own investing plan:
Over the past few years, assets have doubled, debt has gone up roughly 500%, and earnings have plummeted
They don’t own most of the important brands they manufacturer, but rather license them from other big companies
Before being forced to expense stock options. the Board of Directors authorized an acceleration of options, vesting them immediately. These options were so huge that they represented over 4% of the company’s outstanding shares! To put that in perspective, it would be like someone coming in and, for a family earning $65,000 a year between two working spouses, them hijacking over $2,600 of the gross income each year to line their own pockets. This was done to lower the reported stock option expense once the company was forced to follow the new accounting rules. In other words, it was entirely cosmetic, understated true expense, and screwed the owners.
Insisting on growing a business with sub-par earnings, instead of paying out excess capital to shareholders in the form of cash dividends. who could likely do a much better job reinvesting it in other companies, every penny is retained for empire building.
The effective tax rate bounces between 9% and 17%. This is a good indicator of what professional investors call “quality of earnings”. Basically, it just means something along the lines of, “how close to economic reality are the reported profit figures on the balance sheet.” Let me tell you a secret: the IRS is very good at determining how much money a person made. If the income statement shows you made $x million in net income yet you are paying a tax rate that low, in their eyes, your business isn’t that profitable and you are probably using accounting tricks to overstate true earnings. That’s a very, very telling figure.
This is definitely a case of “love the product – hate the stock”. When building your portfolio, as mentioned earlier, these should be red flags. A few of them might – and I stress might be okay if you can come up with a satisfactory explanation or believe the problems are only temporary. Hitting all of them should be a virtual bonanza of fireworks warning you that this isn’t something you want to touch with a ten foot pole, even if the stock is cheap.
