by Bob Andelman
One morning in March 2001, the stock market plummeted.
Within five minutes of the opening bell, the Dow was down 80 points. On his nationally syndicated radio program, "Imus in the Morning," Don Imus described the action the way an auctioneer might. "Down 80. Down 89. Down 96. C'mon 100! Do I hear 100? 100!"
After 15 minutes, it was 200 points. In less than 30 minutes, the market had fallen nearly 300 points and program trading curbs automatically kicked in to slow the freefall.
The studio crew at "Imus" was watching the action on CNBC. Someone cracked, "Ron Insana looks like he's watching an autopsy."
The comment was funny, but few people were laughing.
Several months later, terrorists crashed a commercial jetliner into each of New York's World Trade Center towers and a third into the Pentagon in Washington, D.C. The entire world ground to a stunned halt and silence as the twin towers collapsed and thousands of innocent men, women and child lost their lives without warning or reason.
When the stock markets re-opened almost a week later, no one was smiling. No one was joking. The bottom dropped out of virtually ever exchange around the world. Even the most confident investor was scared; no one had ever seen anything like it. Uncertainty gripped virtually every sector.
What now? Everyone asked everyone else.
Back to basics, of course.
Mama Said There'd Be Days Like This
You probably have an uncle on your mother's side who knows.
Or maybe a guy in the next cubicle at work has it all figured out.
Maybe you've done a little research of your own and concocted a can't-miss, "back of the envelope" scheme.
But do you really know what signals profitability in a stock? Do you know what drives profits, what makes one company a success and the next a flop? How a nightmarish investment yesterday could be tomorrow's comeback kid? What do professional stock analysts look for in corporate profit statements? What do they look for in an earnings report? What sustains a company's prospects when everything around it is in freefall?
Historical results are one potential indicator of the future. Then we look at the market, the competitive factors and the new products coming out. We look at the management. We look at the business design model, the prospects, and the forecasts from people who forecast for a living, whether it is PC or cell phone growth, soy futures, employment growth or whatever. We look at a lot of factors.
For example, if a banking company had three specific characteristics over the last decade, its stock would move up rapidly. Characteristic number one was that its revenue per share grew at 12.5 percent a year. Characteristic number two was that more than 40 percent of its revenues were derived from what are called "non-interest income" sources. Characteristic number three was that its balance sheet had more than 25 percent liquidity, which means that cash and cash-like holdings represented more than 25 percent of all assets.
"If you had those characteristics, man, that stock moved!" says Richard X. Bove, director of financial institutions research at Raymond James & Associates in St. Petersburg, Fla.
But one day the Federal Reserve cut interest rates, and the characteristics that worked for years went out the window. Then analysts such as Bove found themselves looking for companies whose earnings were leveraged to interest rates.
There is a modest bank in Michigan called Mercantile Bank Corp. If the Fed cut interest rates by 150 basis points and Mercantile's net interest margins were to return to where they were in June 1999 before interest rates went up, earnings would go up 59 percent for that company. Or in SunTrust's case, earnings would go up 22 percent if the Fed cut interest rates by 150 basis points.
"Of the companies that met the prior metrics," Bove says, "Bank of New York is selling at 33 times earnings, and the companies that I am looking for under the new metrics are selling at eight to 10 times earnings. The game changed. The game is not static."
One metric Bove found himself attuned to was what he calls "cash draw." Does a company have enough cash to go through a difficult environment for six months or a year? Does it have enough cash to take advantage of what the next financial environmental change might bring?
"The characteristics that we would look for in almost any industry, technology or not, are not dissimilar," says Jay Vleeschhouwer, a first vice president at Merrill Lynch and Co. in New York City. "You always look for characteristics having to do with the quality of management, the articulation of a strategy, a track record of execution and financial performance, a well thought-out business model, and a strong position in the marketplace. I happen to be a very strong believer in creating and building upon franchises, and that is particularly true in technology."
Investors can study particular companies and, by understanding them, make more informed decisions about investments. Numbers change daily and tell one story; the anecdotal evidence presented here tells a far more compelling tale.
PROFIT DRIVERS describes the strategies, new business models and financial measures emerging from many of these firms. An exciting aspect of the book is the mix of companies and personalities included, representing first-generation Internet companies and the rising stars of Wall Street, as well as several standard-bearers and beneath-the-radar operations.
This book serves as an advocate for individual investors, identifying seven key attributes of companies that emerged as a driving force in their industries and the overall economy. The book is organized by these attributes, from management and business model design to innovation and profitability.
Examples of pertinent companies are used throughout the book to illustrate how each attribute takes form and the role it played in shaping the company. Stories of the organizations and their leaders take center stage. Coverage of key sectors such as technology, retail and financial services are among those highlighted.
Among the companies that recur from chapter to chapter: The Home Depot, Cisco, Microsoft, Wal-Mart, General Electric and Charles Schwab. There are also a host of additional companies that appear in chapters tied to a specific attribute. Adobe gets high marks for innovation; Southwest Airlines is noted for its business design model. In the final chapter, "Elements of Surprise," eBay and Celera tie up all seven profit drivers in two nice, neat packages.
Not only will PROFIT DRIVERS help individual investors understand the leaders of today, but it will also devise a framework for recognizing profit drivers in the future. Understand The Home Depot today, and five months from now maybe you'll pick out the small cap stock that could be the next Home Depot.
Sweet Smell of Excess
No single characteristic outlined in PROFIT DRIVERS is an absolute. There is no such thing as a lock for investors. And the description of a company's past performance within these pages is by no means a stock endorsement.
The closest you'll find to a guarantee is this: A company must generate cash profits and cash revenues to be profitable! It's something that experts believe individual investors lost sight of over the past few years.
This isn't the first time in history that investors smelled money in the air. Ever heard of "Tulipmania"?
In the mid-16th century, the value of tulips was as overhyped as Priceline.com. As described in "Tulipmania: The Queen of the Night," a widely read 1998 article in The Economist:
To begin with, the high cost of the bulbs simply reflected their scarcity, a proper function of the market. ... Things only began to fall apart when the bulbs became vehicles for speculation, when traders bought them not to grow but to sell on to other traders at a profit.
Some deals were done by barter. For instance, one fancier agreed to pay a deposit of four cows for a quarter pound of bulbs, with an additional cash payment on delivery. (Charles) Mackay recorded that houses and land were sometimes part of the deals. A contemporary writer calculated that for 2,500 florins, the price offered for a single bulb of a rare species, a whole consignment of agricultural products could have been purchased, including four oxen, eight swine, 12 sheep and stupendous quantities of grain, beer, butter and cheese.
At the same time heart-rending but possibly apocryphal stories circulated of servants eating their masters' priceless bulbs, believing them to be some kind of onion.
But then, as so often happens, the bubble burst. Some lucky bulb-traders got out in time and made their fortunes. Others were forced into bankruptcy when the state authorities intervened by invalidating many deals and compulsorily reducing others to 10% of the price originally agreed. It was some years before the Dutch tulip industry was back on an even keel.
When the tulip market fell back to earth, it ruined thousands of ordinary people with dreams of growing gold in their back yards.
And another thing: What works today won't necessarily work in 24 months. Or, if it's a dot-com or Internet stock, 24 hours. Be flexible.
The stocks that meet today's metrics will get bid up so high that investors will no longer find them desirable. Then a new metric will come along that seeks to decipher what the next growth company will be. What series of numbers do we look at? All of the characteristics described in PROFIT DRIVERS are important, but most important of all is where the market's emphasis lies at a given point in time. That determines which stocks will really move.
Another general issue for your consideration: Does the company you're thinking about investing in know what it is doing?
In 2000, the assets of Whittman-Hart and USWeb/CKS were merged into a new company called marchFIRST. Does the name mean anything to you? Anything at all? Imagine if you knew the company based on its previously independent pieces and bet the ranch that consolidation would be a good thing. Then you saw the company invest millions in a national brand awareness campaign that never offered consumers a clue about what it is, exactly, that the business offered.
The resulting sound you hear is another hapless stock crashing.
"I told the company I thought its ads were terrible," says F. Drake Johnstone, a research analyst who covers marchFIRST for Davenport & Company LLC in Richmond, Va.
Less than six months after its first ads appeared on television and in magazines such as Fast Company, marchFIRST imploded. First was a wave of 1,000 layoffs in November 2000. Another 550 workers were furloughed in January 2001. Corporate expenses were cut 10 percent, according to AdWeek, and "non-core assets" were put up for sale. At one point the company's share price -- once $56.50 -- fell as low as $1.
"But you know, I sort of consider it a learning experience," Johnstone says. "Going forward, I will be a lot more skeptical of a company that had that number of acquisitions."
Show Me (Don't Snow Me)
Some of the cliches about equity research are true.
It is an art, not a science, "and it is a mosaic," says Faye Landes, a senior research analyst at Bernstein Investment Research and Management in New York City. "It is always hard to point to the thing. I can't ever point to the things. There are things that we look for. Some of the things that I look for, that we always look for, are all cliches. But they are all true."
Search for companies with a sustainable competitor advantage and predictability of results. Companies tell us that they are going to do things. Don't just take their word for it. Check and see if they actually do them. It is much harder than it sounds.
Weighing actual performance against a stated plan is a good barometer of how in touch with reality companies are, because time and again, the disclaimers they give analysts are on the downside, not the upside. In other words, if demand for a company's product is higher than it expected, that is a temporary issue. Nike had a period when things were really going well, when it announced that it couldn't manufacture enough shoes to meet demand. That is considered a forgivable mistake. The unforgivable mistakes tend to be when a manufacturer makes too many shoes and gets stuck with warehouses overflowing with unsold merchandise. So being in touch with reality is crucial.
There are some companies that are just terrible at being in touch with reality, and there are some that are better. No one ever sees disappointment or trauma coming from miles away. It is just a question of how realistic they are, and to what extent they can catch things. Certainly nobody is foolproof.
No Soup for You
Buying Amazon.com because you saw Jeff Bezos named "Person of the Year" on the cover of Time in December 2000 didn't help you make a real -- or real smart -- investment decision. Especially not when his company's stock was 90 percent off its 52-week high three months later. Besides, once a CEO is on the cover of a major national magazine, the party's almost always over. That is most definitely not the time to buy. It's kind of like knowing not to bet on the team that Sports Illustrated picks to win the Super Bowl. Or not to drink Kool-Aid being poured by Jim Jones.
The entire Western world is ringing out the excesses of the gung-ho market of recent years, a time in which a company's performance didn't matter quite as much as its market buzz. Investors applied surrogate measurements of the real business at hand. The days of companies being valued on whether they are riding the right hype train may not return in our lifetime.
That is the good news. The bad news is that individual investors felt like they lost a lot of money just not being current on what was the latest hyped-up IPO out of the investment banking world. That was a game that almost no one could keep up with.
But there will still be premiums associated with leadership and innovation. There will still be premiums associated with good marketing, good positioning and connectivity. This won't become a commodity business where all stocks are reduced to sort of their vanilla statistics. The personality of a company still matters. The leadership of a company matters a great deal. But we are going back to basics in early stage investing because too many people were burned by skipping class in 101.
Look for "later-stage" profit driver market attributes. These include companies that will invent, produce or build something that is targeted at a real-world problem and a real-world opportunity. It isn't something for which the stars and the moon and the sun must be aligned before anybody could imagine needing or wanting it. No more virtual concept businesses whose motto is "build it and they will come."
There are three questions that matter every time you invest in an early stage business: 1) Is there a market for the product that is growing, is large, is addressable and is accessible? 2) If you get to that market and you like the market attributes, does the product offer the value proposition that the company proposes? And 3) What do profits look like?
Five Quick Profit Lessons
Are there learnable lessons from the markets' recent fallout? Yes.
If you accept that profit is the ultimate dividend in investing, you can't help but concern yourself with what signals profitability in a company. Once you understand and apply the seven profit drivers outlined in this book, apply the following five lessons to your investment philosophy:
* Set personal investment goals and act accordingly.
Some people approach investing with "back of envelope" personal equations. "If my stock goes up 20 percent, I sell out. If it goes down 20 percent, I invest another 10 percent until it goes down 40 percent, at which time..."
Many people didn't have personal investing discipline in the dot-com market, as demonstrated by their inability to take money off the table. Perhaps they were scared of taxes, so they let things ride well past the company's peak value. Maybe it was simple greed. But in many cases, they invested in companies they knew nothing about. Professionals call it "momentum investing." Individual investors bought companies just because the stocks were going up and they didn't want to be on the outside looking in. They bought individual stocks whose prospects for the future they didn't understand and accepted on faith. They bought the hype and trends and then were not disciplined about actual performance.
* Develop a discipline toward taking profits.
Investing in momentum or in hype might have worked for those with the discipline to take their profits and cut their losses, but if they didn't do either, then they sort of deserved what they got. Either know what you are buying or don't know what you are buying. But have a personal discipline for mathematically interacting with the fact that you don't know what you are buying. If you don't know what you are buying, great; sell when it goes up 20 percent and sell half when it goes down 10 percent. Then it won't matter whether you knew what you were buying.
* Diversify.
There are no absolutes in the business of investing. "I always counsel that the 'D' word -- diversification -- is still holy," says Tony Maramarco, a large cap value manager and managing director at David L. Babson Co. in Cambridge, Mass. As long as you realize that there are no absolutes, that is the first step.
John Hamm, a partner at Redpoint Ventures in Menlo Park, Calif., agrees. "I personally took a whole chunk of my stock as a founding director of Brocade and sold it and bought an Old Economy portfolio," he says. "For the first four months, I literally felt like the stupidest guy on the block. And you know what? I made 7.5 percent on that portfolio over the next year."
Now he feels smart, but mostly what he was was scared. Most people don't realize that being diversified even in a hot tech market eventually will end up paying off.
* Do your own research.
Don't believe everything you hear and everything you see. Don't get caught up in the hype, thinking you've uncovered the next cure for cancer. Don't buy stock because your plumber told you to do it. That was the mentality at the end of 1999 with all the dot-coms.
"I am not a very good trader," says Philip S. Dow, a director at Dain Rauscher Wessels in Minneapolis. "I need a very strong discipline and belief in that discipline to stay as an owner of business. Trying to trade stocks is a loser's game, at least for me. I really need research."
Dow relies on smart people who cover the industries and companies he's interested in and can help him find the "bulldogs," best of breed companies at the crossroads of good industries. Those are the only ones he wants to own. No marginal companies or tertiary players for him. Bulldogs are companies that have defensive as well as aggressive characteristics.
* Don't believe your eyes.
Some people automatically assume things are great with a retailer because they happen into a store and on that particular day it is crowded, ringing up great sales. It takes more than that to know everything is fine and dandy with the company.
About this eBook
PROFIT DRIVERS was written on a backbone of experience and advice from more than 30 professional stock analysts, consultants and financial journalists. Interviews with these men and women led to the following seven key profit drivers:
* Sustainable Management
* Well Crafted Business Design Model
* The Sweet Swell of Innovation and Culture (Or, The Rank Smell of Consequences)
* Trust the Profitability Metric
* Market Share Matters
* High Band Connectivity
* An Element of Surprise
Many of these same authorities and soothsayers (a complete list can be found in the Acknowledgments) regularly provide their expertise in media forums such as Forbes, Fortune, The New York Times, The Wall Street Journal, Business 2.0, Bloomberg News, CNN Money and CNBC. They talked in great depth about the characteristics they research and weigh before going to investors, on the air or in print, to recommend companies and company leaders. There isn't enough time in a sound bite to go deep on-air about their research; in PROFIT DRIVERS, many offer the general public insight into their methodologies for the first time.
The book was written under contract for CNBC as part of series that was then canceled. Although it is still being solicited for sale online, trust me, it was never published. (And contrary to Amazon's solicitation, there was no "import" edition in August 2007.) The cover even has my byline as "Robert Andelman," which I haven't used since the third grade.
Make their contributions pay off for you.
Bob Andelman
St. Petersburg, Fla.
