Recently, I received a message from a person, who lost $4,500 on SunEdison's (SUNE) shares. He saw a few of my articles on the stock's options, which I recommended buying or selling at different time periods since December 2015, when I first wrote about the company. He wondered whether the options could help him offset some of the losses.
The truth is, one cannot do anything about SunEdison's bankruptcy at this point in time. Even options cannot save him now. However, you can learn something from this example. A lot, in fact.
Today, I would like to point out a few recommendations from financial analysis for investors buying stocks (and bonds) in the future:
(1) It is best when a company generates free cash flows (calculated as operating cash flows less capital expenditures, for simplicity). When a company generates free cash flows, it can distribute cash in the form of dividends or buybacks. It can also use the money to finance its own growth, remaining independent of capital markets. It is a rule of thumb that a company is considered healthy when it consistently generates free cash flows;
(2) If the company does not generate free cash flows, make sure it at least has growing operating cash flows from year-to-year (this is why the Cash Flow Statement is paramount to financial analysts). SunEdison not only failed to grow operating cash flows but it had negative cash flows from operations. They were not only negative: they were becoming more negative year-over-year.
When the company has negative operating cash flows, it basically means that investors are paying their own money to keep they company's doors open. In other words, the company is burning cash in daily activities.
Therefore, the company is practically better off closing down the operations. If the company is doing this consistently and raises cash in the form of debt or equity to finance its daily operations, why would you want to own it in the first place?
(3) Analyze operating cash flows: make sure that earnings make up at least half of total operating cash flows. My suggestion is to look at companies that have at least 60%-70% of operating cash flows in earnings.
Remember that adjustments for non-cash items or changes in working capital can add a lot of cash to total operating cash flows. You have to make sure that most operating cash flows come from the company's commercial activities, not timing differences or other advantages (e.g. D&A benefits);
(4) Capital expenditures must drive sales in the long-run. It is easy to analyze that by dividing total capital expenditures by total sales (you can also divide historical CapEx by current sales to see what the trend is). Ideally, this proportion should remain roughly the same.
(5) Check debt ratios: they should stay in line with the industry over a considerable amount of time. If you want to be more conservative, choose industries that do not have high leverage. SunEdison did not have a strong balance sheet from this standpoint at all:
(Source: Seeking Alpha)
(6) Historical information does matter. Many times, I have heard people saying that historical accounting data were irrelevant (e.g. "you are looking in the rear-view mirror). I agree that historical information does not predict future results. But here is what it definitely does: it helps investors understand the company's management's mentality. If the management likes to "go all-in", this is a red flag.
Nobody knows the future, and everyone knows that. If this is true, why overleverage the balance sheet? Why aspire to be the fastest-growing company in the industry at the expense of being the first company in the industry to go bankrupt in the event the market goes south? In short, look at historical trends: smart money does it, why should not you?
(7) Do build financial models for every investment you make. Moreover, build models that encompass different scenarios (I typically choose three scenarios: the Base case, the Bull case, and the Stress case).
Financial modeling is not rocket science - it is combination of intermediate accounting and basic math. Most models are built in Excel, which you probably use at least a few time a month, anyway. There are many resources on the Internet which you can use: templates, YouTube videos, online courses, etc. Invest time and resources in your knowledge: life is not simple, investing is not, either. Again, smart money does financial modeling, why should not you?
There are more recommendations about financial analysis I could give but you probably would not remember most of them because they are very technical.
I would like to give a few investing tips from my own experience instead:
(1) Never buy on an impulse. If you want to satisfy your desire to act on an impulse, open an account on stock simulator (e.g. Investopedia, UpDown) and buy the stock there. Then go home, do the analysis and make a decision cold-headed.
I would actually recommend doing impulsive transactions on stock simulators and then gather statistics on the percentage of successful/failed trades after a period of time. This should give you a general picture of how much value stock tips from friends and family and various psychological biases actually add to your investing success (I hope that most of the readers have a set investment strategy);
(2) Learn options. Yes, they are derivative instruments and our society considers them dangerous for investing. They are dangerous when people use them for wrong purposes and/or do not know them well enough. They are also a lot more complex than equities.
However, this does not mean that you should stay away from them. Options not only can help you reduce market risks but they can also enhance your portfolio's profitability (e.g. look at the "Options Wheel Strategy").
Finally, many options strategies allow you to capture the same upside as the underlying stock in dollar terms, while demanding a lot less downside risk. Options also have disadvantages (e.g. relatively short life, unlimited risks in some cases, timing issues, etc.) but I will focus on them next time;
(3) Set up proper risk management. This should be new for most of Seeking Alpha's audience. Unless you are into day trading, you absolutely must have a risk management strategy for your portfolio (e.g. maximum loss on any position, strict capital allocation rules, target leverage ratios, etc.). Here is a lesson for you:
I frequently write on WhoTrades but mostly offer short-term options plays to my readers there. This is a message I received a day ago from one of my subscribers. The original text was in Spanish, which I do not speak yet, so I had to translate it. The story is painful to read. Unfortunately, when a stock is down 90%, even options cannot save you (unless you set up downside protection from the beginning). All I could do is to be sorry for this person's situation. Unless this is a one-million-dollar portfolio, the $4500 loss is significant. Learn your lessons from other people's mistakes.
(4) Do not buy stocks just because they are cheap (relatively or absolutely - this does not make a difference). Some stocks are cheap for a reason. In our age and time, it is increasingly hard to find mispriced stocks given all the technology and brains smart money has. If a company is traded at a discount to peers or the market, chances are, it is traded like that for a reason.
An exception for that is small cap companies with no-name brands. Oftentimes, they can be undervalued for a very long time. However, even if you are convinced that a company is undeservingly undervalued (you have done a thorough financial analysis, studied the market - or maybe you are the industry's expert - , maybe even talked to the management), this does not mean you have to buy the stock right away.
The main problem with such companies is that they can stay undervalued for years (recall Carl Icahn's Motorola story). Many times they do not pay dividends. This means that your alternative costs will not be paid for for a long period of time.
Remember that your goal is to make money. If you can make money somewhere else (even if the other company is not undervalued), you should go for it. The truth is, financial analysis does not always go hand-in-hand with portfolio management.
One of the goals of financial analysis is to identify undervalued stocks, while the goal of portfolio management is to maximize returns at a given level of risk. Portfolio management does not fall in love with the stocks - it cares about overall returns and volatility of the portfolio. As you can guess, the latter is more important.
(5) Don't bet the farm. I am serious. People have heard this so many times before, yet they still make the same mistake all over again (I have seen that first-handedly). The main cause of this mistake is greed. People must realize that they cannot become rich in one day without taking excessive risks. Investment return is a function of risk, not the other way around.
When you get overexposed to only one position, you are not letting the probability theory to work in your favor. In this case, you are deliberately forgoing diversification - the only free lunch on Wall St. Moreover, you are willingly taking emotional pressure when it is not necessary. One of the many benefits of having a diversified portfolio is that you become disassociated with single securities in your portfolio as they represent a fraction of the overall portfolio's risks and returns. If diversification adds to your personal health, why push it away?
Go to your portfolio and analyze your holdings using the seven-point list I presented in the article. Reduce your investment in companies that do not meet the criteria. Also make sure that you know why you own/short a certain stock. After that, go and see if you can check all points on my "investment tips" list. The truth is, the second list is more important as it offers a framework for investing in general, whether you invest in equities, debt, real estate, or many other instruments.
Please provide comments below on what you think you could add to either list and/or what should be removed/is irrelevant.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.