A friend whose judgment you trust tells you about an interesting stock. Or you read a newspaper article about an intriguing business, or run across one at work or at the mall. Or your dentist tells you that there’s this company that makes a terrific new drill. What do you do?
What you don’t do is run out and buy it.
Instead, you do the research. It’s not hard. Thanks to the internet, investors today have almost the same tools to analyze stocks as Wall Street experts. And, without the conflicts and biases, the amateurs’ choices are often better than those of the pros.
Let’s look at an example to see how it’s done. The company is the Shaw Group (SGR), a manufacturer based in Baton Rouge, La. Its stock was brought to my attention by one of the smartest business minds I know, the former chief executive of a New Orleans bank (whose own shares provided my own biggest score in the market).
The two of us love the chase. We’re always looking for good prospects, and we trade ideas in e-mails. He’s bought one or two of mine, and I’ve bought one or two of his. Most of my assets are held in mutual funds and ETFs (exchange-traded funds, such as Spiders, which mimic the benchmark Standard & Poor’s 500-stock index). Decisions to buy individual stocks to supplement those diversified holdings I make very slowly and very rarely. The research is part of the fun.
In his 1989 book One Up on Wall Street, Peter Lynch, former manager of the Fidelity Magellan fund, argued that small investors can succeed by “ignoring the hot tips, the recommendations from brokerage houses, and the latest ‘can’t miss’ suggestion from your favorite newsletter — in favor of your own research.”
That research doesn’t always involve numbers. It usually begins with listening, watching, and thinking. Lynch himself says he found some of his biggest winners just by being alert: Dunkin’ Donuts from drinking the fabulous coffee, La Quinta Motor Inns because “somebody at the rival Holiday Inn told me about it.” His wife pointed him to a company called Hanes, which was test-marketing pantyhose in the grocery in plastic eggs. “Carolyn didn’t need to be a textile analyst to realize that L’eggs was a superior product,” Lynch wrote.
One of my own best investments has been Starbucks (SBUX), whose stock has tripled in the past five years. I bought it after I saw a long line of average Americans waiting for an expensive latte at a highway rest stop. A lightbulb flashed: Starbucks was not just for yuppies! Of course, I didn’t simply run out and buy it. I looked at the data, read the annual report, checked the competition. But it’s the catalyst that counts, and it can come anywhere: from a conversation with a stranger, a trip to the drugstore.
I have never bought a Shaw product. That’s because it makes industrial pipe. Here, the catalyst was Ian Arnof, my ex-CEO friend. When Ian talks, I listen.
Shaw passed my three initial personal screens.
First, it’s small enough that there is a chance its charms have been overlooked by Wall Street. Since so many big investors buy and sell them, large-caps are rarely flaming bargains. The market for large-caps, in economic terms, is pretty “efficient.” But Shaw Group has a market capitalization (that is, a value according to investors: its price times the number of shares outstanding) of only $400 million, compared, for instance, with $100 billion for Coca-Cola (KO).
Second, it appears — at least at first glance — to be super-cheap. In the most recent 12 months the company earned $2.24 a share, and on Wednesday it closed at $10.71, for a price-to-earnings (P/E) ratio of about 5, compared with 28 for the average S&P stock.
Third, it’s in a boring business that’s not too hard to understand. Shaw doesn’t make any old pipes. Its main customers are electric utilities and other companies that generate power. In that business, pipes aren’t just plumbing; they’re the guts of the operation. Shaw is also the only vertically integrated firm in the business. It provides everything: design, engineering, construction and environmental services.
Gleaning this kind of information is simple. I turn to two reliable, free financial Web sites — MSN Money, a service of Microsoft and CNBC, and Yahoo Finance. They offer profiles, charts, and reams of financial history. I also check Morningstar, which focuses on mutual funds but also has data and analysis on individual stocks, and Motley Fool, a more opinionated site. And, naturally, I spend a lot of time mesmerized by the jampacked one-page description of the company provided by Value Line (800-833-0046), a service I subscribe to. Value Line began covering Shaw only in December, but it has data going back to 1993. (Netflix, it doesn’t cover at all.)
I also check the company’s annual report and any recent news stories: The Google search engine and the personal-finance section of America Online are good sources. What about analysis from investment firms? I read the narratives and look at the data but ignore the ratings (“overweight,” “market perform,” etc.). I can make my own judgments more objectively.
Every company has a story, and, after you have done the research, you should be able to tell the tale in a telegraphic sentence or two. For Shaw, I would say this: Century-old pipemaker acquires related businesses, becomes key niche player, goes international, attracts investors as a play on coming deregulation of electric utilities. Deregulation fizzles in wake of California crisis and Enron scandal, economy slackens, stock tanks.
Shaw, which went public at $14.50 a share in late 1993, rode the boom, the stock rising to $63.50 by mid-2001. Today, it’s about one-sixth of that price.
Investors thought Shaw was a growth stock — and they paid accordingly. Its P/E jumped from 15 to 29, which was actually quite reasonable for a company whose earnings and cash flow (that is, the real dollars free for investment) increased at a rate of 30% between 1997 and 2002. But growth slowed, and disappointed investors dumped their shares.
All of that is understandable. The issue now is whether Mr. Market has become too pessimistic. Value Line expects that weak power markets will lead to flat sales this year and that Shaw’s earnings will fall to about $2. One of the five analysts (that’s all!) who cover the stock predicts just $1.75, but that’s still a P/E, based on today’s price, of about 7. Of course, earnings could go even lower. But Shaw could present exactly the kind of arbitrage (or profitable anomaly) I crave: It’s priced for the short term while I buy for the long term.
Shaw’s latest quarterly income statement, issued in mid-January, does indeed show a slight drop in earnings, but management reported at the same time that its backlog of projects totaled $5 billion, up 11% from a year earlier. That’s a healthy figure for a company with sales of $3 billion a year.
Now check the balance sheet. What we need to know is whether Shaw has the resources to ride out tough times. The answer seems to be affirmative. Shaw has $528 million in debt, but only $6 million is due over the next five years. Value Line reports that at the end of August (the conclusion of the fiscal year) Shaw held $552 million in cash, so it could actually pay off all its loans and have a few bucks to spare.
The decision on whether to buy Shaw comes down to this: Can the company endure a slowdown, in the expectation that the economy will revive and the power market will grow more stable? The kicker is deregulation, which could mean a new wave of power-plant construction.
Shaw is risky, no doubt, but the price reflects that risk — and then some. Last year, according to Value Line, the company generated cash flow of $110 million. Its market cap is $400 million, so an investor pays less than $4 to buy $1 of annual cash flow. An investor in Cisco Systems (CSCO) pays about $30 for $1 of cash flow; an investor in Wal-Mart Stores (WMT), $18.
As I was about to make a decision on Shaw, I stumbled onto a group of sleuths who had come before me. Each year since 1993, about 200 first-year MBA candidates at Tulane University divide into groups of three or four and study nearby companies whose shares are listed on the major exchanges. Many of the stocks have turned out to be “tremendous opportunities,” says Peter F. Ricchiuti, the professor who runs the program, which is called Burkenroad Reports, after an alumnus and benefactor. The stocks have to pass two initial screens besides proximity: first, market caps have to be under $500 million and cash flow and earnings have to be positive for the preceding 12 months.
Four years ago, the students began putting together a portfolio of the stocks they liked most. Total gain since then: 43.6%, compared with a loss of 5.5% for the Russell 2000 index, the best benchmark, since the stocks are all small-caps.
Then, in December 2001, Hancock Bank in Baton Rouge launched a mutual fund, Hancock Horizon Burkenroad (HYBUX), based on the students’ picks. For 2002, its first full year, the fund ranked sixth out of 651 small-cap growth funds, losing a mere 0.8%, compared with a loss of 21% for the Russell and 22% for the S&P 500. Here we go again: amateurs beating professionals.
Shaw, as it happens, is one of the stocks that Ricchiuti’s students studied and recommended, and, at last report, was among the largest holdings of Horizon Burkenroad. The students also wrote a 21-page analysis of Shaw that’s available on the website. They recommended it as a “buy” and set a price target of $35. Unfortunately, the stock — as well as the market as a whole — has taken a nose dive since the report was written, back in March of last year. (By the way, a report last month by a Wall Street firm sets a target of $24 for 2004.)
The Tulane analysis provides valuable detail on the management — a key factor, but hard for investors to assess from afar. Ricchiuti says in an interview in the Feb. 1 issue of Bottom Line Personal newsletter that his students “typically meet with the founders or owners” of the companies they research: “It is vital that they be passionate and trustworthy. Individual investors tend to be welcome at small companies and can listen to conference calls held for analysts.”
Ricchiuti favors companies based far from Wall Street because “the less attention the stock has had from professional investors, the greater the likelihood that we have found an undervalued gem.” Among the gems — potential ones, anyway — that the Tulane students have found lately: Craftmade International (CRFT), which makes ceiling fans and lighting kits, and IberiaBank (IBKC), a consumer bank in southern Louisiana. Beware that Craftmade, especially, is a tiny company, with a market cap of only $90 million. It’s doubled in the past five years, but it’s been very volatile.
Both stocks are listed in Horizon Burkenroad’s portfolio. So are a few others that intrigue me, including Sanderson Farms (SAFM), a well-managed chicken processor (Miss Goldy brand) in Laurel, Miss., whose shares have plunged lately and trade at a P/E of 9, and SCP Pool (POOL), of Covington, La., the world’s largest wholesale distributor of swimming-pool supplies, whose stock has gone from $6 a share in 1998 to $26 last week.
Ian told me about the pool company a few years ago, and, to my chagrin, I followed up in a desultory fashion and never bought it.
That won’t happen with the Shaw Group.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. He does not own Shaw now, but he will soon. This column originally appeared in the Washington Post.