Avoiding the Torpedoes

Preserving and growing capital...no risk of permanent loss of capital...good investment practice revolves around respecting the downside first and worrying about the upside later. Things can always go mishugena, forecasts especially about the future are tough. But sometimes hope prevails over reason, greed over sense.

An example for today, Glenayre Technologies (GEMS) down about 38%. How can we avoid these torpedoes?

Valuation seemed to reflect a cheery consensus...EV/EBIT of 30 times relative to Return on Capital for the TTM of about 5%.

Gross margin declines: 2005 GPM was 31.1% versus the prior year's 49.4%. Drops like this are very unusual and should cause you to avoid the stock until you find out why this is occurring.

Operating Margins: In ten years of history, operating margins were negative for seven years. Not what successful businesses generally demonstrate.

Read the 10-K for management's views of risks in the business. Here is a quote from the most recent 10-K:  "Competition in the Company’s industries is intense. Some of the Company’s competitors have substantially greater financial, technical, marketing and distribution resources than the Company and the Company may be unable to successfully compete with these competitors. In addition, competitive pricing pressures exist in the Company’s industries, which may have an adverse effect on the Company’s profits margins in the future."

Check the balance sheet. Total debt to equity was about 80%, total liabilities/ assets  were up substantially to 68% from prior year's 20% or so.

Calculate an Altman score. The Altman Z-score is a decent guide to look at the riskiness of a business in a simple to caluclate measure. The Altman Z for the last 12 months was .09, well below my comfort zone.

Check what insiders are doing. Insiders on balance are sellers of most stocks, but sometimes, sales at what seem to be rather low levels relative to where the stock is trading can signal something. Note these sales between $$3.08 and $3.30.

Understand your investments, rely on your judgment but base it on fundamentals. I suspect that many investors who would have looked at the facts might have thought twice about being involved.

Disclaimer: I, my family, and my clients do not have a current position in GEMS.