2 Fundamental Warning Signs

02/13/2012 11:45 am EST

Focus: STRATEGIES

Brian Tang

President, Fundamental Research Corp.

Brian Tang says buy and hold is not dead, but it has never been particularly easy. He shares a number of lesser-used indicators that investors can track to spot red flags.

Not everyone thinks buy and hold is dead. We’ll speak to a money manager who actually believes in it. Hi Brian. This is Brian Tang.

Hello.

Brian, you actually deal with smaller stocks—micro cap, small caps, and somewhat larger. But you don’t trade them; you actually buy them and hold them. For how long do you usually hold them?

Well, we have to make a distinction. For our in-house portfolio, we focus on both micro and small caps, but also the larger names. For the micro and small caps, we would take advantage of trading opportunities. However, for the larger names, we would tend to buy and hold.

For how long?

Until one of a few events happen. If the company deteriorates, we would sell it. If it reaches our, say, fair-value estimate, we would sell it.

So it really depends how long it takes to reach that fair value. If it continues to grow, and we think the value is increasing and continues to pay a dividend, if it pays one, we would probably hold it indefinitely.

So you can hold…like Warren Buffett says he holds things forever. He actually doesn’t, but a lot of things he actually does hold for quite a long time.

So do you think…I mean, a lot of people have been told in recent years that buy and hold is dead, and you can’t really do that anymore, and you have to become a trader and things like that. What do you think of that kind of advice?

I think for a certain part of your portfolio, you can certainly trade and allocate a small percentage to more speculative trading ideas.

But I think for the most part, it’s easier to buy and hold. Especially if that’s not your full-time job and one doesn’t have time to continuously follow the markets and be trading. Why not just buy a solid name at a cheap price and you know you don’t have to follow it everyday?

Well, obviously, it’d have to be a solid name. One solid name recently—and I know this is not your expertise—is Hewlett-Packard (HPQ), where sudd nly a change of a CEO and the stock just completely tanked because of the CEO’s erratic kind of strategy. Now isn’t that a risk in owning even well known individual stocks? I mean, how do you stay on top of that kind of thing?

I think the way to stay on top of it is, it is very important to know the general strategy of the company. I think with Hewlett Packard; there are a number of issues there. One is they launched a pad to compete with Apple’s (AAPL) iPad that was not successful.

Right. Until they cut the price, and then it was very successful.

That’s right. So I think it’s important to know the competitive situation of the company and the overall landscape.

Is there any warning sign? A couple of red flags that you look at in particular in the stocks that you own that you may want to hold, but you find that something comes up that disturbs you and you start looking for the exit?

Sure. One thing I like to look at is gross margins. So if I see them deteriorating…

Now the gross margin is basically what? The sales minus cost of sales, right?

Correct. And then you would express the gross profit, the sales minus cost of sales as a percentage of sales.

So if I see that declining, it indicates to me that sales are declining or their cost of goods are increasing. In any case, I would investigate why the gross margin is declining.

OK. Can you give us one more, maybe?

I would look at all of the margins in general. I would look at some of the working capital accounts. For example, if the inventory…

Working capital is current assets minus current liabilities.

Current liabilities. Correct. So in that, I would look at…the inventory.

If the inventory keeps expanding and the number of times it turns over is decreasing, I would worry that their products are not moving fast enough, or their receivables are not being collected fast enough. So those are other key issues that I would look at.

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