Four Tips for Buying Stocks in Bad Times

November 13, 2008

Avoid Companies that Spend More than They Earn

My next tip is to look for companies with strong cash flow. As a former accountant, I like to examine a company’s cash flow because it’s something that’s hard to manipulate. We all learned from the accounting scandals of a few years ago how some companies tried to cook their books. The simplest definition of cash flow is earnings plus depreciation. What cash flow tells us is how much cash is coming into the company from its business compared with the amount of cash going to fund its operations. The problem is that some companies generate a lot of cash, but they require even more to keep things going. Whenever I see that, I know it’s not a good sign. By looking at cash flow, we can cut through the thorns and see how healthy a company really is.

A great example of a company with outstanding cash flow is Mosaic (MOS). Last year, the agricultural chemical company saw its cash flow from operations skyrocket from $700 million to $2.5 billion. That’s an increase of over 250%! What I particularly like about a company with healthy cash flow is that it can fund its operations with its own money, and it can avoid having to deal with the credit crisis. I also like that Mosaic is a phenomenal value here at just 4.5 times earnings.

Big Margins Mean Big Profits

My third tip is to find stocks with expanding operating margins. This is very important because it shows us a company that can grow its earnings faster than its sales. When a company has growing operating margins, it usually means the company has pricing power in its market. That’s crucial in this economic environment. More often than not, a company can grow its margins because it has a dominant niche in its market.

A perfect example of expanding operating margins is Express Scripts (ESRX), the pharmacy benefits management company. This is a highly competitive sector and margins are tight so any expansion here is important. Last year, Express Scripts grew its sales by just 3.5%, but its operating profit jumped by nearly 30%. Those kinds of numbers capture investors’ attention. Over the last two years, shares of Express Scripts are up 75% while the S&P 500 is down by 38%.