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10 Investment Guidelines: Part 2

Scott Rothbort

6. Balance sheets are generally more important than are income or cash flow statements.

Time and time again, I have about the importance of balance sheets. As a young auditor many years ago at Price Waterhouse, I learned to focus on the balance sheet as the central part of a company's financial condition. The profit and loss statement is merely a bridge between balance sheets from two different periods, while a statement of cash flow is just a reconciliation of cash balances between two periods.

While analysts and the media tend to focus on the income statement and get all caught up in consensus earnings estimates, the best investors scour the balance sheet. If the profit and loss is trumped up, the offsetting item will be buried in the balance sheet. Had analysts, auditors and investors focused on WorldCom's or Enron's balance sheets rather than their earnings, then the frauds may have become more apparent at a much earlier point in time.

7. Investors should focus strongly on GAAP accounting and should pay little attention to "pro forma" or "unaudited" financial statements. Bernstein has plenty to say in his seventh guideline. Let's take a closer look.

First, he says that "investors should focus strongly" but does not say "exclusively." I interpret this to mean that the emphasis should be on GAAP accounting without overlooking other forms of income statement presentation, because there may be some merits, however small, in those other accounting interpretations.

Second, when it comes to unaudited financial statements, one has to be careful. Typically, only annual financial results, not quarterly, are not audited, but most public companies will have the quarterly financial statements reviewed by independent accounting firms before disseminating the information to the public. Therefore, on some level, while the greatest amount of accuracy will be present in the annual financial statements, we should not dismiss the quarterly unaudited statements.

When it comes to GAAP vs. "pro forma" accounting, it is best to understand what the differences may be for those two types of accounting styles. There may be some very good reasons to favor "pro forma" over GAAP for certain companies and under certain conditions. But be careful not to fall into the "pro forma" accounting trap that hurt so many investors during the tech and internet mania of the 1990s.

8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.

The bottom line of investing is that it is all about risk vs. return. If everyone is chasing the same investment opportunity, then it is likely that capital is abundant rather than scarce. When capital is abundant, then there tends to be a sense of urgency to deploy that capital, and returns are chased. As capital remains cheap, we will create conditions whereby excessive speculation runs rampant and potential "marginal moron" conditions can be created.

When capital is scarce, then opportunities to the investor will be attracted to the capital. This allows the investor to be far more selective across a greater array of investment alternatives. Hence, return on capital outcomes will tend to be higher as investors separate higher return opportunities from lower return alternatives.

9. Investors should research financial history as much as possible.

I can not emphasize enough how important this guideline is. There is a tendency for people to understand economics and the financial markets from only one event or cycle. That is a big mistake. If all you can relate to is the tech and Internet boom and bust, then you have an incomplete view of financial history. You must go back as far as possible to see how markets reacted under similar circumstances.

For example, as I wrote just last month, this is not the first major bank-related financial crisis that this nation has endured, nor is it the first time that the U.S. central bank and government stepped in to stabilize and support the banking system. Nor will it be the last.

I have lived through two market crashes, in 1987 and 200, yet I still read about prior market crashes and have always made sure to get counsel of elder and more-experienced investors throughout my investment career. Furthermore, through my writing and teaching, I am also passing on my knowledge of such history to the next generation of investors.

While you can, listen to and read what market veterans and historians such as Teddy Weisberg, Art Cashin and Warren Buffett have to say. You won't be disappointed.

10. Leverage gives the illusion of wealth. Savings is wealth.

I could not agree with this accounting lessonmore. Think of your wealth as your own personal shareholders' equity. Anytime you save money, you are pushing net income into your net worth. However, when you borrow, the leverage inflates both assets and liabilities but does not impact net worth. Only once you manage to sell an asset, pay off the debt and convert the gains (after tax of course) to net worth can you safely say that you have created wealth.

As we learned from the housing bust, though, that is easier said than done. Too many people bought houses beyond their means, giving them the illusion of wealth, only to find out they are worse off now than when they started.

In the investment world, one only has to look as far as long-term capital management, which relied on nearly infinite leverage before having to be rescued by a consortium of banks. That is another great bit of financial history that one must know. You can read more about it in Roger Lowenstein's excellent book When Genius Failed . (Note: I am an unnamed participant -- one of the good guys -- in that book.)