>Defensive Investing

With all the recent investing disasters, I have been thinking about
defensive investing. Here are some of my ideas on that:

1) Avoid companies with large amounts of debt. This rule can be
broken for special circumstances, but insure that they are special.
For instance, a gas pipeline operator will carry debt to finance the
pipeline. That is understandable. But, an insurance company should
not have a lot of debt. As a general rule, only bad things can
happen with debt. Someday, those pesky, ungrateful lenders will want
their money back, and it is often at an inconvenient time.

2) Look for high quality earnings. The best companies are those
where you have very little need for capital, and all of their
earnings come home in cash. A money management company is a great
example of this.

3) If you can't figure out how the company makes its profits, don't
invest. This would have saved you from Enron. Who knows how Enron
made ( or didn't make ) money on its trades.

4) If earnings are too good to be true, they are neither true nor
good. The key here is experience. By following many companies,
especially in the industry under consideration, the investor should
be able to determine when earnings appear excessive. If you can't
determine why the company is more profitable than it should be,
avoid it. A key way of determining this is to compare the profits of
the company to its role in the economy. If it is doing something
that seems of little value to the economy as a whole, yet showing a
huge profit for doing so, become suspicious.

5) Avoid companies making a lot of acquisitions in a rush to get
big. Tyco and WorldCom are excellent example of this, but there are
many more. Good acquisitions are hard to make, and most acquisitions
should never happen. They are usually more about the ego of
management than about providing returns to shareholders. One of the
best ways to evaluate management is to watch it for several years,
and study its allocation of capital. If they build new factories, or
buy companies just to get bigger, then avoid them, they are a Tyco
or WorldCom waiting to happen. Since management usually likes to
talk about its acquisitions, and gives its rational for them, I have
found this to be one of the best methods to evaluate the quality of
the management of a company.

6) Avoid companies where the manages are paid huge amounts of money
even when the company is not doing well.

7) Buy companies that have a sustainable competitive advantage, or a
moat. Moats come in all kinds of sizes and shapes, so you must learn
how to identify them. Study the acquisitions of Warren Buffett; he
is a master at identifying moats.

8) Buy companies that do not need to reinvent themselves every two
years just to stay alive. Microsoft is one of the few companies that
has been successful doing this. But Bill Gates himself said that
Microsoft faces a major challenge every three years or so. If you
must reinvent yourself, you do not have a moat, or a least a moat
that does not require huge amounts of maintenance.

9) The three laws of moats:

1) The width of its moat, the depth of its moat, and the size and
ferocity of its resident reptiles is directly proportional to the
profitability of a business enterprise.
2) When an enterprise with a properly functioning and sustainable
moat is presented with a choice between generating higher current
profits, or strengthening the defenses of its moat, the decision
should always be made in the favor of the moat.
3) The ability to differentiate between moats that have an
expandable life and utility and therefore deserving of maintenance
expenditures, and moats that are failed or failing, is the beginning
of wisdom.

The first two laws come directly from Warren Buffett. The third law
seems to logically follow the first two. A company that follows
these three laws is showing good quality management.

10) Look at what a company does, not what it says. Words are cheap,
actions are dear.

11) As a general rule, avoid companies that seem obsessed with
providing and meeting earnings expectations. They are playing Wall
Street, not Main Street.

12) Look for humility in managers. Is the company run for the
benefit of management's' ego and desire for power, privilege and
prestige, or is it run as a business enterprise? Look at what seems
to motive the people at the top.

13) Look for "one-time," "nonoperating," "extraordinary" charges.
Some companies have "one-time" charges every quarter. Watch for the
scams. Often these charges are neither one-time, nonoperating or
extraordinary. Excess amounts of charges show a management that is
either making a lot of bad mistakes, or is trying to manage its
financial numbers.

14) If the company is all about "me," make sure the "me" is worth
being about. Buffett is, but few others are.

15) Never underestimate the ability of bad managers to damage an
otherwise strong and healthy company.

16) We all know about a margin of safety in the purchase price of
the stock, but is there a margin of safety in the operation of the
business? Look at the attitude of the management towards business
risk. The more risk in the business, the more those inevitable
management mistakes are going to hurt.

17) Is the company in denial? As you read its annual report, do you
have the feeling that management will be the last group to discover
that it is a troubled enterprise?

18) Avoid whiplash. If Strategy B, last year's road to glory and
replacement for Strategy A, is now being replaced with Strategy C,
don't wait for the new fix to end all fixes: Strategy D.

19) Is management ever at fault? Does management always blame others
for the problems of the company, or does management take
responsibility for its own actions and results. Don't tolerate
behavior in the managers of the company that you would not accept
from your teenage son.

20) Beware of noncash income. Does the company recognize large parts
of its income before it receives the cash? Look at the footnotes to
the financial statements for evidence of this. They will also show
up on the balance sheet as intangible assets.

21) Beware of deferred charges. These can occur when expenses are
not recognized even though the cash has been expended. Look at the
footnotes and the balance sheet for these.

22) The problem with large amounts of deferred charges and
intangible assets generated from the recognition of income before
the receipt of cash, is that they have a tendency to disappear
as "one-time," "nonoperating" or "extraordinary" charges; and we
know how we feel about them. They may also indicate an aggressive
accounting treatment. But also think about what they do to cash flow
and income. Either the cash is spent but not expensed, or the income
is recorded but not collected. In both cases, profits benefit when
cash flow does not, resulting in low quality earnings.

23) Look at the footnotes for deferred and prepaid income taxes.
They will show differences between income and expenses reported for
tax purposes and book purposes. This is a place that may tip off
aggressive accounting treatments.

24) Read management's discussion of operations in the annual report.
Do they give a plausible explanation of why income, expenses, or
sales increased or decreased, or are they vague and general?

25) At least skim through all the footnotes to the financial
statements, looking for unusual items. If there are accounts on the
balance sheet that you don't understand, look to the footnotes for
an explanation. The more confusing the balance sheet is, the more
cautious the investor should be.

26) Read the letter to the shareholders on several levels. Look for
information, but also look for style and for what was not said. Does
it sound like the CEO wrote it himself, or does it read like the
work of a PR firm? Does the CEO sound like someone from this planet?
I once read the letter to shareholders for a company that was
reporting a billion dollar loss for the year, and not once was it
mentioned in the letter.

27) EBITDA and pro forma earnings are large neon warning signs to
the investor. Do not look away! If you ever see a company reporting
EBITDARES, Earnings Before Interest, Taxes, Depreciation,
Amortization, Rent, Entertainment and Salaries - go short. "