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Research companies before you invest

Tuesday, November 11th, 2014

I have been managing money for more than 30 years now. One thing that comes up every once in a while is clients who have a direct stock purchase plan or a dividend read investment plan, also known as DRIPS.

These plans sound very attractive: There's no commission, no broker to deal with and they appear to be great deals. However, some great deals turn into nightmares.

'm talking about seeing people who have come into my office with this direct stock purchase plan and have no clue what their cost basis is. When clients invest that money with my firm, we keep track of the cost basis. If you are doing a direct stock purchase plan, no one is keeping track of the cost basis unless you are doing it yourself.

Add to this the reinvestment of dividends and now you have to keep track of not just what you purchased stock-wise, but what dividends are purchased in stock as well.

Ads for the dividend reinvestment programs or DRIPS make them sound attractive by avoiding paying an adviser or a commission.

The other thing I don't like about dividend reinvestment plans is that you could be buying the stock at high levels because a plan is an automatic reinvestment. In other words, you could be buying at high valuation levels when you should be looking at selling.

So whenever it comes to investing, it is imperative that investors understand where they are putting their money or have confidence that the investment adviser knows what he or she is doing.

Genworth Financial Inc. (NYSE: GMW) had a bad day Thursday after reporting earnings with the stock closing down 38½ percent for the day.

What could cause such a terrible day for a company to lose that much value? Over the past year, the stock traded as high as $18.50 back in early May. Then about late July, the stock went from more than $16 per share to about $13 per share.

At this point, I decided to look at the fundamentals of this company, hoping to find some great value.

Going over all the financial statements, I discovered a company that appeared to have great potential and was way undervalued, strictly based on the numbers.

One thing I always tell people is they must understand the business in which they are investing. If you don't understand the business, you're playing a very dangerous game and investing your money blindly.

I also fear that many novice investors simply look at the target sale price that I use, which takes the forward earnings and uses the 40-year average of the 40 PE, which is 16.5, and that gives you a target sell price. Without knowing the rest of the story, investors are asking for trouble.

Let me use GNW as an example. Right before the company announced earnings, the mean estimate by 10 analysts was looking at earnings of $1.55. If you use a multiple of 16.5, you would get a target sell price of $23.25, giving investors a potential return of about 70 percent.

In the beginning, I, too, became very excited about the potential value that I was seeing in this company. However, I wanted to understand more about what they do. What I discovered was the company was having problems with policies it had written for long-term care. The problem is people are living longer than estimated and this is costing the company far more than it expected.

So this is a problem that will cost billions of dollars over theyears as the company's policyholders continue to collect on their long-term care insurance policies.

The details show that the company had to make reserves of $531 million to cover possible losses on those long-term policies. Also because of the decline in value, the company also had to write off an additional $517 million and what is known as goodwill impairment.

I always tell investors to watch out for companies with high goodwill or intangible assets because companies are required to write down that value if they can no longer justify the value on their books.

The lesson here should be that if you're going to be investing, do the research to find possible problems with the business or with overstated value of goodwill. It may take more time, but it will prevent you from investing in companies that become major headaches down the road.

Do you have a question or a company you would like us to take a look at?
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