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It is no secret that two of the hottest stocks in technology are Google [stckqut]GOOG[/stckqut] and Apple [stckqut]AAPL[/stckqut]. Google leads in market share between the two companies by offering the Android OS, which is free. Which causes an investor to wonder, is Google really capitalizing on the mobile trend that it is leading?

This infographic from Wordstream shows that Google does just fine in capitalizing on the mobile market.

Google mobile solutions
Find out how Google’s mobile solutions could work for your business.

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I encourage people to ask me questions about my book, The Confident Investor, or about the stock market, in general. I am open to questions from Twitter or on this site. I recently received a question about stock splits. The basic question asked if it was a good time to buy immediately after a company split its stock. The purist answer is that it shouldn’t matter but that may not be the complete answer.

First, a bit about stock splits. Companies split shares of their stock to try to make those shares more affordable to individual investors. When a company does a stock split, its share price will decrease, but the market capitalization of the company will remain the same. For example, if you own 100 shares of a company that trades at $100 per share and the company declares a two for one (2:1) stock split, you will own a total of 200 shares at $50 per share immediately after the split.

The reason for stock splits has dropped over the years. Before the advent of easy trading brokerages on the Internet, it was not uncommon to see penalties for buying shares in increments other than 100 shares. With this penalty removed, individual investors are free to invest the amount they can afford – $1,000 of a $10 stock (100 shares) is just as easy to buy as if that stock was $25 per share and the individual investor only purchased 40 shares. This is mostly irrelevant to “institutional investors” that may be buying millions of dollars of a stock.

Some companies now avoid stock splits altogether. The theory is that the stock split doesn’t matter so why do it. Also, if the company is catering more to institutional investors rather than individuals, then the higher stock price doesn’t matter. As further benefit, the higher stock price eliminates some trading strategies and effectively encourages longer term holders of a stock. Some companies like to have a higher per share price and almost carry it as a badge of honor – Google [stckqut]GOOG[/stckqut], Apple [stckqut]AAPL[/stckqut] and Berkshire Hathaway (BRK-A) being 3 of the most well known with a high stock price. To be honest, a higher stock price even slows down the effectiveness of my program described in my book, The Confident Investor. If you want to learn more about my methodology, you can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in ebook formats for Nook, Kindle, and iPad.

Now to the original question. Should you expect a bump up after a split. The purist answer is no since there is no additional value or wealth being created with a stock split. However, a study of the performance of 2,750 companies from 1975 to 1990 conducted by Rice University professor David Ikenberry found that shares climbed, on average, about 3.4 percent in the days immediately following a stock split.

I could easily argue that this Rice University study is too old to be relevant in the 21st century. This time frame for the study was during the penalty of non-block size trading. It was also a time frame when trades were measured by eighths (1/8) rather than to the penny as they are now (this change happened in 2001).

Bottom line, there may be a small bump up when a stock splits but the markets are efficient enough that this will only be short term and likely not worth trading.

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I frequently get questioned about how to account for stock buy backs and dividends when analyzing a company. I am going to save dividends for another article and just concentrate on stock buy backs. I will start this discussion with a great quote from Dr. William Lazonick of University of Massachusetts:

“Here we have all these companies obsessed, basically with keeping their stock prices up, and saying the best thing that they can do with their money is spend billions of dollars on stock. And my view of that is, any company that says that they have nothing to better do with their money, the CEO should be fired.”

While many will say that this is an extremely strong statement, I believe that Dr Lazonick is not that far off from the truth.

There are many ways that companies can use their cash that helps the long-term success of the company. Among these are:

  • R&D for new products – This helps the company have a competitive advantage in its market in the future.
  • Increased pay and benefits for employees – While we don’t want our companies to give foolish salaries we do need them to have happy employees that are loyal to the company’s success. In nearly every company – turnover is expensive.
  • Invest in the infrastructure of making their products – Apple [stckqut]AAPL[/stckqut] has made a science of this technique. It regularly helps its suppliers with acquiring the manufacturing tools required to produce great products.  Apple also will commit to large orders and effectively buy up the supply of emerging technology.
  • Acquire new products and technology through mergers and acquisitions – Effectively, the more cash on hand a company has, the more flexibility the company has in doing deals that can dramatically accelerate new products and new markets.

If we re-examine Dr. Lazonick’s quote, it now begins to make sense. A stock buy back plan basically means the company has run out of ways to effectively invest in the long-term prospects of the company. Rather, it is trying to shore up its stock price in the short term. Is this in the best interest of its shareholders or just the stock options of the executive committee?

Many times this shoring up doesn’t even work that well.  According to Fortuna Advisors: “…research shows high return companies create the most value for shareholders when they deploy more capital in growing their operations rather than giving it back to shareholders.”

Recently, the Wall Street Journal pointed out that many times the buy back programs don’t even change the amount of stock outstanding. It seems that it is not uncommon that the buy back is offset by stock grants to favored employees.

I hope that you listen to the quarterly comments of the CEO of each of your holdings. When you are listening to those comments and he or she discusses stock buybacks as a way to boost value to the shareholder, you should be actually hearing, “We have a lot of money burning a hole in our pocket and we are not smart enough to profitably use it, so we are doing a stock buy back!” Or, maybe the CEO is saying, “I dare you to fire me based on the advice of Dr. Lazonick!”

The goal of my book, The Confident Investor, and this site, is to help you find great companies and then grow your investment in those companies by using other people’s money (GOPM). I don’t pay attention to the buy back announcements of companies. I assume they are doing the buy back simply because it is the popular thing to do. I refuse to reward them for this activity but I am pragmatic enough to not penalize them.

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One of the most frequent advisories that I give on this site is:

“At this price and at this time, I do not think that a Confident Investor can confidently invest in this stock. It is not possible to confidently invest in a company that is not currently profitable.”

I have probably written that line 150 times on this site.

In addition, on Twitter I will get direct messages almost daily asking about a company that is not able to be run profitably. My replies vary in their words, but they always could be summed up with

“Sell this stock as fast as you can and find a profitable company that you trust. Here is a list of companies to consider: http://ow.ly/ckflM”

Regular readers of my opinions on investing know that I am very consistent in my advice not to invest in companies that are currently unprofitable. I do not limit that advice to just being unprofitable for a year but also to the latest quarter. I thought I would share a few thoughts on the reasoning behind this advice.

Due to the length of my thoughts on this subject, I need to break this topic into a couple posts. The high-level topics are:

  1. How do you evaluate an unprofitable company?
  2. Unprofitable companies can do stupid things
  3. Did management of a company plan to be unprofitable? No? Doesn’t that mean they are failing?
  4. Why invest in companies that are not profitable if you can invest in ones that are profitable?
  5. Is there ever an appropriate time to invest in unprofitable companies?

If you want to be notified when I post about avoiding unprofitable companies, there are several straightforward ways to do this. You can subscribe to my feed in your news reader. You can also sign up for my weekly newsletter which will give you the articles for the week. Finally, you can subscribe to my Twitter account @ConfidentInvest.

I will explore the first topic of the list now, the rest will be in future posts.

How do you evaluate an unprofitable company?

One of the most standard methods of comparing the performance of an investment is the P/E ratio (the price/earnings ratio). While it is foolish to compare the P/E for dissimilar companies (e.g. Ford [stckqut]F[/stckqut] with Google [stckqut]GOOG[/stckqut]) it is entirely relevant to compare the P/E for competitors (e.g. Apple [stckqut]AAPL[/stckqut] with Dell [stckqut]DELL[/stckqut]). Comparing P/E between competitors should not give the investor extreme confidence that one company is better than the other, but it is a consideration. In an unprofitable company, P/E will be a negative number – how do you compare that to its profitable peers?

Another tool for developing an appropriate price is to look at the EPS (Earnings Per Share). Once again, we have a problem with unprofitable companies as this will be a negative number. Comparing a negative EPS with its profitable peer group is never going to result in a situation where we can be a Confident Investor.

We can also calculate the best price for a company based on its Free Cash Flow.  However, that calculation depends on profit!  This is problematic for getting a clear understanding of an unprofitable company.

Another tool is to use the growth of a company to create a P/E equivalent.  If the company used to be profitable and now is not, then the growth of the profit is obviously a negative number. Using this technique, a Confident Investor has to factor the negative growth of profit into any other growth number e.g. Revenue or Stock Price. Typically, we assume that the P/E is approximately equivalent to growth e.g. growth of stock price is 30% so the P/E is 30. This is a rule-of-thumb equivalency and is fraught with danger and inaccuracies.