I was bleary eyed as the line I was standing in snaked halfway across JFK International Airport. I had just gotten off my eight-hour flight from Stockholm when in the distance I saw a TV tuned to CNN. The sound was off and I could barely make out the graphics, but I thought it said something about the Supreme Court ruling on the Affordable Care Act.

I tried to look up the info on my phone, but got yelled at by a customs officer. For some reason, you’re not allowed to use your phone while waiting in line. I wanted to protest, but I thought better of getting into an argument with a customs officer. Cavity searches are not my bag, baby!

Eventually, I was close enough to the TV to make out the graphics that the Supreme Court upheld the President’s healthcare reform law. I had no idea how the market or healthcare stocks were reacting. And I wasn’t going to risk another altercation with Big Bertha (the name I secretly gave the customs officer).

Once I finally cleared customs, I tried to log on to the internet on my phone, but the airport’s Boingo Wi-Fi service jammed it. I finally got hold of a hedge fund manager friend of mine in California who gave me the details.

I barely had time to digest the information when I had to get on another flight down to Florida.

But now that a few days have passed, I’ve had time to go through the news, see how stocks have reacted and analyze the situation…

The Biggest Winners: Hospitals

I expect the biggest winners to be hospitals, because of the likelihood of higher reimbursement rates.

More patients with insurance means fewer indigent and Medicaid patients. The patients who enjoy a weeklong hospital stay and then never pay a dime are the reason it costs you and me $60 for a Tylenol. Additionally, private insurance typically pays a much higher rate than Medicaid, so those dollars should flow right to the hospitals’ bottom lines. A hospital’s cost is basically the same (except for perhaps some administrative costs) whether they’re treating a patient with great insurance or none at all.

In fact, one hospital stock that I recommended in my FirstLine Investor Alert took off after the ruling. The company, which I’m recommending in today’s Investment U Plus, owns 70 hospitals in 15 states and saw its stock price jump roughly 15% since the news came out.

Are Medicaid Stocks in Trouble?

There’s some skepticism on Wall Street about the Medicaid insurers like Molina Healthcare (NYSE: MOH), because the Court ruled that states could opt out of the Medicaid expansion that’s part of the law.

Under the Affordable Care Act, individuals who make less than $19,157 per year or a family of four who makes below $30,656 are eligible for Medicaid. The Federal government will pick up the full tab from 2014 to 2016. After that, states will be responsible for up to 10% of the cost.

Some states, primarily those with outspoken Republican governors, have said they will not participate in the Medicaid expansion, because it’ll cost the states too much money in the long run.

Even if that occurs, the Medicaid insurers won’t be negatively impacted. They simply won’t get the benefit of the expansion. Nothing is being taken away, it just won’t get added.

Just Say “Yes” to Drugs

Pharmaceutical and biotech companies should also benefit as 33 million more insured patients means more customers buying drugs. Bristol-Myers Squibb (NYSE: BMY) has been my favorite large pharma for a long time and is part of The Ultimate Income Letter’s Perpetual Income Portfolio. Bristol currently has a yield of 3.9% and has some exciting and promising new drugs including Yervoy, the first drug ever to show a benefit for patients with metastatic melanoma.

Biotech companies also benefitted from the ruling as the law includes a 12-year period of marketing exclusivity for biologics.

One of the few groups in healthcare that won’t see much of a benefit is the medical device industry. There may be a small uptick in patients, but the typical user of a medical device is over 65 and thus already on Medicare. Additionally, medical device companies are now required to pay a 2.3% tax starting next year.

Love it or hate it, the Affordable Care Act is likely here to stay. Even if Mitt Romney wins in November, it’s unlikely that Republicans will take enough seats in the Senate to overturn the law.

So if you want to insure that your portfolio is healthy, start looking at some hospital, pharmaceutical and biotech companies to hold for the long term. The new law will impact top and bottom lines of these companies for years to come.

Good Investing,

Marc Lichtenfeld

I recently received an email from a reader in his 50s who plans to retire in four years. He told me he’s just getting started in investing and wanted some ideas for “rapid growth.”

Yikes!

Hopefully, he’s got a large 401(k), a pension, or an inheritance. Four years isn’t enough time to get your finances ready for retirement if you’re starting from scratch.

While I like a good speculation as much as anyone, the reader’s approach flies in the face of how to actually make serious money in the markets…

The Dividends Statistics Speak for Themselves

If you’re investing in stocks for the long term, the best thing you can do is buy stable companies with a track record of increasing their dividends and then reinvest those dividends.

Sure, they may only be 3% or 4% dividends, but you’ll be shocked at the way they can create significant wealth. I’ll show you exactly what I mean in just a moment, but first, check out these eye-popping statistics on reinvested dividends:

• From 2000 to 2010, reinvested dividends were responsible for 87% of the S&P 500′s total return.
• From 1990 to 2010, reinvested dividends were responsible for 43% of the S&P 500′s total return.
• From 1871 to 2003, reinvested dividends were responsible for 97% of the stock market’s total return.

Let’s dig deeper…

What Dividend-Paying Companies Are Telling You

The first question to ask yourself when investing in dividends is whether you want stocks that are Dividend Aristocrats or Dividend Achievers.

• A Dividend Aristocrat is an S&P 500 company that has raised its dividend every year for the past 25 years.

• A Dividend Achiever has raised its dividend for the past 10 years.

By raising the dividend, company executives are telling you two things…

• They’re Committed to Shareholders: By returning capital to shareholders, companies are rewarding your faith in their business. Look at it this way: If you invested in your brother-in-law’s restaurant and the business was doing well, at some point, you’d expect him to start writing you checks. The same thing should hold true for the stocks you invest in.

• They’re Confident: Raising the dividend payment shows investors that the company’s management is confident in their business now and in the future. It also shows that they take their dividend policy seriously. Executives are keenly aware that Wall Street doesn’t like dividend cuts – and investors tend to punish dividend-choppers accordingly.

And of course, if you receive more dividends every year, your yield on cost (i.e. the yield on the price you originally paid) rises. For example, if you buy a $50 stock with a $2 annual dividend, your yield is 4%. But five years later, if the dividend has risen to $3, your yield on cost is 6%, even if the share price has doubled to $100.

So what’s the best way to go about investing in dividend-paying stocks?

Are You Looking At These Two Crucial Numbers? You Should Be…

After you’ve identified a Dividend Aristocrat or Achiever, you want to be sure the company can continue to pay its dividend.

You can do that by examining its payout ratio – the percentage of net income that’s paid out in dividends. (And when it comes to determining income, I prefer to use levered free cash flow, as it’s much harder for a company to manipulate the numbers.) Generally speaking, you want the payout ratio to be 75% or less. That gives the company plenty of room to still pay the dividend if net income or cash flow decrease in any given year.

So once you’re pocketing healthy dividends, why should you then reinvest them?

Simple…

A 12.4% Return While Underperforming the S&P 500

Here’s a great example of the power of compounding reinvested dividends. It comes from one of my favorite stocks – Genuine Parts Co. (NYSE: GPC).

Genuine Parts has increased its dividend every year for the past 56 years! That’s an extraordinary record. To put that in perspective, the last time it didn’t raise its dividend, President Eisenhower was in office, Elvis made his television debut on the Louisiana Hayride and The Lawrence Welk Show premiered.

Needless to say, Genuine Parts is a strong performer. Over the past 10 years alone, its share price has doubled. And I expect it to keep rising, as earnings are projected to grow by more than 12% per year for the next five years.

But for the sake of our example, let’s assume a 9% annual increase in share price – less than the 9.6% average return of the S&P 500 over the past 50 years.

Let’s say you bought 200 shares today (with GPC’s current share price around $57, that would cost you around $11,400), reinvested the dividend and the dividend increased by 6.8% per year (the average of the past 27 years)… what would happen? After 10 years, your original $11,400 investment would be worth $36,659.98, growing by an average of 12.4% per year – even while the stock underperformed the S&P 500 by over half a percentage point.

I used the underperformance figure simply to illustrate a point. I actually expect Genuine Parts to outperform the S&P 500 over the next decade.

Now imagine if you have a portfolio of dividend-paying Aristocrat stocks doing the same thing. If you had a portfolio worth $100,000 and it had the same parameters of the Genuine Parts example above, but your portfolio simply matched the performance of the S&P, your $100,000 would nearly triple in 10 years.

And the power of compounding really gets going in the following decade, as your investment would soar to $891,000. That compares with $208,000 after 10 years and $520,000 after 20 years if you didn’t reinvest the dividend.

Unfortunately, for the reader I mentioned at the top, this is a long-term strategy and wouldn’t get him to his goals in four years. But if you have a longer timeframe, reinvesting in quality dividend-paying stocks is an excellent strategy for creating and preserving wealth.

Good Investing,

Marc Lichtenfeld

Despite the fact that the S&P 500 has doubled since the financial crisis in 2009, a shocking number of people still seem turned off by the stock market.

According to a poll conducted by Prudential, 58% of respondents “have lost faith” in the stock market. Even more stunning, 44% say they will NEVER invest in the stock market again. Never ever!

What that tells me is there’s still a lot of buying power on the sidelines. Call me a cynic, but people often say one thing and do another.

I’m sure there are some investors who got so burned by the collapse in 2008 and 2009, that they really never will put another penny into the market. They’ll cower in fear, with all of their money in gold or bury their cash under the floorboards. And while that might keep their money secure, it’ll never produce wealth.

If you’re a long-time reader of the site or subscribe to Investment U Daily, you know that we don’t try to time the markets. That’s a fool’s game. Sure, a market timer might make a great call now and then, but I don’t know any who are consistently accurate.

So rather than the futile exercise of trying to figure out the exact moment to buy or sell stocks, stick to our “Four Pillars of Wealth” to achieve your financial goals. The results will be better and you’ll be able to sleep at night.

1. Stick to an Asset Allocation Model – Investment U follows a formula that won Dr. Harold Markowitz the Nobel Prize in finance in 1990.
2. Adhere to Safety Switch – Buying a stock is easy. Knowing when to sell is the hard part. This way we let our winners ride and cut our losses before they get too big.
3. Understand Position Sizing – Invest no more than four percent of your portfolio in any one stock. That way if things go wrong, no one particular holding will sink your entire portfolio.
4. Cut your Expenses (Including Taxes) – Invest in no load funds with low expense ratios like Vanguard index funds. Also, choose closed-end funds that trade at a discount instead of open-end mutual funds with up-front fees or loads.

You can potentially lower your taxes by not selling your gains for one year, so that they qualify for the long-term capital gains tax rate (rather than the higher short term), avoid actively managed funds in your taxable accounts and keep your high-yield investments in your IRAs or other tax-deferred accounts.

The markets are a little tough right now. The big financials, such as Morgan Stanley (NYSE: MS), were just got downgraded by Moody’s. Typically, it’s difficult for the markets to rally without the help of the financials.

Several other sectors such as networking, transportation and utilities are also weak. One that still looks strong is the drug and biotech sector.

The point is there’s still stocks out there performing well. You just have to look harder for them.

Consider following the Four Pillars of Wealth to achieve your financial goals and leave the panicking to those who have ridiculously sworn off the markets forever.

Good Investing,

Marc Lichtenfeld

Editor’s Note: These “Four Pillars of Wealth” were originally developed by Alexander Green for The Oxford Club. Marc and Alex wanted me to share a more detailed outline of these wealth preservation tips for those interested in learning more.

For a free copy of The Oxford Club’s full report on “The Four Pillars of Wealth,” click here.

It’s not breaking news that dividends are hot. With bonds paying next to nothing, income-starved investors are increasingly pouring money into dividend-paying stocks.

Last year, while $178.2 billion was removed from equity products, $26.8 billion were invested into dividend-focused funds.

And mutual funds that specialized in dividends saw net inflows (more money invested in than taken out) every week for 44 weeks, according to EPFR Global.

I’m not a huge fan of mutual funds in general, and especially not those that are dedicated to dividends. You can do much better yourself.

For example, Columbia Dividend Opportunity I (RSOIX) is rated five stars by Morningstar. It has a current yield of 3.79% and an expense ratio of 0.75%. Since March of 2004, $10,000 invested turned into $16,915 versus $13,426 for the S&P 500.

Those are some pretty solid stats. If I were looking for a mutual fund that invested in dividend payers, this one would be near or at the top of my list. It’s beaten the S&P 500 and its peers since its inception, the yield is solid and the expense ratio is reasonable.

Its largest holdings are Lorillard (NYSE: LO), J.P. Morgan Chase (NYSE: JPM) and Pfizer (NYSE: PFE) – not exactly a low-risk group. Most of the rest of the portfolio are large cap names like Microsoft (NYSE: MSFT), AT&T (NYSE: T) and General Electric (NYSE: GE).

That’s because a $3.9-billion fund has to buy a lot of stock in order for any one position to be meaningful. A large fund is able to go into the market and purchase two million shares of AT&T or Microsoft.

But if there are better opportunities in smaller names, a mutual fund is going to have a tough time buying enough shares to make a difference.

For example, if you invested in some of the smaller-cap names that are in The Ultimate Income Letter’s Perpetual Income Portfolio, you could do significantly better at an even lower cost.

For instance, let’s say you invested $2,500 each into Community Bank System (NYSE: CBU), Omega Health Investors (NYSE: OHI), Main Street Capital (NYSE: MAIN) and Genuine Parts (NYSE: GPC). During the same eight-year period as the mutual fund’s 69% increase, your $10,000 would have become $19,862 – a significant difference over the $16,915 this very good mutual fund returned.

Community Bank System is not a stock that a mutual fund manager would likely buy. It’s a great little bank with a 3.9% yield, but it only trades 200,000 shares a day. It would be hard for a fund to accumulate enough shares to make a difference in the fund’s returns. Perhaps more importantly, it would also be tough to sell a lot of shares if the fund manager no longer wanted to hold the stock. Omega Health and Main Street have yields approaching 8% and Genuine Parts’ yield is 3.2%, but the company has raised its dividend every year for 56 years.

All of the stocks mentioned above trade less than one million shares per day, although Genuine Parts has a market cap of over $9 billion.

And don’t forget that 0.75% expense ratio. While that is on the low side for mutual fund fees, your return is still being impacted by that 0.75% every year.

If you bought the four stocks listed above with a discount broker, it would cost you about $10 per trade or $40. That comes out to 0.4% of your initial investment. However, that’s a one-time cost, not an annual expense. The only time you’ll incur another fee is when you go to sell. So if you sold it today, you’d have incurred a total expense of 0.8% ($80/$10,000) over eight years rather than 0.75% every year. When you pay that 0.75% every year for eight years, you end up impacting your return by 6%.

I don’t know about you, but I prefer to keep the 6% for me, rather than pay it to a mutual fund manager who can’t do as good a job as I can.

It’s not that the fund managers aren’t smart. They are. But the size of their funds limits their flexibility. As an individual investor, you can use that flexibility to your advantage by owning smaller cap stocks that have higher yields and better growth potential.

Stay invested in dividend paying stocks. They’re the best way that I know of to grow your wealth and generate increasing amounts of income over the long term. But do it yourself. With just a little bit of work, you’ll make more money and pay less in fees than you would with even the best mutual funds. Because this is one area where the little guy has the advantage.

Good Investing,

Marc Lichtenfeld

P.S. The four quality dividend plays I listed above are just the tip of the iceberg. There are 17 more dividend positions I’m currently recommending in my Perpetual Income Portfolio. As I write this, our 21 open positions are scoring an average gain – including dividends – of 25.40%. And my portfolio is just one of the many resources The Oxford Club provides to help out the little guy.

For more information on how to access our Club’s full repertoire of portfolios along with the rest of our expert connections and financial intelligence, click here.

As you may have heard, golfer Tiger Woods won his second tournament in three months, after having not won an event since before his personal life went over a cliff in 2009.

We’ll have to see if the old Tiger is back, but regardless, it’s a strong comeback for an athlete and a man who seemed completely lost just a short time ago.

Stocks can act the same way.  Sometimes a stock is enormously popular, only to crash and burn.  And if you can find the ones that will rise from the ashes, there is a lot of money to be made.

Let’s look at a few stocks that have had a rogolugh go of it over the past few years, but seem poised to rebound.

Goldman Sachs (NYSE: GS)  – Goldman’s stock is a disaster, trading at about 1/3 of its all-time high of $250, back in 2007.  Main Street despises Wall Street right now and that will likely only increase as we head into a particularly nasty election where the Obama campaign will attempt to position Mitt Romney as everything negative about the industry.

And although Goldman’s reputation doesn’t shine as brightly as it once did, it is still one of, if not the 800 pound gorillas in the business.  With J.P. Morgan Chase’s (NYSE: JPM) CEO Jamie Dimon seeing his formerly beloved status evaporate due to uncontrolled trading losses, Goldman is still arguably the king of Wall Street.

It’s stock isn’t trading like that though. Near its lowest level in three years, the stock is trading at just 7.6 times this year’s expected earnings.  In 2013, earnings per share are projected to grow 11%, increasing to 12% over the next five years.  On a trailing basis, Goldman is surprisingly trading well below its peers at 13.3 times earnings versus the industry average of 18.5

There are all kinds of regulatory reforms aimed at Wall Street firms, which make them out of favor with investors.  But nobody has done it better than Goldman for years and when the group comes back into favor, Goldman Sachs will likely lead the way.

Facebook (Nasdaq: FB) – Facebook hasn’t had a long history as a publicly traded company, but could anything be more out of favor?  On Monday, an analyst was on CNBC saying Facebook wasn’t going to be around in five years.

I’m going to bet he’s wrong.  Facebook might not have lived up to the hype that was generated in order to get the masses to pump up the stock price, but that doesn’t mean there isn’t a real business here that can grow by leaps and bounds.

Facebook has more of its users’ personal information than any company on the planet.  As it begins to figure out how to monetize that information, revenue and earnings will grow significantly.

Keep in mind that internet users spend three times as much time on Facebook than on any other website.

And don’t underestimate Mark Zuckerberg.  Just because he’s soft spoken and a little awkward, don’t mistake him for being complacent.  He is one of the most driven CEOs around.  He wants to be the next Bill Gates. He has the intelligence and the product to get him there.

It’s still in the early stages with Facebook, but I think long-term investors will be just fine with this stock.

It’s hard to know who is disliked more, Tiger Woods or Goldman Sachs and Facebook.  But Tiger appears to be back and I expect Goldman and Facebook to help investors be at the top of their game in the near future too.

Someone in my office recently called me a finance geek. I was actually a little bit insulted. But then, as I started to write this column, I realized she spoke the truth.

You see, I enjoy looking over financial statements and seeing how the numbers interact with each other. I like to look for clues about what the future might hold.

And if there’s a surprise in earnings, I go back to previous quarters to figure out if I could have detected it earlier. It’s kind of like a big puzzle with lots of interconnecting parts that, once you understand them, give you a clear picture of the company and its prospects.

Today, I’m going to use one of the metrics we’ve discussed before to see if we could have predicted an earnings warning by Qualcomm (Nasdaq: QCOM).

That metric is inventory turnover – an often-overlooked measure that can tell you a lot about a company’s operations.

Inventory turnover is essentially how many times a company turns over its inventory in a quarter or a year, or how many times it sells through the products on it shelves.

I decided to look at Qualcomm’s inventory turnover because, although the company reported stellar quarterly results a number of weeks ago, it issued an earnings warning because it couldn’t keep up with demand due to a shortage from one of its vendors. Therefore, I assumed inventory turnover should have spiked.

Let’s see if it did…

Over the last four quarters, Qualcomm’s inventory turnover climbed from 6.8 to 9.7. In other words, a year ago it was selling through its inventory 6.8 times per year. In December, it spiked to over nine, and in the most recent quarter the company was turning over its inventory 9.7 times per year.

In fact, the inventory turnover is higher than it’s been since 2006.

Now, an earnings warning isn’t a positive, but not being able to keep up with demand is a good problem to have. I expect that Qualcomm’s earnings will be excellent once it gets its distribution issues straightened out.

Earnings per share popped in December and March, as well. Qualcomm earned $0.83 per share in December versus $0.61 in the previous quarter. More importantly, the higher inventory turnover may signify what’s going to happen in the next quarter.

In the September quarter, inventory turnover began to rise and we saw a pop in earnings in December. December’s inventory turnover rose sharply, and earnings in March were also strong.

With another quarter of high inventory turnover in March, I would expect a stronger June quarter in terms of earnings than Qualcomm is letting on.

Keep in mind – most companies give very conservative guidance. But even if June isn’t especially strong, I’d expect earnings to pick back up in the September quarter, as it’s clear that Qualcomm is moving product off its shelves at a rapid pace.

Like I always say, earnings can be and are manipulated to tell the story that management wants to tell.

Looking at inventory turnover can give you a strong idea as to how well a company is operating and what the future may be bring.

Good Investing,

Marc Lichtenfeld

Bears Make Headlines, Bulls Make Money (NYSE: CBU)
by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, May 23, 2012: Issue #1779

My wife and I have very different opinions as to what makes a nice vacation. Her ideal getaway is a hike through the woods, winding up at a nice spot to pitch a tent, cooking dinner over an open fire and hunkering down in our sleeping bags for the night.

I, on the other hand, prefer to sit by the pool (or ocean) sipping a colorful drink that has an umbrella in it, dining at a nice restaurant, catching a show and then going to sleep in our luxury hotel room.

So this year, once again, we had the ongoing debate about what to do this summer. So we reached a compromise…

We’re going camping.

And this year, we’re going to be camping in an area known for bears. Those animals scare the heck out of me. With one kind of bear you’re supposed to play dead, another you’re supposed to scare it away. I have no idea which is which.

I don’t know if it’s the color, the snout, or how you’re supposed to identify them. I know nothing about bears, other than that I don’t want to come across one.

But when it comes to the stock market, I know a lot about bears. And despite this nasty sell-off we’ve had lately, this is no bear.

Watching Stocks Bleed Every Day

The market is off 7% since May 1 and has fallen 12 of the past 15 days (as of Tuesday morning). It’s been painful to watch stocks bleed every day like a fighter who’s been cut and keeps getting hit in the same spot over and over.

But that’s not how bear markets usually work. They usually don’t have those drops that feel like a punch to the gut. A bear market typically dribbles lower until one day you wake up and realize you’re down 20%.

Bears usually appear when investors are optimistic. That’s hardly the case right now. According to the American Association of Individual Investors Sentiment Survey, only 23.6% of investors are bullish, while 46% are bearish. The bears are up 3.9% from last week. The long-term average is 39% bullish against just 30% bearish.

A Franklin Templeton Global Investment Survey found that 45% of respondents are more risk averse this year and only 20% would consider becoming more aggressive in their portfolios in 2012.

Combing the financial websites, it’s hard to find someone recommending that investors buy stocks.

In other words, investors are scared, and that’s usually a good time to pick up some cheap stocks. There may not be outright panic quite yet. The bottom may still be a little further down, but it’s probably a good time to start nibbling at some stocks that you’ve had your eye on for a while but wanted to wait until prices went lower.

Take Advantage of Higher Yields

For example, some of the stocks in my Perpetual Income Portfolio whose yields declined as the stock prices rose, once again have attractive yields.

One I really like, Community Bank Systems (NYSE: CBU), is a great little bank based in upstate New York and Pennsylvania. It’s currently yielding 3.9%, that’s up from 3.5% just over a month ago when the stock was trading several points higher (although Ultimate Income readers are enjoying a yield of 4.7% if they bought it when it was first recommended in September).

Could the market head lower from here? Of course it could. We’re not market timers at Investment U, so I’m not going to make a prediction. However, I will say this certainly doesn’t feel like a bear market.

Instead it feels like an opportunity to leg into some positions, particularly for income seekers who felt shut out over the past few months as income stocks’ prices rose sharply, making obtaining an attractive yield difficult.

Thanks to this sell-off, it just got a little easier.

Now, if anyone has any suggestions on where to find bear repellent (for real bears), I’d appreciate it.

Good Investing,

Marc Lichtenfeld

P.S. One of the MLPs in my Perpetual Income Portfolio fell about 17% since hitting a high early this year. But with a yield that’s up and the news that it’s raising its dividend even more, this one looks prime for dividend seekers.

To find out more about Investment U Plus and how you can access this pick and more, click here.

Money-Losing Companies That Beat the Market By 46% Each Year
by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, May 16, 2012: Issue #1774

When I was young, stupid and chasing girls, good looks were the most important attribute a female could have as far as I was concerned.

A disastrous relationship with an insane model changed my thinking pretty quickly. After splitting up with “Crazy Christine,” as my friends used to call her, I became much more interested in what was beneath the surface.

The same can be said about my approach to stocks.

Most investors look at earnings when evaluating a company. And that’s a great place to start. Typically, a company that’s consistently increasing its earnings has a healthy business, and the stock should emulate that success.

But I like to dig deeper and really get to know the company. To do that, I look at cash flow.

Cash flow is how much actual cash came into the company versus how much went out. At the end of the year (or quarter) if more cash came in than went out, the company is cash flow positive.

Now, you may be asking, if the company is profitable, shouldn’t it be cash flow positive?

Not always.

Due to complex accounting rules, earnings can be doctored to tell pretty much any story an executive wants.

Here’s an example of how a company can be profitable, but not cash flow positive.

In 2011, InterDigital (Nasdaq: IDCC) made $89 million in earnings. However, its cash flow from operations was negative $34 million. How is it possible the company was profitable, yet saw more money go out the door than came in?

When we look at InterDigital’s statement of cash flows, we see that the company recognized $235 million in deferred revenue, which is subtracted from cash flow. Here’s why…

Deferred revenue is when a company gets money up front, but doesn’t recognize the revenue right away. This is very common among software, technology and services companies. For example, a company will sell a software package that has a $1-million service agreement that’s valid for four years. The company might get paid that $1 million up front, but will only recognize $250,000 per year for four years.

On the cash flow statement, however, that money has to be accounted for, because cash flow represents how much money flowed into or out of the company.

So in InterDigital’s case, the negative $235 million means the company recognized the revenue in calculating net income; however, it doesn’t represent any actual cash that flowed into the company in 2011. That money came into InterDigital in previous years, but is only now being recognized as revenue and contributing to earnings.

To sum up, InterDigital made a profit in 2011 because it recognized revenue on cash that it received prior to 2011. But it didn’t bring in more cash than it spent. Keep in mind, this is actually a conservative strategy, because if the company recognized all of the revenue at once, when it still owes a client four years of service, that could cause problems down the road if its obligations aren’t met.

And it goes both ways…

This earnings and cash flow discrepancy can work the other way, too, where a company is unprofitable. but takes in more cash than it spent.

For example, in 2011 Zynga (Nasdaq: ZNGA) lost $404 million. But when we look at its statement of cash flow, we see that $600 million in expenses was stock-based compensation expense – which is a non-cash item. It still needs to be accounted for on to determine profitability, but it doesn’t represent cash going out the door in the same way paying employees’ salaries does. So that $600 million gets added back to cash flow. After a few other small adjustments, the company’s cash flow from operations was $389 million.

So even though it lost $404 million according to the income statement, the business actually generated $389 million in cash.

I ran a screen to see which companies were unprofitable and cash flow positive and profitable but cash flow negative. Here are some of the largest in terms of market cap. Results are for the full year 2011.

Knowing which companies are getting too much credit for their earnings, or too little for their cash flow, is a good starting point for your investment research.

In fact, over the past 10 years, if you bought all of the stocks that lost money but had positive cash flow, you’d beat the market by an average of 46% per year.

So whether you’re checking out potential dates on Match.com or looking at the fundamentals of a stock, it pays to look beyond what you see on the surface and dig a little deeper. The rewards for doing so are significant.

Fortunately, I realized that a long time ago. I’ve been happily married to my wife, who was previously not my “type,” for 16 years.

Good Investing,

Marc Lichtenfeld

Finding the Best Cheap Stocks to Buy
by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, May 9, 2012: Issue #1769

My mother believes shopping is a sport. If it were, there’s no doubt she would be a world champion. I’d say an Olympic gold medalist, but she lost her amateur status years ago.

When my mom shops, she’s not satisfied unless she’s getting top merchandise for at least 40% off.

And like a hunter who can’t wait to brag about the 12-point buck he took, my mother will tell anyone who’ll listen about the $300 sweater she got for $80. But unlike the tales of hunters and fishermen, when it comes to my mom and shopping, the big one doesn’t get away.

Everyone loves a bargain. But some people are willing to work harder to get it. Investors are like shoppers. Some will stand in line to buy the latest hot Apple product (or stock), while others will wait patiently until the product or stock they want goes on sale.

When investors look for cheap stocks, they often concentrate on the price-to-earnings ratio, or P/E. The P/E is simply the price per share divided by the past year’s earnings per share.

So in the case of Intel (Nasdaq: INTC), for example, the company earned $2.36 per share in the last 12 months. The current share price is $27.69. Divide $27.69 by $2.36 and you get a P/E of 11.7.

You can use that number to compare it to the P/E of the S&P 500 (15.3), its industry average (15.4), its historical average (17.1), or other specific stocks in its sector, to get an idea of whether the stock is cheap or pricey.

Analysts also look at forward price to earnings, which divides the price by the consensus analyst estimate for the next year. In Intel’s case, analysts project earnings of $2.49 per share in 2012, giving it a forward P/E of 11.1.

Methods Better Than P/E…

But I believe investors pay too much attention to earnings and not enough to cash flow. You can also obtain a company’s valuation based on price to cash flow and, like P/E, compare it to industry averages, the S&P 500, etc.

Other popular valuation metrics include price to sales (P/S), which is the share price divided by revenue per share. If revenue per share isn’t readily available, all you do is divide the last 12 months’ sales and divide by the number of shares.

Price to book value (P/B) is also a popular tool. Book value is the value of the assets investors would get if the company were liquidated. Book value is simply shareholders’ equity (found on the balance sheet) divided by the number of shares outstanding.

Which one is more important when it comes to price performance?

Let’s take a look at each. I ran a stock screen and a corresponding backtest to measure the performance of all stocks whose valuation in each of those four metrics (separately) was below the average of its industry.

Over the past 10 years, if you bought every company (that was profitable) trading below its industry’s average price-to-earnings ratio and held the stock for one year, you’d have outperformed the S&P 500 by 218%. In only two out of the 10 years would that formula have underperformed the market – and not by much.

A recent example is Apache Corporation (NYSE: APA), trading at 7.8 times earnings versus the average oil and gas company at 17.8.

Price-to-Cash Flow

Testing undervalued, cheap stocks based on price-to-cash flow also turned out a stellar outcome, beating the market by 749%. It underperformed the market in three out of 10 years, but the worst year was only by 3.15%. Conversely, in six of the seven years it beat the market it did so by double digits, several times by 50% or higher.

Sprint Nextel (NYSE: S) currently trades at just 1.9 times cash flow, which is dirt cheap, even in its industry, which only trades at an average of 4.6 times cash flow, compared to the S&P 500, which is valued at 9.1 times cash flow.

Price-to-Book Value

The results were even better on stocks trading at a lower price-to-book value than their industry average. Over the 10-year period, those stocks climbed 2,193% versus the 13% of the S&P 500. These stocks beat the market every year, including by over 100% in 2009 and 2010. A current example is NVIDIA Corporation (Nasdaq: NVDA), which trades at 1.8 times its book value, versus its industry average of 2.8.

Price-to-Sales Ratio

When I ran the backtest using companies whose price-to-sales ratio was below the industry average, something incredible happened. A $1,000 investment in 2001 turned into $286,535! While the same amount invested in the S&P 500 was worth $1,130.

The screen beat the S&P 500 in every year. But what was really interesting was that in 2003 and 2009, years in which the overall market recovered from steep sell-offs, the low P/S stocks went nuts. They outperformed the S&P 500 by 232% in 2003 and 745% in 2009.

Keep in mind, this involved owning a few thousand stocks, so this isn’t easily copied in real life, but it might give you a starting point the next time we start to come out of a nasty bear market.

Symantec (Nasdaq: SYMC) is a current example, trading at just 1.8 times sales versus its peers’ average of 3.8 times sales.

You obviously don’t want to run a screen, throw a dart at the list and buy a stock. You want to dig a little deeper. But by knowing which types of stocks tend to outperform the market, you increase your chances of getting a bargain that you’ll be as happy with as my mother is with a $400 designer jacket that she got for $35 (true story).

Good Investing,

Marc Lichtenfeld

2 High-Yield Dividend Stocks to Avoid (VIVO, PT)
by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, May 2, 2012: Issue #1764

Meridian Biosciences (Nasdaq: VIVO) and Portugal Telecom (NYSE: PT) have a high risk of cutting their dividends.

Dividend investors are enamored with yield. Obviously, they want to get paid as much as they can. It’s why stocks like Annaly Capital Management (NYSE: NLY) and its 13.5% yield are so popular.

But what many investors ignore in their search for yield is safety. What good is a high yield if the dividend is cut in the near future? Not only does an investor receive less income when a dividend is cut, capital can be lost, as the stock usually tanks as a result.

When I look to add a stock to The Perpetual Income Portfolio, yes, I’m looking to obtain as high a yield as I can, but only if I’m comfortable the dividend is safe. If I’m not confident, then I won’t recommend the stock no matter how juicy the yield is.

To analyze the safety of a dividend, look at the payout ratio, which is the percentage of net income paid out in dividends – although I use a slightly different formula. I look at cash flow from operations and free cash flow instead of net income, because net income, or profits, can be manipulated fairly easily with accounting tricks. Cash flow, which represents the actual amount of cash that came into a business versus the cash that went out, is a more accurate representation of a company’s business.

So let’s take a look at a couple of companies whose dividends may not be entirely safe.

The first one is Meridian Biosciences (Nasdaq: VIVO). It pays a 3.7% yield and business has been strong. I applaud management’s desire to return a significant portion of profits to shareholders. However, they return too much. Their stated goal is to have a payout ratio (based on earnings) of 75% to 85% each fiscal year.

My threshold for the payout ratio is 75%. Anything higher and the dividend could be in jeopardy if the company has a bad year.

Meridian just reported quarterly results and earned $9.6 million in the quarter. Its dividend payment of $0.19 per share should come out to approximately $7.9 million, which equals 82% of its net income.

The company’s cash flow results weren’t released. But in the last quarter, dividends ate up over 80% of free cash flow and in the three prior quarters, dividend payments were more than 100% of both earnings and free cash flow. The company has about $24 million in cash and no debt.

With earnings expected to grow this year and next year, paying the dividend shouldn’t be a problem if Meridian hits its numbers. However, if they experience a hiccup in business and net income falls, the company may have to dip into its cash to keep the dividend the same. And if business stalls for more than a quarter or two, the company would have to think seriously about cutting its dividend.

Let’s look at another.

Portugal Telecom (NYSE: PT) paid a dividend equal to all of its free cash flow in 2011. It did the same in 2010, but dividends didn’t eat up all of its free cash flow prior to that.

The company has 6.4 billion euros in debt and 5.7 billion euros in cash and it’s located in a country that’s facing difficult times right now. Keep in mind, it does a lot of business in Brazil, so it’s not solely focused on Portugal. But the Portuguese portion of the business is something to worry about, particularly since its payout ratio based on free cash flow is 100%.

Should the company run into trouble, it will likely cut the dividend the way some of its peers have. The 7.2% yield is attractive. But I’m concerned it’s not sustainable.

For both companies, I’m not saying a cut in the dividend is imminent, but if you’re an investor in these stocks, you should be watching the financial statements very closely to see if there’s any trouble on the horizon. Often, a company won’t cut the dividend immediately after reporting a bad quarter. They’ll wait to see if things improve. But then a quarter or two down the road, investors get hammered when the dividend is reduced.

Keep a close eye on these two. You’ve been warned.

Good Investing,

Marc Lichtenfeld