Avoiding getting screwed is essential if you want to make money. Fergus Cullen talks through his strategies for researching the financials of a company, a step-by-step guide that can be directly applied to your own investments.
"Avoiding pitfalls is something I’ve always been cognisant of since losing the first $20,000 I saved up to trade. My broker BBY dipped into client accounts trying to meet margin calls before going into administration. That $20,000 had been saved from a year of sacrifices which made it all the more painful." - Fergus Cullen
An informed investor is a smart investor. In this article, you will learn how to find important financial information required to perform proper due diligence (DD) on any public company. Much like people, you can tell a lot about a company and their intentions through how they are being financially incentivized.
To illustrate some of these steps, we will be using the company Uranium Energy Corporation (NYSE: UEC) as an example.
Researching a Company’s Financials
If you want to dive into the financials when researching a new company, pull it up on Yahoo! Finance, and click on the 'Statistics' tab, which is circled in red.
The first thing to check is the percentage held by insiders. With some of the smaller cap companies, it's a good sign if a large percentage is held by insiders. It shows they have their own money invested in the growth of the company, as we like to say - ‘skin in the game’.
Also check the percentage of the float that is short. Short sellers are usually quite knowledgeable and confident traders. They know what they are doing and if there is a large percentage of short positions in the market, that can be an important signal to pay attention to.
UEC is a non-cash flowing company. If they are not producing Uranium ore, you want to evaluate how much cash they have on hand.
- How much are they burning?
- How long until they go into another round of raising capital?
- What sort of terms are they raising on?
These questions can tell you quite a lot about the situation the company is in. This guide will walk you through how to gather and assess this information.
SEC Filing
This next image is from the Uranium Energy Corporation SEC filing. This is linked from the press release section of their website.
As you can see, they extended their credit facility to January 2020. This report is from a few years ago, but it's a good example. They extended an additional USD $20M at 8% interest, which is marked on the image. In addition to that, they are required to pay an extension fee to the lenders in the form of common shares that are equal to less than 1% dilution of total shares outstanding: this works out to just under 1 million shares.
That is quite something when you consider they are already paying 8% interest and 1% of the company (in shares) for $20 million dollars in cashflow.
On top of that, UEC will also lower the exercise price of existing warrants. The warrants had been lowered from $2.51 to $1.35 and had a new expiry price extended through to January 2020.
As a shareholder, this is bad news. That's a steep price for not a lot of money, relatively speaking.
To put this in context, this is after the Fukushima nuclear disaster, which was a negative environment for Uranium companies, especially because a lot of the Uranium companies didn't have revenue. UEC was not a big Uranium producer. But even so, this is akin to maxing out a credit card and then getting another credit card to pay off the first one - but at a worse interest rate. This is an egregious dilution of the company assets.
Understanding the 10K Report
On the UEC website, click on 'Invest' in the menu bar and select 'Filings'. Click on annual and quarterly reports and look for the 10K annual report.
The 10K is a very useful tool for investors. 10k Filing Reports are typically long documents, so the easiest way to look for specifics is to use the find function. (CMD+F on Mac or CTRL+F on PC)
What you're looking at now is a screenshot. You can also go to the top toolbar, click edit, go down to 'find' and click find and then you can simply type in whatever keyword you're interested in learning more about.
In this case, we typed in “compensation.”
On the toolbar you'll notice it pops up with a chart showing the frequency of the word and we usually scroll down to the part where it gets the densest, which will usually be the most relevant part.
Make sure to go right down to the bottom. It’s a good rule of thumb to read from the footnotes up; often the most of the interesting stuff is in the last of the footnotes, where they're hoping most potential investors haven’t bothered to read.
This is the fine print. It's worth reading that twice because the phraseology and the wording can be deceptive at times. You sometimes don't catch it the first time around so read it twice. It can be very revealing.
Researching how much Management actually Earns
In the above image from the middle of the 10k, you can see the compensation table for UEC.
It's got the last 3 years of compensations: salary, bonuses, stock awards, option awards and total package. You can actually see that they have had a consultant who has reviewed all of their compensation and actually lowered their compensation.
If you watch any interviews with Amir Adnani, the CEO of Uranium Energy Corp, he will often say that they've had their salaries cut, which is true. You can see that in 2018 he was paid $396,000. 2019 he was paid the same. Last year, in 2020, he was paid $340,000. So he's taken a $56k pay cut and he also missed out on his $450,000 bonus he paid himself the year before.
The more important figure at the end is that the total compensation is $1.5M. Also, notice that, Pat Obara, who's the chief financial officer, is earning $500,000, and Scott Melbye, the vice-president also a similar compensation.
Now, remember those figures because we're going to dig down into the real numbers:
Amir Adnani, CEO - $1.5M total package including stock options and stock awards.
Pat Obara, Chief Financial Officer - $500,000.
Scott Melbye, VP -$511,000.
So those are high compensation packages to start with. But if you look through the footnotes and look at all the instances "compensation" is mentioned, you'll notice that they set up a company and pay themselves a side salary in addition to that base salary.
Adnani will provide various consulting services to the company which are in addition to his duties and responsibilities as the company's President & Chief Executive Officer. And due to this arrangement, Amir will receive a monthly fee of $34,000, then it runs through and it gets reduced down to $30,600 per month.
That’s on top of his $1.5M package. He will earn an extra $360,000 for ‘additional services'. He's charging himself out to the company, of which he is the President & CEO, for additional work.
When you sum it up, $30,600 x 12-months is $367,200. This is higher than his actual original salary, if we remember he was being paid $340,000, so he's actually earning more from his side contract than his actual job. Pat Obara and Scott Melbye both have a side service contract that is also 20-30% higher than their base salary.
And all 3 of these gentlemen are involved in 2 or 3 other companies that they are also charging for, including Uranium Royalty Corp and a Gold Mining Inc. With this sort of billing, egregious is not too strong a word.
This is why it's important as an investor that you know the full story about management compensation packages - and they can be quite different than how they appear at first glance.
This is another example of the 10k being a good place to check if you are unsure of anything.
Listening to what is not said
This is an example about UEC again. There was an interview with Adnani where he said that the Titanium project could potentially be the current market cap of UEC, and then in subsequent interviews with him later on, there was no mention of it. That's where this is interesting; there's a lot of information in what people omit rather than what they most want to talk about.
If you've heard something mentioned then it no longer gets mentioned, it's a good idea to go into the 10K with the search function because legally they have to include it somewhere in disclosure, because if they don't disclose it, they can be in serious trouble.
This is from the 2019 10K:
As it turns out, the Ministry of Public Works and Communication, which is the mining regulator in Paraguay, had decided that the projects or certain concessions were not eligible for extension. That ruling has been challenged in court ever since, yet if you go through all the news releases, it hasn't been mentioned.
This sort of thing is typical in the mining industry. Mining companies tend to get tight-lipped about any issues like registration disputes. As an investor, it shows you a lot about the company and the mindset of the leadership. If you hide or obscure the facts about a potential issue like this, what else could that company be hiding?
So looking at UEC in particular, you want to notice the exorbitant pay structure, the deliberate lack of transparency about any court rulings, and also that it hasn't made money for years and is now being financed entirely by bad credit.
The purpose of this article isn't to knock UEC. After all, this is all public information. It's a tutorial on how to use the find function on the 10K - which is something every investor should do before making a trade. Do the groundwork and go through the numbers and see if it makes sense. Too often investors just go off tips and go with the easy answers rather than doing more thorough research like this.
Behind The Scenes of an IPO
This is what happens behind the scenes in an IPO (Initial Public Offering.)
This is the value pyramid where you've got founders who generally get in at $0.01, friends and family getting in at $0.05, private -which is industry insiders, brokers and letter writers – they come in at $0.15. Then you have the IPO where it gets handed out to the public at $0.50, and this is standard throughout the space.
A lot of people need to understand that if you're getting into something like this, the founders and friends & family literally have a good outcome... regardless of what happens.
The stock price can drop to 2/3rds of this and they're still making multi-bagger returns. It's also the amount of capital that the IPO investors are putting up. It's got a nice chart down the side with the amount of capital that has been invested for the amount of stock. The founders are putting up 2.5% of the capital and they're getting 43% of the stock, whereas the IPO investors are putting up 80% of their capital and getting 27% of stock.
As an average investor, you can easily become a bag holder if you don't know or trust who you're getting involved with. (A bag holder is a term that refers to somebody who holds a stock all the way down to zero when it becomes worthless.)
It's important to understand where you as an individual investor sit in this inverted pyramid. Many new investors to IPOs think they are getting in first (after all, it’s called an initial public offering), but as you can see, that's not really the case at all.
There are industry insiders, brokers, letter writers etc who get these discounted shares, and promote the stock... even if they know the asset is not a good investment... with an intention to pump the hype behind the stock and then dump the shares as soon as the 4 month lock-up period comes off. It's much better if a company has a longer hold period like 12-24 months for example, because it shows that they are serious.
Understanding the Lock-Up Period
One tactic Cullen likes to use periodically is trading the lock-up period on Tech stocks. A stock lock out period is a predetermined amount of time following an IPO where large shareholders, typically company executives and investors representing significant ownership, are restricted from selling their shares on the open market.
So you can short shares as the lock-up is coming off with the expectation that once the lockup comes off there will be selling pressure in the market from those executives anxious to unload some of their stock.
It's absolutely essential that you know when the lock-up is coming off; there can be a decent return if you are correct.
If you pay attention to this information when new IPOs launch, you can profit. There are some very good management teams that openly say what average market price they purchased at. So if you know the current share price is below their average cost, you know they are in it for a longer-term investment.
There are lots of examples of how brokers and promoters fool you into investing in uninvestible projects, and if you understand all these different scams, that will significantly reduce risk. We regularly talk about different scenarios to avoid. A helpful part of spotting scams is to know how they work in the first place so that you can be aware of them. Be curious about how deals and companies are structured so that you can have an idea of what it should look like and therefore know how to avoid getting caught out.
All The Glitters... Is Not Gold
Investing is hard. Be wary of companies claiming that a major catalyst is "just around the corner." Often these are based more in the company's hopes and goals rather than their reality. Be sceptical about claims of how many tonnes of ore a company will be able to produce and the cost of doing so. Discount numbers heavily. If the company still works with the discounted numbers then it has a chance. In investment banking financial models supplied by the company routinely discounted by 40% as starting point. You don't want to make assumptions or rely on skilful speakers to paint an unduly rosy picture. Do the research.
Also be aware that some CEO's are fabulous promoters. Some have the gift of being very eloquent and persuasive. But is there hard evidence to back up the claims? That's why you want to do the research into any company prior to investing your money into it.
Charles Ellis has a few books on trading, and in one of them, “Winning The Loser’s Game: Timeless Strategies for Successful Investing” he shares a theory that makes a lot of sense. The idea is that there are winner's games and loser's games.
Professional tennis for example, is a winners game. The pro players have a strong skill set and are trying to beat the other player with a near-perfect winning shot.
Alternatively, a loser's game is like amateur tennis. When two amateurs play each other, they are both trying not to make a mistake. The person who wins is the person who doesn't make a mistake first.
This applies to investing because investing is a loser's game. If you can avoid silly mistakes, such as avoiding margin, dodgy brokers & promoters, scams, hyperbole, hype, and dumb mistakes, you will end up winning.
Keep following the "How To Get Lucky" rules, like asymmetry, keep volleying the ball back over the net, and you will win in the markets. Too many people think investing is a winner's game where you have to hit a solid ace shot, but that's not how the markets work.
Timing is really important. Ultimately, it comes down to how much can you make when markets are good? How much did you lose when markets got rough? Eradicate the dumb mistakes and you should do well with your investments.
Excel Valuations are a Terrible Way To Invest
Paying attention to the market is more important than multi-page Excel valuations.
Accountants always show their multi-page valuations about why something's going to work but they are often some of the worst investors. Go with your judgement of market behaviour. It’s important to trust your convictions.
FOMO: Fear of Missing Out
Be aware of FOMO. The thing to remember is that where there is FOMO there is no asymmetry. Very little good comes from feeling the urge to get involved in something. When you get caught up in FOMO, you stop doing clear-headed analysis. Your money is precious and deserves to be with someone who will manage the company in a style that you would expect.
Expect scams to have their own mini-bull market. This is the idea that if it's going to take off, more people will jump on the FOMO train trying to take advantage of it. One of the best things Cullen says his mentor taught him to do was to shut down your brokerage account and forget your password at the start of the bull market. You won't do a lot of extra good for yourself thinking you're smart and swapping back and forth between stocks. Generally, you will drag on your own performance.
Merrill Lynch had a study of the best performers and their mutual funds over the years, when they looked back, the ones that had metaphorically lost their passwords (people that knew to stop playing with the market) performed better during bull markets.
FOMO changes the landscape and more often than not you could end up selling something low and buying high.
What Next? Action Steps
The important takeaway from this is that you need to do your research. Sometimes management compensation is substantially higher than it may first appear.
It’s important to take the time to dig into the financials and the 10K annual report in order to get a true sense of what the company is all about. For one of the companies you own stock holdings in, do some research right now into the financials. If you want to internalize this information, the best thing to do is to go and practice right now on a company you have in your portfolio. You’ll be a better-informed investor for it.
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