ISBN: 0-03-028931-9

Chapter 2 Financial Statements, Cash Flow, and Taxes

Doing Your Homework With Financial Statements

Suppose you are a small investor who knows a little about finance and accounting. Could you compete successfully against large institutional investors with armies of analysts, high-powered computers, and state-of-the-art trading strategies?
The answer, according to one Wall Street legend, is a resounding yes! Peter Lynch, who had an outstanding track record as manager of the $10 billion Fidelity Magellan fund and then went on to become the best-selling author of One Up on Wall Street and Beating the Street, has long argued that small investors can beat the market by using common sense and information available to all of us as we go about our day-to-day lives.
For example, a college student may be more adept at scouting out the new and interesting products which will become tomorrow's success stories than is an investment banker who works 75 hours a week in a New York office. Parents of young children are likely to know which baby foods will succeed, or which diapers are best. Couch potatoes may have the best feel for which tortilla chips have the brightest future, or whether a new remote control is worth its price.
The trick is to find a product which will boom, yet whose manufacturer's stock is undervalued. If this sounds too easy, you are right. Lynch argues that once you have discovered a good product, there is still much homework to be done. This involves combing through the vast amount of financial information that is regularly provided by companies. It also requires taking a closer and more critical look at how the company conducts its business-- Lynch refers to this as ``kicking the tires.''
To illustrate his point, Lynch relates his experience with Dunkin' Donuts. As a consumer, Lynch was impressed with the quality of the product. This impression led him to take a closer look at the company's financial statements and operations. He liked what he saw, and Dunkin' Donuts became one of the best investments in his portfolio.
The next two chapters discuss what financial statements are and how they are analyzed. Once you have identified a good product as a possible investment, the principles discussed in these chapters will help you ``kick the tires.''

DISCUSSION QUESTIONS:

1. How viable do you think this "common sense" investment strategy is for the small investor?
2. Using the "common sense" approach, what are a few companies you would be likely to invest in? Take a moment to brainstorm a few possible firms, and detail your reasoning for choosing these companies.

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