4 'Soft' Factors Analysts Use to Evaluate Stocks

What's not on the balance sheet can tell the real story about a company's potential as an investment.

Mutual fund managers and analysts are increasingly looking beyond today's numbers and through tomorrow's to detect underlying momentum that indicates how well a company is likely to grow and throw off profits that flow to investors.

Here are four under-the-hood factors that fund managers and analysts often consider, and why.

Fine print. Todd Ahlsten, chief investment officer of Parnassus Investments, told attendees at the Morningstar Investment Conference in June that he pays attention to the footnotes and fine print accompanying financial statements. He's on the lookout for "financial engineering," such as stock buybacks, that can boost stock prices temporarily, but that have little to do with long-term performance.

Field trips. Morningstar's Jon Hale, director of manager research for North America, says that when equity analysts take field trips to companies, it's all about "getting to know company management. We not only do the financial analysis, but get to know management for their long-term understanding of the industry," he says.

Analysts want to understand how managers are thinking about the long-term trends that shape the competitive landscape and the company's ability to keep doing what it does, only better, faster and more profitably. Increasingly, Hale says, analysts listen with an ear to how managers define "success" and "return." "Investors want to be in companies with a higher level of social and environmental responsibility," he says. That means analysts are listening for how managers are investing in technology, processes and sources that are sustainable, and whether they anticipate emerging expectations for environmentally sustainable practices.

"How do they know that a best practice is a best practice?" Hale asks. He and other analysts say they expect to see social responsibility reports; dedicated internal research to environmentally sustainable practices; and internal analysis that shows how such practices would require the company to change.

And analysts don't just take management's word for it. "You do comparisons within the industry and for other peer groups," Hale explains. Analysts check with specialized research organizations that get into the science and engineering of environmentally sustainable practices. "We get into industry specifics. So, for hazardous waste management, does the company have a program, and is the program executed in a way that they can show measurements?" Hale says.

Ahlsten cites a rearview mirror snapshot that can quickly validate or undermine the credibility of management forecasts. He calls it the "say vs. do" ratio: did the company's CEO's statements over the past 10 years come to fruition? If the company did what the CEO promised, what was the result? And if the CEO abandoned plans, why?

Franchise. "We think hard about the essence of the franchise and potential challenges to it," says Bruno Paulson, a portfolio manager with Morgan Stanley Investment Management. "In terms of stability, we worry about vulnerability to cycles and the vulnerability to structural changes. History helps us understand the cyclical sensitivity, subject to the usual provisos that the future may not match the past, and we have to think very hard about the potential structural changes to the business and/or the markets."

The noise of the market can drown out unspectacular but reliable performers -- companies Paulson calls "steady Eddies." "Steady Eddie" DNA includes steady growth and steady margins, recurring revenues and limited operational leverage, Paulson explains.

Drama grabs headlines, but it's metronomic performance that drives sustained performance. "The market is very relative-driven, short-term and growth-fixated. As such, the benefits of the top compounders are not fully recognized. As of March 31, 2015, our global portfolios have higher forward free cash-flow yields estimates than their benchmarks, which we believe supports our claim that compounders do not get enough credit from the market," Paulson says.

Finite resources. Supply chain goes beyond the reliable flow of materials that the company needs to do what it does. Companies are increasingly expected to monitor the practices of their second- and third-tier suppliers, Hale says. Analysts sometimes look at external certifications of supply chain responsibility.

As analysts become versed in industry culture, they see not only today's patterns but can detect tomorrow's momentum. Paulson says he's on the lookout for the ultimate 'know it when you see it' factor: how excited managers get when they think they've got a great acquisition on the hook -- especially if those managers will reap personal incentives driven by acquisitions. "If they get excited when talking about acquisitions," Paulson says, "We worry!"