Nearly everyone uses basic valuation ratios to determine how much value a stock holds. Meanwhile, a much smaller number are willing to devote the time to look beneath a company's surface. However, those who do are often richly rewarded.

Let's assume your coworker just stumbled upon a new stock, which seems to represent a compelling value considering it trades at a rock bottom P/E of 8. The stock may indeed be a great find, but if simple screening based on fundamental financial statistics was the only tool one needed to become a great value investor, then everyone would be as rich as Warren Buffett -- not a likely scenario.

Although running a screen for companies with low P/E ratios can be a useful way to uncover new ideas, further research must be done to determine a company's true value. Moreover, since everyone has access to this type of screening data, it isn't going to help you earn exceptional profits over the long haul.

What will help you, though, is to learn how to identify important financial items that most other investors miss. With this in mind, in today's guest article I'm going to discuss a few simple, yet important tips that should give the diligent investor a distinct advantage over Wall Street.

I won't cover techniques used to measure the quality of earnings or other financial comparisons that must also be weighed, as these are beyond the scope of this discussion. Rather, this article will provide you with a brief introduction to some non-financial data that savvy investors should examine first before making any investment.

This information can be found in a company's 10Q or 10K filing. It can also be obtained free of charge at MSN, Yahoo, Edgar, or the company's website. Best of all, I won't ask you to read through a company's entire 10K or 10Q financial reports -- for the purposes of this analysis it simply isn't necessary.

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Keywords to Look for in a Company's Financial Reports
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Before placing a buy order for a particular stock, I strongly recommend doing a few basic word searches on the company's most recent 10Q. Investors who fail to perform these important background checks will suffer the financial consequences. Although I will limit this article to the introduction of just a few ideas -- customer concentration, litigation risk, product diversity, real estate holdings, patent protection, management compensation, and stock dilution -- I will share more information in the future if readers express an interest.

Keyword Search #1 -- Customer Concentration
Inside a firm's most recent 10Q -- which all publicly traded companies are required to file quarterly – you should use your web browser (in Microsoft Explorer, choose the "Edit" option from the top menu, then select "Find on this Page") to search for the keyword "customers". For some companies, the search may reveal a section in the filing called "concentration of credit risks and major customers." What we are trying to determine in this search is whether the firm derives a disproportionate percentage of revenue from just a handful of major customers, or possibly even a single source. Firms whose revenues are tied to a small number of customers may not be bargains -- regardless of their valuation levels.

Obviously, a high degree of customer concentration represents substantial risk for a company. American Locker Group (ALGI, $5.63) provides a perfect case study. The stock was recently selling for $16.00, and based on most common valuation metrics ALGI looked cheap at that level -- very cheap. The company had a great product, positive cash flow, a great balance sheet, a single-digit P/E, an established operating history -- what else could you want? The company's press releases were always upbeat, highlighting its great financial results.

However, performing a search on the key word "customer" in ALGI's latest 10Q would have uncovered the fact that more than half of the firm's revenue over the past four years has been generated by a single customer -- the U.S. Postal Service. Unfortunately for investors, ALGI recently lost its USPS contract. Not surprisingly the stock was quickly battered, eventually losing more than half of its value. Now, the very survival of this company has been called into question. Those investors who simply focused on the company's financial statements and positive press releases and overlooked customer concentration would have incurred severe losses here.

Keyword Search #2 -- Litigation Risk
A company's legal picture is also worth a closer examination. When a firm releases its quarterly earnings, it seldom divulges much information regarding current litigation or off balance sheet risk. Astute investors should dig deeper by searching for the word "litigation" in the most recent 10Q. In most cases you'll simply need to read a few paragraphs to find out if the company is facing significant future legal entanglements. Litigation could take the form of patent infringements, shareholder lawsuits, environmental violations, employee lawsuits, etc.

There are plenty of real-world examples of companies whose stocks have been kept in check (or in some cases crippled) by legal setbacks, ranging from tiny value plays like GameTech Intl. (GMTC, $3.25) to blue-chip giants like Altria (MO, $63.72). Some otherwise solid companies have even been forced into bankruptcy. A quick search for "litigation" will prevent the unwary investor from falling victim to a company whose future obligations are not recorded in any financial statements, but are instead buried somewhere inside the 10Q. This simple check will help you avoid this common pitfall.

Keyword Search #3 -- Product Diversity
Does the expression "one-trick pony" define your stock? Many companies are overly reliant upon a single product for the majority of their revenues. If you have your sights set on such a company, then you should carefully weigh this dependence while evaluating its other credentials. For example, many software companies market just one niche product, whose runaway success may soon invite competitors into the market. These new players may be able to duplicate the functionality of this one successful product -- possibly at a lower cost.

Anytime a firm relies almost entirely on a single product, it runs the risk of facing contracting margins or falling market share -- if not outright obsolescence -- whenever competition escalates or a better product emerges. Therefore, take a few minutes to assess a firm's product and revenue diversity.

Keyword Search #4 -- Real Estate Holdings
A company's real estate holdings are almost never disclosed -- except deep within its SEC filings. A quick search for "real estate" or "properties" will reveal, for instance, whether the company leases or owns its properties. Remember, real estate is carried at its historical cost basis on the balance sheet, not its market value. For that reason, you may be able to uncover whether a prospective company owns valuable hidden real estate assets, or perhaps is instead saddled with off balance sheet liabilities from various long-term leases.

Keyword Search #5 -- Patent Protection
Another quick search that may be useful -- particularly for investors looking at biotech or pharmaceutical firms -- is for "Patents". Patents provide companies with a certain degree of protection from the encroachment of competitors, and are usually recorded as an intangible asset on a firm's balance sheet. Skim through the search results to see if you can gather more information on the firm's patents. Are the company's products or ideas protected? Is a key patent set to expire soon? These types of questions may provide better insight into the merits of an investment idea.

Keyword Search #6 -- Management Experience & Compensation
Next, I always conduct a thorough background check of the compensation and experience of a firm's senior management team. Much of this information can be routinely found by checking the firm's profile on Yahoo Finance. Additional information can also be found at Reuters.

To begin, I take a look at each officer's compensation to ensure that it is commensurate with the size of the company. Excessive salaries can be a warning flag that management's interests aren't aligned appropriately with shareholders', particularly if the company has been performing poorly. With this in mind, I am always interested to see if there is an equity incentive plan in place that aligns an executive's interests with those of shareholders.

Aside from compensation, I also find the bios of senior management to be enlightening. Is a manager's prior experience directly related to the company's industry? Does he/she have a successful track record in the sector with other companies? What other credentials or accomplishments does he/she bring to the table? I would also advise taking a few minutes to track down the investment banking firm that took the company public -- was it a reputable firm, or was it a more questionable underwriter? 

Keyword Search #7 – Stock Dilution
Finally, I strongly encourage a 10Q search for the word "dilution". Dilution occurs whenever a company increases its number of shares outstanding. Increasing share counts can be the result of generous stock options, preferred stock offerings, the issuance of convertible debt, equity-funded acquisitions, etc. A certain amount of dilution is commonplace, and is often easily combated with stock repurchase programs.

However, if a firm's shares outstanding show a repeated pattern of substantial increases, then I would advise caution. After all, what good are buckets of cash if excessive dilution is watering down your stake in the company and reducing the value of your ownership? Terms such as "warrants", "preferred stock", "redeemable preferred", "options in the money", and "convertible debt" are all possible hiding places for future dilution. Companies that rely heavily on this kind of financing could pose problems to the common shareholder.

Other key 10Q search words include the following:

"Acquisition"
"Backlog"
"Competition"
"Convertible"
"Deferred Tax"
"Dependence"
"Risks"
"Strategy"

Diversification is Critical
Okay, so let's say you have now done your homework by digging beneath the surface of a company's SEC filings. Let's also assume that everything checks out well and you still find the stock attractive. It now becomes essential to put that information to work by applying proper money management techniques.

The effective use of prudent money management is an integral part of constructing a winning portfolio. Every professional card player is aware that having a firm grasp of probability is essential, yet is only the first step to making money. Regardless of the knowledge at your disposal, you simply can't win every hand played. The key is to not only enter the game when the odds look favorable, but to also effectively manage your bankroll to weather the down times so that when things do turn around, you will still be around to reap the profits.

Investing is similar in many respects. We can put the odds on our side with solid research, but there is still an undeniable element of risk that remains. Just like a good card player, no investor wins every day, week, month or even year. We can learn something from successful gamblers -- investors must not only utilize sound stock selection techniques, but must also combine that methodology with effective money management.

With this in mind, when putting together a winning portfolio I always broadly diversify among a number of carefully selected investment ideas. Instead of concentrating my assets among a handful of stocks, I only commit a modest percentage of my overall portfolio to any one position. By doing so, I like to think that I'm planting numerous seeds that will eventually grow into a very productive farm.

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Today's New Micro-Cap Investing Ideas:
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As a group, micro-cap companies with a value-oriented tilt have posted significant gains over the last two years. Therefore, valuations in this sector are generally quite inflated from the levels seen just a couple of years ago. Furthermore, there are no perfect companies, and many of the ideas I present will exhibit weakness in one regard or another.

Nevertheless, despite this cautious approach, I'm still very optimistic that my carefully researched selections will continue to significantly outperform all the market averages. Below you will find an analysis of three promising micro-cap candidates...

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JLM Couture (JLMC, $3.26)
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JLM Couture makes upscale bridal gowns, bridesmaid gowns, and related accessories. The company markets its bridal wear through several lines, including Lazaro, Valenta, Occasions, Couture, and the more affordable Visions. Its gowns are widely available in bridal departments throughout traditional department stores in both the U.S. and overseas, and can also be found in the pages of bridal catalogs or online at one of the company's five websites.

JLM's financials have been trending lower over the past few quarters. The firm's net income was cut in half last year on sales that slid -8% to $24.6 million. However, brides tend to purchase their wedding gowns up to a year in advance, so much of the falloff can be attributed to earlier economic and labor uncertainty. On that front, the economy has since showed some major improvement, and this should help sales going forward.

Nevertheless, the company's future sales may be crimped by a nationwide trend towards simpler, scaled-back wedding ceremonies. Perhaps the most troubling issue surrounding the company is CEO Joseph Murphy's $436,000 annual salary, which seems excessive given the size of the company and its poor performance of late.

Still, JLM looks intriguing as a possible takeover candidate. I wouldn't be surprised to see this company either go private for a premium or get swallowed up by a larger retailer or apparel maker.

From a financial perspective, JLM has much to offer. The firm's balance sheet is clean, with no potential for dilutive effects from warrants, convertible securities, etc. Furthermore, the company's shareholder equity has been on the rise lately, and last year it generated more than $327,000 in free cash flow. JLM also has a healthy $3.84 per share in working capital (current assets – current liabilities) on the books. Finally, the company threw off $9.5 million in gross profits last year on sales of $24.6 million (gross margin of 39%), which translates to a relatively cheap trailing price/sales ratio of just 0.26. The company is also trading at a substantial discount to its book value of $4.28. With management owning a 40% stake in the company, and Fidelity (the largest institutional owner) holding another 10%, taking the company private should be fairly clean and easy.

Given the negative investor sentiment that surrounds the stock in the wake of its most recent quarterly results, we are going to take advantage by establishing a position. Further, we also plan to capitalize on any future weakness in the stock by adding to our holdings.

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Immucell (ICCC, $4.34) 
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Immucell is a biotechnology company that develops and manufactures diagnostic testing equipment for veterinarians and livestock owners in the beef and dairy industries. The company's products help test for and protect against infectious diseases. Last December, it got the green light from pharmaceutical giant Pfizer (PFE, $26.17) to proceed with a product development and marketing agreement for Mast-Out -- a treatment for lactating dairy cows.

The beauty of Mast-Out is that milk from cows undergoing the treatment might still be viable. By contrast, regulatory requirements stipulate that milk produced from cows undergoing other treatments must be discarded. Pfizer's interest came with a $1.5 million up-front payment, which Immucell will use to develop the product. Mast-Out will begin to undergo efficacy trials this year. If they prove successful, then Pfizer will hold a long-term license to roll out the treatment worldwide.

Immucell is not a value stock in the strictest definition, but does look attractive relative to other biotech stocks. The company has remained profitable since posting a modest loss of $0.04 per share in 1998. It also boasts a spotless balance sheet, with zero debt and $4.3 million ($1.46/share) in cash. Board member Johnathan Rothshild owns about 14% of the company, and Fidelity is the largest institutional holder, with a 2% stake. With a promising new treatment potentially on the horizon, we believe that this small, well-managed biotech has a bright future ahead of it.

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Scott's Liquid Gold (SLGD, $0.54)
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Scott's is a distributor of beauty care and household products. The company is probably best known for its flagship Liquid Gold brand -- a wood preservative and cleaner that has been around for more than thirty years. However, the company derives the majority (around 60%) of its revenues from the sale of skin care products -- a venture the company first entered in 1992 through the acquisition of Neoteric Cosmetics.

Scott's recent financial results leave room for improvement. After reaching a plateau in the $24.5 million range over the past few years, sales actually dropped about -8% last year to $22.6 million. Meanwhile, net losses more than quadrupled from $190,000 to $900,000. Much of the bottom-line weakness stems from the de-leveraging of manufacturing costs, which have been spread over a smaller number of units as the firm's sales volumes have contracted. The decision to drop prices to spur holiday sales promotions also cut into margins. With both volume and pricing on the decline, every product line reported lower gross profits last year.

Despite the weak recent performance, I still think Scott's is well positioned for future growth. The company is actively working to expand the retail presence of its Montagne Jeunesse line, and redoubling efforts to increase sales of its core Alpha Hydrox skin care products and namesake Scott's Liquid Gold. Furthermore, the company is also considering the development of new niche products and the utilization of its manufacturing capabilities by making private label products for others through joint ventures.

In the meantime, the company trades at attractive price/book and price/sales ratios of just 0.36 and 0.25, respectively -- both well below industry norms. Additionally, last year's gross income was more than double the current market cap, and the company has been free cash flow positive for the last three years. Also, by searching for "properties" in the most recent 10K filing, I discovered that Scott's appears to own 16.2 acres of land in Denver, comprised of three connected buildings and a parking garage. I will have to explore further, but this property could have substantial value relative to the company's tiny $5 million market cap.

If Scott's can find a way to reverse its slumping sales and begin to show some sustainable growth rates, then the company may prove to be a promising turnaround candidate. Even if operations continue to slide lower, though, I'm hopeful that SLGD may be an acquisition target for a larger company. A sale of the firm's land could also unlock value for shareholders. At this point, the future is unclear, but I believe a small position at current prices could be very rewarding.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
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