For Robert Olstein, the primary research
goal is to always follow the money.

    Is this the golden age of corporate accounting? Backlash against the accounting scandals from the 1990s bull market that were symbolized by the likes of Enron and WorldCom, combined with increased scrutiny highlighted by the Sarbanes-Oxley Act of 2002, seems to have inflicted the fear of God, or at least the SEC, into corporate bean counters and executives.
    Pro forma earnings in 2005 were 14% more than reported actual earnings, down from a 70%-plus difference in 2002. This implies that there's a lot less accounting hanky-panky going on to inflate earnings by artificially boosting income or hiding losses through off-balance sheet activities and other measures. And balance sheets on the aggregate are fat and healthy, with free cash flow among industrial companies in the S&P 500 at $100 billion in 2005, up tenfold from the 1990s. Roughly $1 trillion is sitting on the books at these industrial companies, money that has helped fuel the recent M&A binge across several industries.
    No less an earnings quality watchdog than Robert Olstein, portfolio manager of the Olstein Financial Alert mutual fund, who has made a career of exposing corporate financial chicanery, declared on CNBC in early April that earnings quality is at its highest level ever. But, he added both on television and in subsequent interviews, that doesn't mean investors should let their guard down.
    "Earnings quality goes in cycles," he says. "As markets get stretched, the quality of earnings becomes more imaginative because there's more pressure to meet expectations." In others words, careless investors who don't do their homework in the current bull market might find themselves holding the next big meltdown stock.
    In the 1970s, Olstein and Thornton O'Glove published the Quality of Earnings Report, a twice-monthly newsletter that warned fund managers about businesses that doctored their financial statements. As a fund manager, he believes that pouring over a company's books paints a better picture of its current health and its future prospects than does talking to management, in part by adjusting financial statements and earnings for economic reality versus assumptions made by standard accounting methods that might, in some cases, lead to inflated earnings.
    True to its name, the Olstein Financial Alert fund has sent out numerous financial alerts over the years through its shareholder newsletter to clue-in investors to various accounting signals that can help unmask a company's true financial health.
    Some of the top alerts include:
    Substantial differences between net earnings and cash flow
      Inventories, especially finished goods, rising faster than sales
    Accounts receivables rising faster than sales
    Serial acquisitions overstating internal growth
    Recurring nonrecurring write-offs combined with drops in retained earnings
    Nonrecurring gains from noncore sources, such as sales from a venture capital portfolio, that comprise a good chunk of earnings growth
    Earnings massaging (legal or otherwise) has long been a part of the financial accounting game. Some practitioners have become Wall Street legends of the negative sort, from the above-mentioned Enron and WorldCom to Cendant Corp., the travel and real estate services company that was formed in 1997 by the merger of HFS Inc. and CUC International. Prior to forming Cendant, HFS was a serial acquirer that, according to Olstein, used purchase-acquisition accounting to report growth rates that were as much as three times greater than actual internal growth rates without acquisitions. Investors who saw that as a red flag and bailed avoided the roughly 80% implosion of Cendant stock in 1998, after it was discovered that CUC padded its revenue by about $500 million over a three-year period to meet analyst expectations.
    Olstein believes that cash-particularly free cash flow-is king because he thinks it's a truer measure of a company's underlying performance. He and his staff analysts look for companies trading at a discount to free cash flow. Lack of free cash flow is one reason why he doesn't like homebuilders, despite the recent housing boom and their seemingly low valuations based on low single-digit price-to-earnings ratios. He cites D.R. Horton as an example, which sported a forward-trading multiple of 5.74 on consensus-forecasted 15.8% earnings growth in fiscal 2006. "That sounds like a deal, but you have to dig deeper because something's going on there," he says.
    The company earned $4.62 a share in 2005, while free cash flow was negative $2.62. Olstein notes both its debt and inventory levels rose in recent years as it gobbled up real estate for future homebuilding, and he estimates that a healthy slice of earnings have come from rising prices on its real estate inventory. "Some people are saying the game is over because there's no free cash flow and maybe margins will drop because it'll have to rely on profits from actual home construction versus inventory profits," says Olstein.
    Elsewhere, new rules for handling options expensing has been one of the hot topics in corporate finance, with some companies taking an earnings hit after accounting for stock-based compensation. But Olstein dismisses the options expensing issue as an academic debate, because the debit expense of issuing options is balanced by the credit added to the book value in the form of additional shares outstanding. "It has nothing to do with free cash flow and the company's valuation," he says, adding with a bit of bravado, "That's a very controversial statement by me."
    Olstein, 64, rattles off facts and figures in his New York accent and in a voice that rises in excitement as he emphasizes certain points. He began his career in stock research and portfolio management in the late '60s not long after getting his M.B.A. in accounting from Michigan State University. His stint as publisher of the Quality of Earnings Report taught him that the biggest long-term winners were people who made the fewest mistakes, not those delivering meteoric gains followed by precipitous declines. And he concluded that the only way to value a company was by gauging its free cash flow.
    He sold his stake in the newsletter in 1981 and put his ideas to work as a portfolio manager at Smith Barney and its predecessor companies, until he started his mutual fund in September 1995. The ten-year average annualized return of his fund was 15.65% as of March 31, placing it in the top 8% in its category, according to Morningstar.
Olstein's investing M.O. is based on finding beat-up companies with a lot of bad news and a lot of cash. "I like ugly ducklings," he says. In that vein, he likes Radio Shack, which he says has lots free cash flow but is a mismanaged company with a "tremendous" if misused distribution network. There's a new CEO in place, and Olstein is betting on a turnaround and accompanying price appreciation on a stock that was down by roughly half of its 52-week high as of late-April.
    He also likes Jo-Ann Stores, a specialty crafts retailer searching for both a new CEO and the right product mix for its new superstore format. The latter problem has hammered the stock, and it has been a loser in Olstein's portfolio in the year he has owned it. "We hope that today's troubles will be tomorrow's leaders," he says. "We buy companies with a two- to three-year horizon."
    The fund, which is evenly split between large-, mid- and small-cap equities, gained only 2.8% last year. That significantly trailed its category average, which Morningstar defines as mid-cap blend. "He tends to invest in things that are out of favor," says Morningstar fund analyst Greg Carlson, adding that such a bias caused him to miss out on the blistering energy sector (although the fund profited from an earlier investment in Williams Companies).
    Olstein bristles at suggestions that he's out of step with current trends. "Derek Jeter practically went 0-for-April two years ago and people said he'd lost it," he says, using an apt analogy that, nonetheless, is surprising coming from a Mets fan. "Olstein didn't get stupid overnight. Look at my long-term track record and my 5% gain in the first quarter. My discipline doesn't work all of the time, but tell me what does."
    Olstein takes a value approach that embraces pessimism because that enables him to buy stocks at the right price. "It's not easy to invest this way," he explains. "Sometimes you're going to get stomach cramps." He notes that roughly 30% of his picks don't pan out, and that can range from flat performance to a 20% loss. "Our performance isn't made in the 70% [winners], it's made in the 30% [nonwinners]," he says. "The key to long-term performance is what your errors do, and buying stocks with built-in downside protection is how we did 15% during the past ten years."