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."