Jewish World Review Feb. 22, 2002 / 10 Adar, 5762
James K. Glassman
The right thing is cash. The earnings statements that obsess Wall Street analysts are based on technical, arcane accounting conventions. But what truly counts for investors is how much cash they can put in their pockets, and shareholder cash is inextricably linked to the cash that the company itself generates and uses.
I have come reluctantly to the conclusion that massive corporate filings rarely illuminate the true state of corporate health. Adding more requirements and plugging the latest Enron-inspired loopholes won't help, either. Most large, publicly traded companies are simply too complicated.
Robert Olstein, who manages the successful Olstein Financial Fund by digging deep into financial statements, says that detecting trouble is a job for professionals. When I asked him whether small investors could ferret out the mess at Enron, he said bluntly, "The public has no chance."
He added: "I don't do my own refrigerator repairs, so why should you think you can do your own stock picking? Instead, you should spend your time finding good people to manage your money." That statement may be self-serving, but it is hard to imagine any amateur beating Olstein's own record. His fund has returned 17 percent during last year's market debacle and an annual average of 21 percent over the past five years, compared with 12 percent for the Standard & Poor's 500-stock index.
But don't despair. By concentrating on cash, investors can learn enough about a company to eliminate it as a possible investment. For example, if you want to get a quick-and-dirty reading, look not at a firm's "income statement" but at a more obscure - but still readily available - table of numbers called its "statement of cash flows." In Enron's case, that statement - part of the 2000 annual report, published before the firm's problems were revealed - showed troubling numbers.
First, add up the cash that Enron generated from its operations over the past three years. Then subtract the cash that Enron devoted to capital investments - that is, the big-ticket items, including acquisitions, that eventually generate the operating cash.
Here is what you get: Cash from operations - $7.6 billion. Cash used for investments - $11.7 billion.
Subtract the bottom line from the top line and you find a deficit of $4.1 billion. That's not good. Then subtract the cash that went to paying dividends and the deficit jumps to $5.5 billion. Ouch. By the way, Enron made up that deficit, again according to the cash-flows statement, by issuing new stock and taking on more debt.
Our quick-and-dirty analysis does not examine the question of whether Enron's investments - in excess of its operating cash - were wise or foolish. That's an important matter, of course, and it requires more study, but it's not unreasonable to dismiss out of hand any company with such a lopsided difference between the cash it generates and the cash it invests.
By contrast, consider the 2001 annual report of Automatic Data Processing Inc., which handles payroll processing for companies that employ 30 million Americans. ADP has raised its dividend for 28 consecutive years, so it is no surprise that from 1999 to 2001 the firm generated net positive cash flow of $2 billion. ADP used $650 million of that to pay dividends and $1.2 billion to repurchase its own stock (in effect, a tax-free dividend). In other words, it returned the profits to shareholders - an encouraging sign.
A company that plows all the cash it generates into capital investment is not necessarily shaky; the money could be going to productive uses. In three of the past four years, for example, Cisco Systems Inc., the Internet infrastructure giant, has run slightly negative net cash flows. By any measure, however, Cisco is a solid, highly profitable company - it's rated A++ (highest) for financial strength by Value Line - that gets considerable bang for every internally invested buck.
There's no hard-and-fast rule that separates a Cisco from an Enron, but check out the "return on capital" line that you can find in almost any analysis of a company. even with last year's slowdown, Cisco's returns were more than 20 percent between 1997 and 2001. In other words, for every dollar of debt (loans) plus equity (stock), Cisco was bringing 20 cents down to the bottom line. That's impressive. Enron, by contrast, was averaging returns on capital of a mere 7 percent - hardly better than a Treasury bond - over the past five years, even before the company had to reveal some hidden debt and restate its earnings downward.
Finding information like this is relatively simple. Most companies post annual reports on their Web sites, and the SEC makes Form 10-K (and quarterly 10-Q) filings available through its Internet-based Edgar database (www.sec.gov/edgar.shtml). In addition, sites such as MoneyCentral (moneycentral.msn.com) offer detailed historical statements of return ratios, income, cash flows and balance sheets.
A balance sheet tells what a company owns (assets) and what it owes (liabilities). Olstein says that all investors should look at a company's cash (on the asset side) and its debt (on the liability side). If there's more cash than debt, that's a good sign. Enron's cash at the end of 2000 was $1.4 billion, and its debt was $10.2 billion - again, a lopsided negative figure.
Enron executives have been accused of deceiving investors by moving debt off the consolidated balance sheet - which is the official statement from which those numbers above are drawn - and onto the backs of "unconsolidated" partnerships and corporations with which the company had a close relationship. In fact, sketchy information about unconsolidated entities does show up on Page 77 of Enron's 214-page 10-K. Debt, for instance, totaled another $9.7 billion.
But there's no need to burrow into the small print. As Olstein says, "when we looked at Enron, we saw negative cash flow." That was a bad sign, and so was the huge difference between cash and debt. Again, compare Enron with Cisco. At the end of fiscal 2001, Cisco had $7.4 billion in cash and no debt. But Cisco is a powerhouse. A more surprising example of a well-heeled firm is Apple Computer, with cash of $4.3 billion and debt of $300 million. Cash minus debt equals $4 billion, or about $12 for every share of stock. Apple was trading Friday at just $24.76 a share, which makes it an intriguing candidate for purchase.
Olstein's own investing style is more sophisticated than simply purchasing firms with lots of cash. "We try to buy companies that are down and out but can keep their balance sheets intact," he says. In other words, finding firms in robust health - like ADP - does not excite him. As a value investor, he wants to own companies that are shunned by the market because they look shaky but which, on closer examination, are pretty sound.
A good example is J.C. Penney Co. The company, at last report, had $1.7 billion in cash, and while its debt totals $5 billion, that number has been cut in half in the past three years, and most of the loans are not due for more than five years. In addition, net cash flow was positive last year by more than $1 billion. Penney's was Olstein's second-largest holding last year, and it rose more than 100 percent over 12 months.
Other winners for the fund include Furniture Brands International, a company with deceptively strong cash flow, and Mattel Inc., which last year suffered a loss on its income statement but maintained a positive cash flow - just the opposite of Enron. Typically, the official numbers reported to the SEC don't tell you as much as statistics that companies use internally and rarely share with investors. American Express Co. is an exception. It devotes a page of its annual report to such data as total credit cards in force (52 million in 2000, up 15 percent from 1999), average basic cardholder spending ($8,229) and past-due loans to cardholders (1.9 percent between one and three months and 0.9 percent longer than three months). This material is meant to be informative rather than promotional, and it helps investors decide whether Amex is a stock worth buying.
Berkshire Hathaway Inc., the Omaha-based conglomerate with businesses as varied as auto insurance, candy and jewelry, produces an ideal annual report (available online at www.berkshirehathaway.com). It includes not only the wit and wisdom of its chairman, investor Warren Buffett, but also the statistics that investors need to decipher the activities of a large, diversified company.
"At Berkshire," Buffett wrote last year, "full reporting means giving you the information that we wish you to give to us if our positions were reversed." That's a credo that all CEOs should follow. Clear, transparent statements, written in understandable English, attract investors. When you can't decipher reports, it is safe to assume that the company has something to hide - again, remember Enron.
Buffett also refers to the "limitations of conventional accounting" - which are significant. "Consolidated reported earnings may reveal little about our true economic performance," he writes. Investors need more - but often, as in the case of American Express, what they need varies with the business. For that reason, trying to edify investors by writing new, more complex accounting rules is a futile pursuit. Look for companies that want to tell you what's happening - Walt Disney Co., for instance - and dump the obfuscators.
Two other pieces of advice: Favor smaller, simpler companies, whose businesses are relatively easy to understand. A couple of good examples are retailers Urban Outfitters and 99Ę Only Stores; both are top-rated by the Value Line Investment Survey, and they have strong cash flows and zero debt. And remember, as I said last week, that dividends are the most certain evidence that a company is actually earning money - which is why real estate investment trusts (REITs), which consistently pay high dividends, should be in every investor's portfolio.
You can't fake the checks you send to shareholders. In fact, you can't
fake cash in general. In a world of more and more complicated accounting
rules, of fancy tax techniques and slippery footnotes, cash is the real
thing. Count the cash, and you won't go far
02/06/02: Investing After 9/11