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When companies report their profits and losses every quarter, what you see is not what you get.
No, it's not that every company is run by wannabe Kenneth Lays and Jeffrey Skillings, or that there isn't money being made in Corporate America.
It's just that even rule-abiding corporations use an accounting system that really isn't meant to help investors make good investments. It's a system better equipped, say accounting experts, to help banks spot looming bankruptcies.
The good news is that there are tools that professional investors use to steer clear of the accounting system's problems and find stocks truly worth buying. Below I'll describe one such system and pass along three stock picks from one of its leading users.
Adding value?
First, here's a look at how you can easily be misled if you rely only on widely used earnings reports.The heart of the problem is that standard accounting rules do a poor job of producing reports that identify what ultimately moves stocks -- the size of a company's profits and how much was invested in the business to generate those profits. That's because the system often misses how much companies and shareholders are really putting into the business. Widely used accounting practices can also regularly misrepresent the true level of profits.
Under standard accounting rules, companies report how much of their earnings they keep and reinvest in their businesses. It's known as "retained earnings." But they don't disclose what they would have paid in interest had they borrowed that money rather than using funds they could have paid out to investors. The earnings they retain, you see, aren't really free. There is a cost, and it's equivalent to what the company would have had to pay to borrow the money. If a company pays 10%, for example, to borrow funds, then it's not doing its investors any favors by generating a 5% return on the profits it plows back into its business.
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One way some professional investors work to better evaluate what a company reports is by using a system known as "economic value added" or EVA. Investors using EVA size up the true amount of capital injected into a company. This includes retained earnings invested in items such as research, brand development and long-term leases. Then the EVA analysis assesses whether the company is earning enough in real profits to pay off the cost of the money at a true market rate and have enough left over to give shareholders a healthy return.
If not, the stock gets a sell rating.
In accountant-speak, EVA takes net operating profits, or revenue minus overhead and taxes, and subtracts the cost of capital based on real-world interest rates, even if the company isn't billing itself for that cost. This produces an income number that's often lower than what companies report using standard accounting rules. Then the EVA system divides this income by the amount of money deployed, to figure out how much of a true return on capital managers are producing for shareholders.
EVA is used by a New York-based firm called Matrix USA, which manages money for wealthy investors and institutions, and sells its rating system to professional investors. Matrix throws a valuation measure into the mix to pinpoint companies that are creating healthy real returns for shareholders, but still look cheap.
The stock ranking system produces impressive results. A focus list of stocks from Matrix USA is up 69% since the investment advisory service launched in September 2004, compared to a 14.7% gain for the S&P 500 as of June 22. So far this year, the Matrix focus list is up 8% compared to flat returns for the S&P 500.
Here's a closer look at how the Matrix system sizes up five companies.
Red flags
P.F. Chang's China Bistro (PFCB, news, msgs). Like a lot of restaurant chains, P.F. Chang's leases properties because it doesn't want to tie up funds by owning property and "being in the real estate business."This makes sense for a restaurant, which knows more about serving food than real estate trends. The problem for investors is that accounting rules don't make companies report leases for what they really are -- a kind of long-term investment in the lease holder by the property owner. Its an investment on which P.F. Chang pays the equivalent of interest -- even if the company isn't required to report it that way -- says Ivan Feinseth, Director of Research, Matrix USA.
That fact led Matrix to put a sell rating on the stock in 2005 at $57.99 in February and again at $49.40 in October. The stock recently sold for $39. Matrix still has a sell rating on the company.
Feinseth isn't accusing P.F. Chang's of breaking accounting rules. Indeed, the company releases detailed information on leases at its Web site, way beyond what's required by regulators, points out Bert Vivian, who handles investor relations for PF Chang's.
Electronic Arts (ERTS, news, msgs). Matrix also has a sell rating on game developer Electronic Arts. Chalk it up to higher development costs, which Matrix -- unlike the company -- books as a capital expense complete with interest charges.
By Matrix's calculations, return on capital has been declining steadily since March 2004. Return on capital fell to 15.6% last March compared to 34.3% in March of 2004.
Matrix downgraded the stock to sell in August 2005 at $59.04 and to strong sell in November 2005 at $59.90. Even now, with Electronic Arts at $41, Matrix still has a strong sell on the stock. The company declined to comment.
The buy list
EVA and return-on-capital trends can also be used to spot stocks to buy. The Matrix buy list includes:- Apple Computer (AAPL, news, msgs), where return on capital expanded to 44.8% by March 2006 from negative territory in March 2004, thanks to the popularity of iPods and the spillover effect into computer sales. Matrix thinks those trends will continue. "Apple's personal computers are being discovered by a new generation of iPod owners," agrees Morningstar (MORN, news, msgs) analyst Rod Bare.
- ConocoPhillips (COP, news, msgs), whose stock still looks cheap even though return on capital jumped to 16.3% in March 2006 from 7.8% in March 2004. "It is one of the cheapest multinational oil companies," says Feinseth. But it has the highest return on capital of all the large integrated oil companies. "They are the most efficient operator, from pulling the oil out of the ground to getting it to the refinery and into your car," says Feinseth. The company is also doing a good job of building reserves. "In 2005, excluding acquisitions and divestitures, ConocoPhillips replaced 119% of the oil and gas that it pulled out of the ground with new reserves," says Morningstar analyst Justin Perucki.
- Sierra Health Services (SIE, news, msgs) is one of the smaller health maintenance organizations but has the highest return on capital in the industry, according to Matrix calculations. Return on capital has increased to 27.4% in March 2006 from 14.5% in March 2003. The company, whose stock recently traded for $43.50, also has over $7 a share in cash and solid free-cash flow. That makes it a possible takeover target for a bigger HMO, says Feinseth.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for the New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.
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