Investors, sharpen your pencils. A new book suggests that before putting your money into any individual stocks, you would do yourself a big favor by performing some extra work to look way beyond the company's stated financials. A new book, It's Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits (McGraw-Hill, $27.95), details a method for triangulating the true earnings power of public companies. (BusinessWeek Online is a unit of The McGraw-Hill Companies.)
The author, Hewitt Heiserman Jr., is a financial analyst and columnist at TheStreet.com, whose work can also be found at his Web site, earningspower.com (see BW, 4/12/04, "Twin Tests For Stocks That Measure Up"). He chatted recently with BusinessWeek Senior Writer Robert Barker via phone and e-mail. Before they were through, Heiserman shared some of his current stock picks and pans. Edited excerpts of their conversation follow:
Q: Why do we need another new book on investing?
A: This is the first book that advises investors to use two income statements, not one, to gauge a firm's earnings quality. And this is an idea that comes from the legendary Benjamin Graham. He writes in The Intelligent Investor that you can divide all investors into one of two camps -- defensive or enterprising.
Q: Most investors have a hard enough time getting through one income statement. Why two?
A: For the same reason you would get a second and third opinion [in] a medical situation. The defensive income statement reveals certain qualities about a firm that the accrual and the enterprising income statement aren't able to provide.
Q: Stop there. What's the defensive income statement?
A: The defensive income statement tells you whether or not a company can self-fund its growth from internally generated free cash flow. And what's unique about the defensive income statement is that it expenses investments in fixed and working capital immediately.
Q: Instead of putting those costs on the balance sheet?
A: Correct. An accrual income statement does not record a direct charge for investment in fixed and working capital.
Q: You also mentioned an enterprising income statement.
A: The enterprising income statement is unique in two respects. It converts things like research and development, employee education, marketing, and advertising from operating expenses into capital assets. This fulfills a key principle of accrual accounting, namely, matching sales with expenses.
And so for a company that's investing in its future growth, one of the prime drivers of future growth is intangibles. And the enterprise income statement rewards companies for investing in growth, where the accrual income statement, which is the income statement that you'll see in an annual report, a 10-K and 10-Q, penalizes companies.
Q: If I open up a 10-K I'm not going to find something labeled, "Defensive Income Statement." So where do you get these things?
A: Well, you have to buy my book! [Laughs.]
Q: I see.
A: What you do is you use the income statement in the annual report or the 10-K, but you also use key data from the balance sheet, the statement of cash flows, and from the footnotes.
So what these two alternate income statements do is they force you to look at a company in a more comprehensive fashion than would be the case if you were just focusing on the accrual income statement.
Q: Sounds like a lot of work. Is this for most investors?
A: It does take some work, yes. But two things: I believe that if you're going to make a big investment of your family's net worth in a company, you really want to spend time knowing what you're buying. There are some short cuts that actually can check whether or not a company probably has enterprising and defensive profits. These involve simple, fourth-grade math, which any investor can apply.
Q: Well, if I had used these alternative income statements, would I have been able to avoid buying stock in say Tyco (TYC), Enron, WorldCom, or one of the companies that blew up?
Q: How come you didn't write a book telling everyone to get out of Enron?
A: I'm a slow writer! Actually, to be truthful, I didn't study Enron until after its demise. I don't have a way yet to systematically look at every company. But if I had, [I would have seen that] it had enterprising and defensive losses. And that would have been the red flag that there was less there than meets the eye.
Q: What's your method telling you about individual stocks now?
A: I like UnitedHealth Group (UNH), Infosys Technologies (INFY), The First American (FAF), Amerigroup (AGP), and Sanderson Farms (SAFM).
These companies enjoy high-quality profits, good top-line revenue growth, low debt loads, meaningful insider ownership, and, with the exception of Infosys, they [cost] less than 15 times defensive profits, or free cash flow.
Q: What else?
A: Paychex (PAYX). It looks like they just reported a fine quarter.
Q: And which companies don't have earnings power that impresses you?
A: Allied Waste (AW) and General Motors (GM).