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Jubak's Journal
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Join forces to build a list of stocks to trust
No crooks. No liars. No double-dealing CEOs or indifferent boards. I want a registry of companies that won't embarrass or burn investors.
By Jim Jubak
Want to get back into stocks but are afraid that we havent heard the last of cooked books, fraudulent Wall Street research, lackadaisical boards of directors and self-serving CEOs?
Wouldnt it be great to have a list of stocks of companies free of those kinds of problems?
Such a list would certainly be very useful. Think of it, a universe of stocks that you are reasonably sure wont blow up on investors, as Ahold (AHO, news, msgs), Lucent Technologies (LU, news, msgs) and HealthSouth (HLSH, news, msgs) did.
And if these stocks were good investments, too, even the most skittish investor could use the list to find those shares best suited to form the core of a portfolio.
I have no illusions about how difficult putting together such a list would be. Or any egomaniacal belief that I could successfully tackle that job by myself.
Mobilize the troops
First, it involves the notorious difficulty of proving a negative. Its easy to show that a company is blemished -- just find a bloated CEO option plan in the proxy statement or some off-balance-sheet expense hidden in the footnotes to the financial statement. But no matter how hard you search, no one can prove that a company is blemish-free, only that the search has failed to unearth any negatives.
Plus, the data we need for such a list cant be quickly retrieved by any computerized stock screen. To do the job right, we need intimate, long-term knowledge of the internal workings of thousands of companies. No one individual or a reasonably sized team of individuals could hope to handle this task.
Which is why the Internet is the perfect tool for putting together this list. The individuals who make up the network collectively have in-depth knowledge of thousands of companies. Collectively, they know more obscure dirt on individual companies than even the best Wall Street research department. Theyve investigated more potential investment candidates than any mutual fund portfolio manager. And, while individually, they may have their own conflicts of interest and personal motives, collectively theyre unbiased.
So I propose that the readers of this column -- and anyone else we can hook into the effort -- put together a registry of clean stocks.
There's strength in numbers
Ill start the ball rolling and serve as umpire and bookkeeper. And Ill add whatever knowledge I can contribute. But the ultimate list will grow out of the collective efforts of investors on the Internet.
This process isnt guaranteed to catch every bomb before it goes off, but the effort should provide some extra security in a very uncertain investing world.
Heres how it will work. (And Im open to suggestions to improve on the idea. I wont cast this process into concrete until weve given the mechanism a trial.)- Each month Ill put three candidates for our clean stocks list out in front of you in one of my regular columns. These three names will be the result of my sifting through e-mails from you during the previous month suggesting stocks for the list.
- Once the three names are out there, readers can send me e-mails arguing for or against each of the stocks. The more readers who comment on a stock, the better chance we have of unearthing important information about the company, both good and bad.
- In my monthly column, Ill report on what this collective research effort has uncovered. Stocks that pass this test will join our standing registry of clean stocks. Stocks that got dinged by readers will fall to the wayside, and Ill say why. (Of course, any reader who subsequently finds out anything about a stock already on the list that might lead to its disqualification can open up the discussion on that stock all over again.)
- Once weve built up a critical mass of clean stocks in our registry, Ill set up a standing portfolio of stocks in the list, with dates picked and performance since that date. Plus Ill add links back to the original column adding the stock. At the same time, Ill also set up a community on MSN Money to discuss these stocks -- so that everyone can see the exchange of information (and so I can unclog my e-mail). Until then, Ill report on the most interesting contributions from readers on the candidate stocks in the updates to my columns.
A sample framework
I think that the standards that we want to hold these stocks to will evolve with the list, but heres a rough starting point.- Executive compensation: Excessive executive compensation, especially massive bonuses for mediocre performance, large personal loans and big grants of options are signs that the board of directors may be asleep. And it may signal that company executives have incentive to manage for short-term goals that line their pockets rather than working to increase long-term shareholder value.
- Accounting: Financial reporting should be as free as possible of one-time charges that make it difficult to get a handle on company performance (and watch out for companies that take one-time charges every quarter). It should give a picture of company performance without the effect of trends outside the companys control such as currency exchange and interest rate changes. Lastly, it should give investors a way to judge the difference, if any, between growth produced by acquisitions and organic growth that comes from the development of existing businesses.
- Conflicts of interest: Theyre everywhere, so were looking for companies that work to control the potential for such conflicts and the potential damage they might cause. Danger signs include entrenched accounting firms that have done the books year-in and year-out and also do massive amounts of consulting work with the company; and a lack of strong outside directors on the companys accounting, compensation and corporate government committees. To that, we add directors with outside business interests that sell or buy from the company, and ownership structures that put the interests of a class of owners at variance with the interests of public shareholders.
- Growth strategies: Growth by acquisition can produce a constant barrage of one-time charges and write-offs that make it impossible to judge company performance. Companies structured as roll-ups where a single competitor acts to consolidate smaller businesses in a fragmented industry are notorious for producing overly optimistic pictures of revenue and earnings growth.
- Corporate structure: A company with a plethora of subsidiaries and off-balance-sheet entities presents a challenge to investors trying to figure out where the cash is coming from and where its going. Transfers of cash between related entities or less-than-arms-length business relationships between related entities present opportunities to hide or distort cash flows. (This, after all, is the point of the exercise in the first place.)
- Potential return to investors: The shares of the company in question should show the potential for outperforming the general market over the long-term.
I expect that readers will suggest other standards to use in defining clean companies and other places to look for danger signs. And Ill add any good suggestions to the list that Ill append to my next progress report.
3 clean stocks to start
Let me kick off our list with three nominees for the registry of clean companies:
Paychex (PAYX, news, msgs). Compensation at this Rochester, N.Y., company is reasonable and actually tied to performance. For example, no bonuses were awarded in 2002. And the company, which doesnt award any options to CEO Tom Golisano, doesnt seem to have succumbed to options-grant fever. Financial accounting is clean and free of one-time charges, although I dont like the fact that auditor Ernst & Young received about $300,000 for auditing services and $2 million in non-auditing fees. The boards audit committee, on the other hand, seems solidly independent and experienced. The only outside entity that I was able to find in the financial footnotes are some investments in low-income housing partnerships that dont seem significant to the companys financial picture. The company has adopted new accounting standards on goodwill and did not show any goodwill on its balance sheet at the end of the last fiscal year.
CEO Golisano is deeply involved in New York politics, and he recently bought the Buffalo Sabres hockey team (from the ruins of Adelphia Communications (ADELQ, news, msgs)). These outside interests, however, dont put him in conflict with the interests of shareholders. It helps, too, that Golisano owns 10% of Paychex and is worth around $1.1 billion. Earnings growth has dropped to 10% with the weak economy, but analysts estimate that the company will recover to a 15% annual rate beginning in the fiscal year that starts in May 2005.
Northern Trust (NTRS, news, msgs). Northern Trust promotes its managers from within: CEO William Osborn is a 30-year veteran of the Chicago-based banking company. That assures the continuity of values and strategy but can create a clubby atmosphere ripe for abuse. Fortunately, Northern Trusts very independent board seems to have this situation in hand. In April 2002 the company replaced its accountant Arthur Andersen with KMPG. CEO Osborn is well, but not extravagantly, compensated (by banking standards): $950,000 and a bonus of $1 million. The bonus was less than the maximum allowed under corporate guidelines. In addition, Osborn received options on 135,000 shares, a big hunk but down from the 150,000 received in 2001 and the 170,000 in 2000. Like the financials of all banks, those of Northern Trust include items for derivatives and various swaps and hedges that can make getting a true picture of the banks finances difficult. But I didnt see anything here that flashed a danger sign. Much of Northern Trusts revenue comes from its trust management division; it has some $1.6 trillion in assets under its custody. After falling this year, projected earnings per share will grow by 18% in 2004 and an annualized rate of 11% for the next five years.
Apache (APA, news, msgs). Apache is really good at getting oil out of the ground, both from mature fields and from new finds like those the company recently announced in Egypt. Thats why the stock has the potential as an investment to wind up on this list. But its the conservative nature of Apaches culture that makes me put the Houston company forward for a list of clean stocks. Apache is among the most conservative oil companies when it comes to accounting for reserves, a big plus because it reduces the likelihood that investors will be disappointed. Financial accounting is just as conservative with the company recording all revenue in U.S. dollars, which eliminates substantial exchange rate fluctuation, and hedging much of recent production. Apaches board isnt especially strong or terribly independent and that is certainly a matter of concern. But with a relatively simple corporate structure and relatively straightforward books, it doesnt worry me excessively.
So those are my three candidates for the first members of the registry of clean stocks.
Rip into them. Turn those financials upside down. Find details that Ive missed. And dont worry about my feelings if you disagree. The point is to put our heads together and come up with the best names that we can -- out of whatever collective wisdom we can muster.
Send me those e-mails on these three stocks. And propose your own candidates for the next group of three.
Ill report next at the beginning of August.
New developments on past column
8 stocks to watch in a wandering market
When I added shares of PepsiCo (PEP, news, msgs) to Jubaks Picks on April 15, I said the stock was cheap -- if the company could deliver the 12% earnings per share growth that Wall Street expects for both 2003 and 2004. Well, after delivering a 13% gain in earnings for the first quarter, PepsiCo has done it again, announcing a 15% jump in earnings per share for the second quarter of 2003. Once again the companys Frito-Lay snack food division powered growth with revenue and operating profit both climbing 6% from the second quarter of 2002. That was below the companys 8% goal because of the costs of switching from oils containing trans fat to more expensive corn oil. PepsiCos North American beverage business turned in 4% volume growth led by double-digit gains in the companys Gatorade and Aquafina brands. Even with the stocks climb in price after the earnings report (it was one of the few gainers Thursday in a down market.), I think PepsiCo remains attractive in this uncertain market. Its predictability deserves a premium. As of July 15, Im raising my target price to $53 a share by December from the recent $46. (Full disclosure: I own shares of PepsiCo.)
10 signals to watch in a pivotal third quarter
Yes, employment is a lagging indicator that wont turn up until the economy is well on the mend, but the continued deterioration of the jobs number is starting to make economists nervous. The latest numbers for the week ended June 28 show the number of people collecting unemployment benefits jumping another 87,000 to hit a 20-year high of 3.82 million. That's especially troublesome because many unemployed workers have exhausted their benefits and arent counted in that number. The number of people filing for unemployment benefits for the first time, whats called initial claims, climbed another 5,000 to 439,000 during the week. Economists had been predicting a drop in initial claims to 412,000 for the week. Theres always a lot of noise in the weekly numbers -- events such as the July 4 holiday and regular summer plant closings in the auto industry skew the numbers. But the negative trend is clearly still in place, and that isnt encouraging for those counting on the economy to deliver 3.5% growth in the third quarter.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Pepsico. He does not own short positions in any stock mentioned in this column.
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