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Jubak's Journal
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| | Jubak's Journal
Our first 'Clean Stocks:' Apache and Paychex
In our search for companies that won't embarrass investors, two survive reader scrutiny and one doesn't. Heres why, plus three more to consider.
By Jim Jubak
Well, I asked for it.
In mid-July, I nominated three stocks -- Apache (APA, news, msgs), Northern Trust (NTRS, news, msgs) and Paychex (PAYX, news, msgs) -- to form the foundation for my new Clean Stocks Portfolio. Then, I prodded readers to suggest their own candidates for the portfolio and take potshots at mine. Boy, did they ever.
Two of the stocks survived the scrutiny, one was tossed off the island. First, a little background. I created six guidelines to judge stocks trustworthiness. Today, Im adding a seventh. (To read the original column, click here.)
To the original guidelines (which you can view by clicking here), add this standard:
Options accounting. Companies should engage in modest use of options and accounting that honestly tries to account for options as compensation.
Readers anger on this issue is palpable. The role of options in creating the incentives for management to lie to shareholders at Enron (ENRNQ, news, msgs), Lucent Technologies (LU, news, msgs), Xerox (XRX, news, msgs) and other companies has made a lasting impression on many investors.
Im still wrestling with an eighth standard on pension accounting suggested by a reader: Companies with defined-benefit pension plans that are clearly understating the size of their future pension liabilities should get the ax.
What do you think? Let me know by e-mail for the next monthly report on the Clean Stocks portfolio.
Lastly, a big thanks to the hundreds of readers who critiqued my nominees and offered their own suggestions for the next round.
Why Northern Trust goes and Paychex and Apache stay
OK, back to my selections. Paychex and Apache made the cut; Northern Trust didnt. Lets deal with the objections to Northern Trust first.
I received a number of e-mails critical of Northern Trust. Some were critical for reasons I cant judge because I have no way of putting them in a larger context. One characterized initial discussions about opening a trust account at Northern Trust as so chaotic that the bank lost the e-mailers business.
Other criticisms were arguable. (Thats a polite way of saying I disagreed, and, as the referee of this endeavor, I get to make the final call.) Said one reader: No matter how honest their financial reporting, that still doesn't obviate the need for a successful business to back it up. I'm sure you know their principal competitor, U.S. Trust, has now been fully integrated into Charles Schwab & Co. (SCH, news, msgs), and is now beginning to eat into Northern Trust. I have more than one client that has moved assets from Northern to U.S. Trust this year, and I am in the process of assisting another even now. I believe this trend is going to accelerate as U.S. Trust is integrated even further into the Schwab corporate structure and begins to leverage the low cost structure at Schwab, not to mention the technology.
Frankly, I dont see Schwabs U.S. Trust acquisition as such a serious threat to Northern Trust, and I think the company has plenty of new business to go after as it moves into the New York market. So is the potential return that the rules required adequate or not? To me, yes; to this reader, no. And so Im sharing the disagreement with you.
Its the options
But that disagreement isnt what booted Northern Trust from the list. Options did. Northern Trust doesnt account for options as employee compensation. (To paraphrase Warren Buffett: If options arent compensation, what are they?) Its unreasonable to toss every company from the Clean Stocks portfolio that fails to expense options, but it is reasonable to shun companies where the method of accounting for those options creates a significant difference between the reported earnings and what earnings would be after options were expensed. And thats the case at Northern Trust. (For the record, Im not a purist on the issue: Both Apache and Paychex use options and dont expense them. But in both cases, the accounting treatment of options does not significantly change the financial picture of the company.)
In government filings, Northern Trust noted in a footnote that earnings per share would have been $1.73 in 2002 if options were expensed instead of the fully diluted $1.97 the company reported. Not only did the failure to expense options inflate earnings per share by 24 cents, or about 14%, but it disguised the degree to which earnings declined at Northern Trust from 2001 to 2002. Using the reported numbers, earnings per share dropped 7% in 2002. Using earnings with options expenses, earnings per share dropped 10%. And Id argue that the importance of that number even exceeds that extra 3 percentage point decline. In a year when business was lousy for banks and investment companies, Northern Trust saw its options expense climb by almost 8%. Thats not the kind of cost-cutting an investor would like to see in tough times.
Paychex, which handles payroll and benefits for small businesses, made the Clean Stocks portfolio despite some blemishes. Some customers griped about its business methods. For example, one e-mailer, the controller of a company that does business with Paychex, complained that Paychex took five days to deposit 401(k) money from its customers. And Paychex got the profits from that five-day float -- just as banks do when they take five days to clear a depositors check.
But more directly related to the kind of tests that the Clean Stocks portfolio requires is the huge jump in goodwill on Paychexs balance sheet because of the acquisition of Advantage Payment Services in September 2002. Goodwill increased to $243 million in the quarter ended Feb. 28 from zero in the quarter ended in May 2002. Goodwill is the accounting entry that a company uses to make up the difference between what it pays for a company in an acquisition and the market value of those assets. According to the new accounting rules governing goodwill, Paychex wont be able to amortize that goodwill annually. Instead, it will use an impairment test to see if the value of the asset has declined so that Paychex needs to take a charge against that good will. That increases the accounting uncertainty in Paychex in any future downturn in the economy or its business. But its not enough to keep this stock out of the portfolio. Paychex is, in my opinion, good enough.
Is Apaches accounting conservative or not?
Many e-mails that I received on Apache praised the stocks past performance and felt the energy company was well-positioned to outperform in the years ahead. (The stock has posted an average annual return of 14% a year for the last 10 years and gets an 8 currently from our StockScouter. Click here for more.) Management, many readers felt, did a great job of controlling costs and wringing the most out of each dollar.
But two e-mails challenged my description of Apaches accounting as conservative. J. Mooney wrote, I disagree with your statement concerning Apaches conservative accounting. I would argue that the full-cost method of accounting for oil & gas reserves that Apache utilizes (similar to Devon Energy (DVN, news, msgs) and Anadarko Petroleum (APC, news, msgs) is more aggressive than the successful-efforts method, which is utilized by Royal Dutch Shell (RD, news, msgs), Exxon Mobil (XOM, news, msgs) and Burlington Resources (BR, news, msgs). The full-cost method prescribes that companies capitalize (and amortize) the cost of drilling dry holes, or unsuccessful wells. Accordingly, companies utilizing this method are booking assets for wells drilled that wont produce commercial hydrocarbons.
Another reader, Phil, seconded that opinion and added a little historical perspective. Most large oil companies use successful-efforts accounting, in which unsuccessful drilling ("dry hole expense") is written off as incurred. Full-cost accounting was originally intended for small companies to prevent violent quarter-to-quarter moves in earnings.
Thats exactly the kind of knowledge I hoped to elicit when I asked readers of Jubaks Journal to join with me in putting together a Clean Stock portfolio. And now its up to you to decide if Apaches accounting methods are enough to keep you away from the stock. Im comfortable with it in the portfolio.
My decision is based on a subjective judgment about the world of stocks and the companies that issue them: I dont believe there are any perfect companies out there. If thats true, then companies like Apache and Paychex are good enough.
I readily admit that my judgment is based on a very small sample. I havent checked all or even a majority of stocks to see how they measure up against my seven (maybe eight rules) and up against these two imperfect companies.
Giving that subjective opinion more objective evidence to back it up is part of what this effort is all about. Even when a stock doesnt make the list or even when you dont agree with my decision on adding it or not, I think this kind of analysis helps to identify the risks in owning a Paychex, an Apache or a Northern Trust.
And the process will get better as we go along and have more companies to compare. So on to the next round.
Three new stocks to chew on
I received almost 70 nominations for the second round of the Clean Stocks portfolio. From that list Im picking three stocks for next months analysis:
- Expeditors International (EXPD, news, msgs), which provides freight services ranging from freight forwarding to customs brokerage.
- Applebees International (APPB, news, msgs), which operates the Applebees restaurant chain.
- Paccar (PCAR, news, msgs), the big truck builder. Brands include the Kenworth and Peterbilt truck lines.
All the other nominees will go up against next months suggestions.
So send in what you know about those three stocks. Do they meet the test? Are they clean enough? E-mail me with your facts and opinions.
And send me your ideas for the next round as we keep building the Clean Stock portfolio.
Guidelines for trustworthy companies
- Reasonable CEO compensation as a sign that the board wasnt asleep and that management was aligned with shareholder interests.
- Clean books that used conservative accounting practices and avoided gimmicks like off-balance sheet entities.
- No conflicts of interest so that accountants, management, and Wall Street didnt have extra incentive to hide or distort the numbers.
- Simple growth strategies that minimized a companys wiggle room on accounting and reporting.
- Clean corporate structures that made it easy to tell where the money was coming from and where it was going.
- And enough potential return to investors to make owning this paragon of virtue rewarding over the long term.
- Companies should engage in modest use of options and accounting that honestly tries to account for options as compensation.
New developments on past columns
Six reasons to take your profit now
So far, so good, but the stock market isnt out of the woods yet, two of my favorite technical analysts are saying. Dan Sullivan, editor of The Chartist, says that the Standard and Poors 500 ($INX) hit a wall just above 1,000 at 1,012 on June 17. In the 29 trading sessions since then, the index has been stuck in a very narrow trading band no more than about 2% to 3% wide. Thats consistent with a market thats digesting the gains of the recent rally. So far, none of the major indexes has broken below major support. Recent moves up have been quickly blunted, says Phil Erlanger, editor of Erlanger Squeeze Play, and so have down days. A market thats moving in a very narrow and gradually narrowing range, he reports, is usually resolved by a larger move either up or down. In short, the rally hasnt broken down, but the probability of substantial volatility, up or down, is increasing.
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.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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