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T. Rowe Price, Stryker make 'Clean Stocks' list
A fund company with squeaky-clean books and a fast-growing medical equipment maker are the newest members of the club. Heres why -- and why Equifax didn't make it.
By Jim Jubak
Can investors ever prove that a stock is clean?
Probably not. No matter how hard you research a company, you can never produce a 100% guarantee that someone -- the CEO, the accountants, the board -- isnt conspiring to fake the quarters numbers.
In fact, if theres a company out there without even a tiny skeleton in managements closet, Ive yet to meet up with it.
Thats why I launched my Clean Stocks project as a collaborative effort between myself and readers to build a list of stocks that investors can trust. Putting a company through tests like those readers and I have developed over the last three columns exposes a companys character.
I couldnt ask for a better illustration of a company with great character than T. Rowe Price (TROW, news, msgs), one of the three stocks nominated in my last column on Clean Stocks -- 2 more companies pass Clean Stocks test.
Every day brings a new disclosure that some mutual fund company sold out its shareholders by letting hedge fund managers and other professional investors make money by buying and selling shares of their funds after the stock market had closed. Obviously, I cant be 100% sure that T. Rowe Price isnt part of the scandal. But Im as certain as one can get that I can trust the company when it says it isnt part of that mess.
Officials from the mutual fund company have said from nearly day one that they arent part of the scandal, and I believe them. And judging from my e-mail, so do the readers of this column.
I had three stocks to choose from for this round -- T. Rowe Price, Stryker (SYK, news, msgs) and Equifax (EFX, news, msgs). Of the three, Equifax didnt make the cut. Next rounds nominees are Trustmark (TRMK, news, msgs), Southwest Airlines (LUV, news, msgs) and Walgreen (WAG, news, msgs).
But now on to this rounds selections.
T. Rowe Prices shares: investor-friendly
As a mutual fund company, T. Rowe prides itself on being investor-friendly. I think you can say the same thing about the companys own shares. The fund companys selling proposition is pretty simple: Produce solid investment returns and charge low fees and customers will buy your products. In its review of the companys funds, Morningstar calls T. Rowe Price one of the most investor-friendly fund groups around. But with big fund companies such as Janus Capital Group (JNS, news, msgs) and Strong Capital Management and the mutual fund divisions of Bank of America (BAC, news, msgs) and Bank One (ONE, news, msgs) all entangled in the after-market trading scandal, even investor-friendly fund companies are facing new scrutiny.
(In this scandal, mutual fund companies allowed traders to buy and sell shares of their mutual funds after the 4 p.m. close of the stock market -- but at 4 p.m. prices. That let traders make money on any news that moved the price of the stocks in the funds portfolio but not reflected in the funds 4 p.m. price. In exchange, these traders would invest assets with the mutual fund company, letting the mutual fund company earn management fees on those assets. Everyone made money except the investors in the mutual funds themselves who often had gains sucked out of their pockets into those of traders.)
What did T. Rowe Price say when Wall Street stock analysts asked if the company was about to be implicated in the industry scandal? That it didnt participate in late trading, frequent trading or insider trading. It also pointed out that contracts with third-party distributors dont allow such arrangements. And because the company sells many of its funds directly to investors and without sales charges, there are very limited incentives for T. Rowe Price to make deals with distributors at the expense of investors in the funds.
Do you, an investor interested in buying shares in T. Rowe Price itself, believe company management? Certainly the last thing any investor wants to do is buy shares of T. Rowe Price as a way to play the recovery in the equities markets and discover that the company is under investigation by New York Attorney General Eliot Spitzer and the U.S. Securities and Exchange Commission (SEC).
Thats where a Clean Stocks examination of T. Rowe Price can help.
If you apply our check list to T. Rowe Price, you find a squeaky-clean company that walks the talk. For example, management compensation, for any investor reading about what the New York Stock Exchange paid former Chairman Richard Grasso, is amazingly modest. Chairman and President George Roche, who started with the company as an equity analyst in 1968, earned $300,000 in salary in 2002 and received an additional $1.6 million in bonuses. Stock options? None. In fact the biggest grant of options to any member of the management team in 2002 was just 50,000. The upper management team got just under 2% of all options granted in 2002. (Charging all the options granted to management and employees by T. Rowe Price in 2002 as a compensation expense would have reduced earnings by 21 cents a share to $1.31 from $1.52.)
Not just one auditor but two
On the auditing front, another area where investors are rightly looking for conflict of interest, same picture: squeaky clean. In September 2001, the company changed accounting firms because the independent directors on the board decided it was a good idea to have different firms audit the individual mutual funds and the parent company as a whole. PricewaterhouseCoopers remained the auditor for individual funds, and KPMG was hired to audit the parent companys books. In 2002 the company paid KMPG $284,000 for auditing and $734,000 for consulting.
And so on down our checklist. The important audit and compensation committees of the board of directors are composed totally of independent directors -- and the independent directors, judging from their bios in the companys proxy, really are independent. The company has relied on organic growth rather than acquisitions, which minimizes the tricks a company can play with its books. Not that I found any tricks: The company has used cash flow to pay down debt until the debt-to-equity ratio stands at a minuscule 0.01. Cash flow has also gone toward increasing the dividend to 68 cents, a 1.7% current yield. Dividends have grown by an average of 16% annually over the last five years.
Now how about the last item on our list? T. Rowe Price may be a Clean Stock, but is it a good investment? The company has launched new products to attract third-party distributors that will open up new marketing channels for the companys funds. The revival of the stock market has brought money back into equity mutual funds, $18 billion in August alone. And the company is sitting on enough cash so that it is in a good position to make bite-sized acquisitions as the mutual fund industrys consolidation continues. Wall Street is looking for earnings to grow 39% in the third quarter of 2003, 31% in the fourth quarter, and 23% for all of 2004. Long-term, this looks like a solid investment in the recovery of the asset management business.
Capitalizing on the needs of an aging population
Stryker, which makes specialty surgical and medical products, also makes the Clean Stocks list -- although there are a few blemishes Id like to bring to everyones attention. About 30% of the Kalamazoo, Mich., companys stock is owned by the Stryker family trusts. (For more, click here.) And Rhonda Stryker, granddaughter of founder Homer Stryker, is a director and chairs the compensation and governance committees. That kind of concentrated ownership bloc always creates the potential that a single group of shareholders will pursue policies that arent in the interest of general shareholders.
But the arrangement hasnt had any deleterious effect on compensation that I can see: CEO John Brown received a salary of $875,000 and a bonus of $925,000 in 2002 plus 50,000 options. Thats certainly defensible given Strykers growth record during the 26 years that Brown has been at the helm. (The company seems to have a succession plan in place: Stephen MacMillan, a pharmaceutical industry veteran, was appointed to the newly created positions of president and chief operating officer in April 2003 and appears to be the heir apparent.)
Stryker reported sales of $3 billion in 2002 and seems on track to hit $3.4 billion this year. The companys growth engine is the orthopedic implants division, which makes up 59% of sales; its riding the aging of the general population. Sales in that division are projected to climb by 18% in this years third quarter with corporate earnings estimated to climb 25% in the period. Revenue is projected to grow 12% in 2004 with earnings climbing 20%.
Complex accounting knocks Equifax off
I cant put the third nominee, Equifax, on the list -- much as Id like to. The company owns 40% of the credit-reporting market and is one of the most profitable companies in the Standard and Poors 500 ($INX). Return on equity has averaged 65% over the last 5 years.
But with the companys core credit reporting market near maturity, Equifax has looked for growth both internally and through a set of acquisitions that has made the companys accounting more opaque than I think the Clean Stocks rules permit. For example, the June 30, 2003, balance sheet shows goodwill for these acquisitions of $700 million. That is a huge amount for this squishy accounting category, considering that the companys total assets were $1.6 billion.
When Equifax acquires a company, the accounting can be very complicated. Heres an explanation from the 10Q for the June-30 quarter: We acquired all of these businesses for $42.7 million primarily in cash, allocating $21.2 million of the purchase price to goodwill, $15.3 million to purchased data files, and $6.2 million to non-compete agreements.
Dig deeper in the companys books, and youll come up against other practices that make it difficult for investors to understand exactly whats going on. For example, as of June 30, the company was using interest-rate swaps to fix the interest rate on the $29 million synthetic lease on its corporate headquarters. (A synthetic lease is a real estate transaction that looks like a lease for accounting purposes and a loan for tax purposes. It essentially lets a company get real estate debt off the books.) Derivatives like these swaps and synthetic leases complicate a companys books, to say the least. Hedges like the swap make it hard to judge the volatility of a companys earnings and interest payments. Synthetic leases distort the picture presented by the balance sheet.
Just too much going on in Equifaxs books to get this one onto the Clean Stocks list.
Okay, thats this months report on our progress in building a Clean Stocks list. Membership is now up to six:
Most of these are fully and even overpriced at the moment, and I wouldnt make them immediate buys. But I have added Applebees International to Jubaks Picks, and, with this column, Im adding Paychex as well. I think each of these stocks is at a good purchase point given current market and economic conditions.
Remember the nominees for the next round are Southwest Airlines, Trustmark and Walgreen. Until then, keep those e-mails on these three nominees and new stocks to consider for the next round of Clean Stocks coming in. Youll find the e-mail address at the very end of this column.
And, of course, if you learn or know anything about a stock already on the Clean Stocks list send it along. Even the clean can get dirty with time, and investors cant let any stock get by on reputation.
Sell Sysco
Im selling Sysco (SYY, news, msgs) out of Jubaks Picks, not because anything important has changed with the company but, because the economy has changed. When I bought these shares in September 2002, the companys very solid double-digit earnings growth quarter-in/quarter-out looked extremely attractive in an uncertain economy. But now that the recovery is clearly on track, I think its appropriate to get a little more aggressive about growth in a portfolio like this one that invests for the next 12 to 18 months. (This sell goes along with a buy of Paychex (PAYX, news, msgs).) Long-term holders of Sysco dont need to sell at this point. The stock remains in my 50 Best in the World long-term portfolio, although I wouldnt add more shares at this point. Im selling with a 9.4% gain since I added the stock to Jubaks Picks on Sept. 13, 2002. (Full disclosure: I will be selling my personal position in Sysco three days after this column is posted.)
Buy Paychex
Im adding Paychex (PAYX, news, msgs) to Jubaks Picks as a double-barreled play on (1) the economic recovery finally beginning to add jobs and (2) outsourcing of back-office jobs such as payroll as companies in the United States and Europe continue to look for ways to cut costs. This recovery is still generating jobs as a lower rate than the average recovery, but it looks as if it is finally starting to produce more jobs rather then shedding them. Thats good for Paychexs payroll business, which sees revenue accelerate when companies start adding workers. Earnings per share, which have been flat lately, are projected to grow by better than 15% on average over the next 5 years. Some of Paychexs businesses, like its bread-and-butter Taxpay product, look like theyve matured. Still, theres plenty of growth left in the outsourcing market for a company like Paychex. The company has been moving into new sectors in the United States such as retirement services, and its just starting to build up business in Europe. (Paychex is also a member of the Clean Stocks portfolio. For more on Paychex from that perspective, see my Aug. 1 column Our first 'Clean Stocks:' Apache and Paychex.) Im adding the stock to Jubaks Picks with a December 2003 target price of $43 a share. (Full disclosure: I will be adding shares of Paychex to my personal portfolio three days after this column is posted.)
New developments on past columns
2 more companies pass Clean Stocks test
Is there a material problem at Applebees serious enough to take it off the Clean Stocks list? After I put the stock on the list, one reader sent me an outraged e-mail taking me to task for ignoring the problem on the companys board. I didnt ignore it; I just didnt regard it as material given everything else I know about Applebees. But here are the facts. You should make up your mind for yourself. Mark Hansen sits on Applebees board of directors until 2005. He is the former CEO of Fleming Cos. In March, he was asked to resign by Flemings board in the midst of a Securities and Exchange Commission investigation into the way Fleming accounted for vendor discounts and for some sales transactions. Hansen came to Fleming in 1998 after five years at Federated Foods in Chicago, eight years as president and CEO of PetsMart (PETM, news, msgs), and a year as president and CEO of the Sams Club unit of Wal-Mart (WMT, news, msgs). In Hansen, Applebees gets a director with extensive food industry and retail experience but whose record on corporate governance at Fleming doesnt build confidence. He is one of nine directors. Make up your own mind. Ive sent a letter to Applebees asking for their thinking on Hansen as a director, and Ill share that response with readers.
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.
E-mail candidates for the Clean Stocks list to Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equity mentioned in this column: T. Rowe Price. He does not own short positions in any stock mentioned in this column.
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