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Posted
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The Speculator
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The Speculator
Count on a company's cold, hard cash
flow
All
earnings are not created equal. Companies that show solid cash flow
from operations, without big increases in inventory or accounts
receivable, pay off much better for shareholders.
By Victor
Niederhoffer and Laurel Kenner
I don’t know how he does it, but he lives like
a king; and he dallies
and he gathers, and he plucks and he
shines, and
when the man dances, certainly boys, what else: the
piper pays him.
Yes sir, yes sir, yes sir, yes sir.
"Rock
Island,” from Meredith Willson’s "The Music Man"
You can talk,
you can bicker, you can boast about the earnings, but when earnings
don’t show in cash flow from operations, you got to be careful if
you don’t want your investments dancing to the wrong
tune.
Companies that report more “accrued” profit than cash
flow from operations perform significantly worse than those with the
lowest accruals. The situation is so bad that James Van Horne,
professor of banking and finance at Stanford, says that when he
evaluates a company, he is tempted to just throw out the accrued
earnings that come from such things as increases in inventories and
receivables. He focuses on cash earnings from
operations.
Investors would be wise to do likewise -- because
increases in inventory and accounts receivable are the very two
elements of accrued earnings that most strongly indicate poor stock
returns in the next year, according to the study by professors Jake
Thomas and Huai Zhang we discussed
in last week's column. Looking at inventory changes, the
difference in performance between the most and least favorable
deciles is on the order of 10 percentage points. For accounts
receivable, the difference is five percentage points.
We
confirmed the professors’ findings with a pencil-and-envelope update
of our own, using the 30 companies in the Dow Jones Industrial
Average ($INDU)
over the past three years. At the end of last year, the five Dow
companies with the biggest inventory increases were:
- McDonalds (MCD,
news,
msgs)
- Caterpillar (CAT,
news,
msgs)
- General Electric (GE,
news,
msgs)
- Merck (MRK,
news,
msgs)
- Home Depot (HD,
news,
msgs)
The
five Dow companies with the biggest increases in accounts receivable
were:
We’ll report details on our Dow
study later on. But first, we’ll explain the accounting issues in a
bit of detail. You don’t need a green eyeshade to understand this
stuff, and an investor who knows a cash profit from an accrued
profit will have a meal for a lifetime. (Microsoft is the parent
of MSN Money.)
Cash comes
first
Let’s start at the beginning. Cash is the first item
on the balance sheet. By looking at its change from one year to the
next, you can tell whether it increased or decreased. But where did
that cash come from, and how was it used? Since 1988, all public
companies have been required to file an audited statement of cash
flows to answer these questions.
In a nutshell, cash flow
from operations is designed to show the cash effects of revenues and
expenses. If a business is to survive, it must in the long run
generate such cash flows. Conversely, if a business constantly loses
cash from its operating activities, who would want to own it?
So what is the main difference between cash earnings and net
income (the “accrued” number usually used and reported by the
media)?
The cash-earnings equation is this: Net income + all
non-cash expenses + decreases in inventory + decreases in accounts
receivable + non-operating losses used in computing net income + any
increases in current liabilities.
The basic equation that
determines this calculation is the double-entry equation:
Assets = liabilities + owners’ equity If we split assets
(the left side of the above equation) into cash and non-cash assets,
we can see that any increase in a liability increases cash, and any
increase in a non-cash asset reduces cash.
(The double-entry
bookkeeping system, followed by all major companies, is designed to
reflect the fact that economic transactions have impact on two or
more than two accounts. For example, if you go out to buy a beer,
your cash decreases and your beer increases. An increase in an asset
or expense is a debit, and an increase in liability or revenue is a
credit.)
The GE
example
Let’s use some selected financial figures from
General Electric for the calendar years 2001 and 2000 to put this in
perspective.
| General Electric |
| Selected financial items* |
Year ended 2001 |
Year ended 2000 |
| Inventory |
$8,565 |
$7,812 |
| Accts receivable |
$9,590 |
$9,502 |
| Sales |
$12,568 |
$12,914 |
| Net income |
$13,684 |
$12,735 | | *All values in millions
Bear in
mind that these are just selected figures, and that we have not
queried GE about these items, as the company still refuses to grant
us an interview. Nor have we been able to question GE about the $56
billion in assets it held in off-balance-sheet “special purpose
entities” at the end of 2001. Thus, this is merely an illustrative,
anecdotal and incomplete picture of GE’s financials.
However,
do note that despite a sales decrease of $346 million, GE was able
to increase its net income by $949 million. This is highly
commendable. However, of this $949 million, $753 million came from
an inventory increase and $88 million came from an
accounts-receivables increase. Taking this $841 million away, the
net increase in earnings was just $108 million.
And that’s
exactly the procedure that’s used by accountants and analysts with
all the other asset and liability accounts to compute the difference
between cash earnings and accrual earnings. (We emphasize that this
is merely a partial picture of GE’s financial statement, and that
the company generated cash flow of $32.2 billion in 2001, up from
$22.7 billion the previous year.)
Our
own accounting
As we wrote last week, the Thomas-Zhang
study used a sample of 39,315 company-years, from 1970 to 1997.
However, the limitation of their sample to companies with complete
and continuously available data, their use of ratios with their
inherent instability, the unavoidable survivor bias of the database
they use and the changes in the market since 1997 make an update
seem highly appropriate.
We tested whether inventory and
account receivable changes are inversely associated with subsequent
price performance for recent years. Since this was an exploratory
study and we wished to use prospective data from a relatively
homogeneous sample, we restricted our study to the 30 Dow companies.
These companies are important in themselves, accounting for some 28%
of the total market value of all U.S.-based publicly traded
companies.
We took the five best (those with the greatest
decreases) and the five worst (those with the greatest increases) in
inventory and accounts receivable for each of the two years. The
performance for 2002 is not yet in, of course -- but here are the
next-year results for the warning-flag companies of 2000 and
2001:
| Total % return in next
year* |
|
2000 |
1999 |
| 5 greatest inventory increases |
-7 |
-17 |
| 5 greatest inventory decreases |
-1 |
12 |
| 5 greatest accts receivable increases |
-1 |
-18 |
| 5 greatest accts receivable decreases |
4 |
6 | | *Price appreciation + reinvested
dividends
The results show that in the year
following a big increase in inventory or accounts receivable, a
company's performance was highly inferior, with returns of some -10
percentage points.
For the companies with the greatest
decreases in inventory and accounts receivable, the performance in
the next year was relatively good, with returns averaging about 5
percentage points.
Because there were only 20 companies
involved, and the results are highly variable and subject to much in
the way of ever-changing cycles, the odds are only about 20 to 1
that these results could not be attributed to chance variations
alone.
However, we have ranked the 30 Dow companies for
year-end 2001 on both the inventory and accounts-receivable scales,
from best to worst. The three winners were International
Paper (IP,
news,
msgs),
Honeywell (HON,
news,
msgs)
and Eastman-Kodak (EK,
news,
msgs).
The three losers were McDonald’s, Wal-Mart and Home Depot.
The full list appears below:
| Dow 30, Rated by change in inventory
& receivables (best to worst)* |
| Company |
Inventory Change |
Inventory Rank |
Receivables Change |
Receivables Rank |
Combined Ranking (most attractive
to least attractive) |
Stock Chg YTD |
| Int'l Paper (IP) |
-14.1 |
2 |
-22.8% |
3 |
5 |
-7.7 |
| Honeywell (HON) |
-10.1 |
3 |
-21.7% |
5 |
8 |
-9.3 |
| Kodak (EK) |
-33.8 |
1 |
-11.9% |
8 |
9 |
1.1 |
| Alcoa (AA) |
-6.4 |
9 |
-25.5% |
2 |
11 |
-32.3 |
| Hewlett-Packard (HPQ) |
-8.7 |
7 |
-22.1% |
4 |
11 |
-30.7 |
| 3M (MMM) |
-9.6 |
5 |
-14.1% |
7 |
12 |
7.2 |
| Intel (INTC) |
0.5 |
15 |
-36.9% |
1 |
16 |
-48.3 |
| Disney (DIS) |
-4.4 |
11 |
-7.1% |
11 |
22 |
-21.7 |
| Boeing (BA) |
-3.2 |
12 |
-6.6% |
12 |
24 |
-3.2 |
| DuPont (DD) |
-9.5 |
6 |
7.4% |
21 |
27 |
-1.8 |
| General Motors (GM) |
-8.3 |
8 |
7.1% |
19 |
27 |
-1.6 |
| Procter & Gamble (PG) |
-3.0 |
13 |
0.7% |
15 |
28 |
17.8 |
| United Technologies (UTX) |
5.8 |
19 |
-7.9% |
9 |
28 |
-4.9 |
| IBM (IBM) |
-9.7 |
4 |
14.0% |
25 |
29 |
-37.5 |
| Johnson & Johnson (JNJ) |
3.0 |
17 |
0.6% |
14 |
31 |
-5.6 |
| Philip Morris (MO) |
1.8 |
16 |
2.6% |
17 |
33 |
6.0 |
| Exxon (XOM) |
-4.8 |
10 |
11.3% |
23 |
33 |
-10.4 |
| Caterpillar (CAT) |
8.7 |
21 |
-0.6% |
13 |
34 |
-16.4 |
| Coke (KO) |
-1.0 |
14 |
7.1% |
20 |
34 |
8.6 |
| General Electric (GE) |
9.6 |
22 |
0.9% |
16 |
38 |
-27.2 |
| Merck (MRK) |
18.5 |
23 |
3.9% |
18 |
41 |
-14.8 |
| McDonald's (MCD) |
6.2 |
20 |
10.7% |
22 |
42 |
-19.4 |
| Wal-Mart (WMT) |
5.5 |
18 |
31.8% |
26 |
44 |
-5.1 |
| Home Depot (HD) |
19.4 |
24 |
42.2% |
27 |
51 |
-35.0 | | *Excludes financial firms and companies without
inventory.
We conclude that you gotta know the
accounts receivable and inventory territory if you’re going to make
music in the market.
Thomas, who teaches at Columbia
University, and Zhang, from the University of Illinois at Chicago,
have continued to do groundbreaking work. Zhang, working with a
colleague, professor Somnath Das, has been looking at how companies
report fractional earnings per share. (Rounding to the nearest cent
is required. A company with actual EPS of 4.4 cents will report EPS
of 4 cents, while a company with actual EPS of 4.5 cents will report
EPS of 5 cents.) If everything took place by chance, with no
earnings management, we would expect a coin toss: 50% of companies
would round up reported EPS and 50% would round down. It turns out,
however, that 54.4% of companies “round up.” Says Zhang: “The 4.4%
above 50% cannot be explained by anything other than earnings
manipulation.” Zhang and Das also found that the rounding-up
proportion is significantly higher when earnings are close to
analysts' forecasts, consistent with the notion that managers have
the incentive to round up reported EPS to meet analysts’
expectations.
Thomas, meanwhile, has been looking at the
equity premium -- the amount in excess of the “risk-free” return of
U.S. Treasury bills that investors demand as compensation for the
risk of investing in stocks.
Final
note
Vic was in Akron, Ohio, last weekend, to celebrate
the induction of his Harvard roommate, Jim Wynne, into the Inventors
Hall of Fame. Wynne, with Rangaswamy Srinivasan and Samuel Blum,
invented the excimer process of the ultraviolet excimer laser used
to perform eye surgery. This year’s inductees also included the
inventors of the implantable defibrillator (Stephen Heilman, Alois
Langer, Morton Mower and Michael Mirowski); catalytic converter
(Rodney Bagley, Irwin Lachman, Ronald Lewis); three-point safety
belt (Nils Bohlin); and the Kurzweil Reading Machine, which
transforms print into computer-spoken words (Raymond Kurzweil).
Posthumous awards were given to the inventors of aspirin (Felix
Hoffman); the ENIAC computer (J. Presper Eckert Jr. and John
Mauchly); and the Bessemer Steel Process (Henry
Bessemer).
The inventors all made the point that the pace of
innovation is increasing and that the encouragement and
dissemination of inventions is America’s greatest resource and hope.
Kurzweil, who has founded nine publicly held companies to distribute
his inventions, was particularly optimistic. He looks for the pace
of invention to keep accelerating exponentially in the next 20
years, and for advances in artificial intelligence and biology to
yield enormous human betterment. What a cause for optimism for the
future, and what a contrast to the black, bearish forecasts making
their way around the world for the prognosis of American enterprise
in this century.
At the time of publication, neither
Victor Niederhoffer nor Laurel Kenner owned or controlled any of the
securities mentioned in this article.
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