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Posted 9/26/2002













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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"

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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: 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.




MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.