More than half the companies in the Standard & Poor's 500-stock index have reported their third-quarter earnings, and investors are surely relieved that only 14 percent of them fell short of forecasts. According to First Call, that is a slightly better performance than usual.
But while actual earnings may be recovering, earnings quality remains iffy at certain companies. As a result, investors who focus on one figure miss warning signs evident elsewhere in the financial statements.
Ramu Thiagarajan, director of investment research and active strategies at Mellon Capital Management, obsesses about earnings quality. Responsible for all stock-selection research at Mellon, he watches for deterioration that can signal future mishaps at companies. For example, he said, he spotted trouble in financial reports of Enron 10 months before it blew up.
"Most people focus on what happened off balance sheet at Enron," Thiagarajan said.
"But there were quite a few red flags on the financials: gross margins were declining, interest coverage was getting worse, return on sales was deteriorating."
Thiagarajan noted that avoiding disasters could produce better returns for investors than trying to pick big winners. And as one accounting failure after another has unfolded in recent months, investors have begun to reward the stocks of companies whose results still look solid when subjected to scrutiny.
Several companies look vulnerable to Thiagarajan right now. One is Circuit City, the electronics retailer whose stock is now at US$10.39, down 40 percent this year.
he trouble shows up when comparing the company's tepid sales growth with the greater increases in both its inventories and accounts receivable in the most recent quarter.
"Sales have gone up only 9 percent," Thiagarajan said. "But inventory is increasing by 41 percent and receivables have risen by 46 percent. We think that stock could suffer margin pressure."
Another caution light is blinking at King Pharmaceuticals, a maker of prescription drugs. Although its shares have fallen 60 percent this year, Thiagarajan said the stock might decline further, in part because the company shows a worrisome increase in inventories and accounts receivables. Sales have risen 37 percent recently, but inventories are up more than 70 percent and receivables have more than doubled.
Shares of Pulte Homes gained 3.9 percent this year, but Thiagarajan said its inventories were also outpacing sales significantly. Interest expense has almost doubled at the company, compared with only 54 percent growth in earnings before interest, taxes, depreciation and amortization.
Companies with high-quality earnings, in Thiagarajan's view, include H&R Block, the provider of tax and other financial services. At $43.89, its shares are down 1.8 percent this year, but a hopeful sign is that the company's receivables have been falling recently even as its sales have risen. Also, gross profit margins went from negative to positive in the second quarter.
Forest Laboratories, a maker of generic pharmaceutical products, is another favorite. Its sales have risen while accounts receivables have fallen, Thiagarajan said.
Lockheed-Martin, up 21.3 percent this year, holds promise for the same reason. Inventories and accounts receivables have declined while its sales have grown.
Thiagarajan is quick to say that he will surely not be right on all his picks. But his scrutiny of financial statements has served his pension fund customers well recently. A fund that Mellon started last March to reflect his analysis of earnings quality produced gains of 3.5 percent through the end of September. Not bad, considering that the S&P 500 fell 26 percent in the same period.
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