Spear Report editorial for this week
Cooking the Books
Executive Summary
Using actual profits and the price to sales ratio rather than pro forma or operating earnings, is a good formula for bear market performance and leads us this week to profile two food stocks. Profiles include Dean Foods (DF); up 20% over the past 5 years while the S&P is down 30%, and American Italian Pasta (PLB). Continuing our gold coverage, we also discuss new Consensus name Kinross Gold (KGC) and add a rare consensus penny stock, McLeod USA (MCLD).
Detail
These days it makes sense to be skeptical about everything associated with Wall Street, especially finan-cial reporting from companies. Individual investors need valid measures of real financial health. This week we discuss the concept of actual earnings as opposed to pro forma or operating earnings, and we discuss another practical yardstick for the skeptical investor- price to sales ratio.
We have all heard the maxim that stock markets look ahead and try to anticipate and reflect financial realities 6-9 months down the road. But the truth is that by some measures, not even the actual financial results of the past few years are accurately reflected in stock prices. During the bubble of the 90's a quiet shift was made on Wall Street in regard to how Fortune 1000 profits were calculated. Not only was the concept of "forward earnings" introduced, but we were also introduced to a great deal of creative accounting, with financial statements loaded with "one time charges" and pro forma profits.
Every week we get reports of new accounting shenanigans from Enron or Tyco or some other major corporation now under forensic accounting scrutiny. Three years into the post-bubble world, investors are still struggling for access to clear, standardized and appropriate financial statements for large, publicly held companies.
Doug Cliggott, former chief strategist for JP Morgan Chase, and the only major Wall Street strategist to correctly call the successive stages of the bear market, differs from 99% of Wall Street analysts because he focuses on actual corporate profits, not on one of the many definitions of pro forma or "operating earnings" accepted by most strategists and institutional investors. Cliggott believes that to exclude what are often massive one time charges over an entire economic cycle to arrive at pro forma or operating earnings is equivalent to cooking the books. In 2001, for example, operating earnings for the S&P 500 totaled $38.85 per share, but actual reported profits after writeoffs were less than $25. In 2002, operating earnings are estimated at about $49, but reported earnings may total just $36, and may reach $40 in 2003, if this is a good year. A P/E of 16, which is near the long-term average, on $40 in actual earnings corresponds to an S&P level of 640 vs. today's level of 823, showing that by this measure, the market is still sharply over-valued.
But in these difficult times, value-oriented investors may wish to take it one step further and discount bottom-line earnings numbers, focusing instead on the top line, which is revenues. That means including the more con-servative price/sales ratio (P/S) in addition to the price/earnings (P/E) ratio. Creating phony sales on a balance sheet is possible, but it is much harder to do than getting creative with earnings, and can much more easily earn a CFO some serious jail time. According to one study of 43 years of data, stocks that combined low P/S ratios with positive price momentum beat the broader market on an annual basis 77% of the time, posting average annual returns of 18.4%, compared with 13% for the broader market. But we have hints of even more interesting statistics
One of the most interesting aspects of New Consen-sus is that we are starting to see some of these high P/S names percolating to the top of our PWR lists. When you look at price to sales ratios you get into an area of invest-ing that most growth stock investors are not familiar with, namely low margin businesses such as food. But when you combine the two measures of sales and price performance, you get great looking charts that are not particularly sensitive to economic cycles. Is that a good thing in these turbulent times? You bet. Maybe your portfolio could use some highly stable names to cushion volatility? Look to consumer staples, but not just any consumer staple. That's where New Consensus shines.
Got Milk?
For example, on this week's Top 20 Buy List we find Dean Foods (DF). Dean is one of the US's largest producers of dairy products, pickles and other specialty foods and beverages.
DF has an impressive BearPWR score of 61, which indicates that the sources currently recommending it have done exceedingly well over the last three years.
Those sources include two AAII screens (Cash Flow and Oberweis) and S&P's The Outlook. DF, therefore, has passed muster on multiple fronts: tons of positive free cash flow, rapid sales and income growth, and a rea-sonable PEG ratio (price to earnings ratio divided by the company's earnings growth rate). In addition, the Cash Flow screen has one of the best 3 year track records of any source we follow.
Dean is a savvy marketer and just signed skate-board legend Tony Hawk, the second most familiar sports name behind Michael Jordan, to a promotional contract for HERSHEY'S milks and milkshakes. This is the guy that can spin around on a skateboard two and a half times in mid-air and made Activision (ATVI) a competitor to Electronic Arts (ERTS).
Dean is a $3.7 billion market cap company with a P/E of 14, and sales of $9 billion, up 50% after a recent merger. If you look at a monthly chart of DF you see a stock in the process of making a slowmotion breakout to new all time highs, but not over extended. True, DF shares are trading just a little higher than they were 5 years ago, but in times when the stock market, as meas-ured by the S&P 500, is down 30% from its 1998 highs, that's pretty impressive.
This past Thursday, DF reported quarterly net income of $63.1 million, or 63 cents a share, compared with $23.7 million, or 37 cents a share, a year earlier. Interestly, those results included a variety of "one time charges" such as plant closings. The company operates over 120 plants in 38 U.S. states and in Spain, employing more than 30,000 people. Sales rose 39% to $2.24 billion from $1.61 billion. For the full year, Dean reported net income of $175.4 million, or $1.81 a share, up 60% from $109.8 million, or $1.78 a share, for 2001.
DF is also using it's cash to buy back shares, which indicates a high degree of confidence by the company in its own future. It repurchased more than 2.75 million shares during the last quarter and has bought back 3 million more so far in 2003. That means that DF was buying back its own shares near all time highs! That is in sharp contrast to 99% of Fortune 1000 companies, where insiders are selling like crazy or modest share repurchases occur in broken stocks from very depressed levels just to boost investor confidence.
At a time when money market funds are paying 1% annually, safe stocks like DF start to look very attractive, especially to mutual fund and pension fund managers. As individual investors, we want to follow in the footsteps of these "elephants" and catch the new investing trends as early as possible. Food is in.
Mama Mia
American Italian Pasta Company (PLB), P/E 18, selling at a little over 2 times sales, is a producer of more than 175 dry pasta shapes in vertically integrated milling, production and distribution facilities in the United States and Italy. Unlike most companies in these uncertain times, PLB is actually expanding operations. For the fourth calendar quarter '02, revenues rose 16% to $107.0 million and net income rose 1% to $8.9 million. The company sells to Wal-Mart and Sysco. On its recent conference call, the company guided expectations for revenues and EPS growth higher for 2003, 13% to 18% EPS and 15% to 22% revenue growth. The company is also repurchasing shares.
Equally interesting for traders is the fact that 27% of the float is short. That is a very large bet against this company, which will take 31 days to cover at an average volume of 156k per day. PLB has been in a cash flow pinch but the situation seems to be getting better. In January they reported a 78% improvement in that department. This is the recipe for a classic short squeeze, wherein price begins to go up, forcing shorts to buy shares to exit their positions, and this buying pressure forces prices up still higher. That means the dough rises.
Gold Fever
This is a time to be defensive in one's exposure to equities. That does not necessarily mean reducing exposure, but it does mean allocating capital to sectors that trade counter to the main indices. Gold stocks are the classic portfolio counterweight and act as a hedge, reducing volatility and producing gains. While Wall Street brokerages would like you to believe that a new bull market started in October of 2001, the charts say that the equity bear market is still intact and the new bull market is in gold and gold stocks.
When we first started getting names from the New Consensus screens back in November of 2002 we were very excited to find it laced with gold stocks. That was an unusual and quite prescient message. Gold stocks have been consistent performers since then and New Consensus has been sifting through them over the intervening months. The mix of names has changed and one in par-ticular is a standout now.
We are speaking of Kinross Gold (KGC). Kinross is merging with Echo Bay (ECO) and TVX (TVX) to become the seventh largest primary gold producer in the world. Kinross is the only senior North American based gold producer with both a strict nonhedging policy and less than 5% of reserves hedged. Hedging gold reserves, which usually means selling forward at guaranteed prices, is a way for gold miners to smooth out cash flow and protect from market fluctuations. During the very long bear market in gold, that was a good idea. Now that gold prices are rising, the hedged producers are underper-forming their unhedged peers.
Kinross (KGC) responds more strongly to changes in the price of gold than all other North American-based primary gold producers. The company has joint venture interests in 12 gold mines located on four continents. Although global in reach, approximately 65% of Kinross gold production is from North America, the highest percentage of any senior North American based gold producer. Kinross' annualized gold production is expected to reach nearly 2 million ounces per year, at a total cash cost of less than $200 per ounce.
A Penny for Your Thoughts
Last and definitely least we want to mention a penny stock that is on the Top 20 buy list this week: Mcleod USA (MCLD). They are a CLEC (Competitive Local Exchange Carrier) providing long distance and Internet traffic services. Most of the companies operating in this space are history. Bankrupt. Kaput. MCLD just completed selling off over $1.1 billion in assets, part of which was used to pay down debt and the majority is going to be used for operating expenses. It is quite possible that they will survive. The stock is up 23% in two days on no publicly available news, but penny stocks are volatile. It could go down 23% in two days just as easily. The company will report quarterly results on February 19th and this could be some advance positioning. If you have allocated your investment capital carefully into conservative investments, you may be interested in adding a little fizz to the mix, at 80 cents a share.
Timing Model:
The Timing Model is 50% invested. The model is heading down from a recent pivot point of 1467.35 on 1/13/03. The next downside trigger is a close at or below Nasdaq 1258, which will take us to 25% invested. The following downside trigger is Nasdaq 1195, which would take us to 0% invested. The next upside trigger is a 5% rise in the Nasdaq from the lowest recent intraday low, measured on an intraday basis.
Chat With The Pros!
When:
Tuesday, Feburary 18th, 2003 @ 4 pm EST
Where:
Logon at spearreport.com
Spear Report community members continue to come to "Chat with the Pros", our live, online chat with Gregory Spear and Kenneth Reid |
