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Stocks: Sturm's Screen: My Favorite Metric

Sturm's Screen
My Favorite Metric

By Paul Sturm
April 13, 2004

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IF YOU BACKED me into a corner with a revolver and demanded to know my favorite financial benchmark, what would it be? I'm often asked this question albeit in a less threatening manner and my answer may come as a surprise. Some folks insist that book value is the only way to find bargains. Others are partial to screens based on earnings or growth rates. And what about enterprise value?

Until recently I didn't have a favorite. Sure, there are situations when some yardsticks are more appropriate than others: It makes more sense to use book value than revenue to screen for bargains among companies that are losing money. But when you track their predictive power over time, all the benchmarks I cited above are remarkably similar.

I'll explain why in what follows. But don't think you've learned enough to stop reading. I'll also introduce a benchmark based on cash flow from operations, which I call P/CFO. There's persuasive evidence that it works better than other screening yardsticks. I'll also tell you how to calculate P/CFO and why it's so powerful. And I'll use this new statistic to create my own table of bargains.

But first, I want to explain what those yardsticks in the first paragraph have in common. You can't screen based on absolute numbers simply looking for stocks with lots of earnings. That would reward big companies and penalize little ones. That's why we create ratios such as price/earnings. All price-based screens are contrarian in the same way. They highlight companies that are cheap relative to book value, earnings or whatever. Wait long enough and these stocks experience what statisticians call reversion to the mean. Low prices move up, and high prices move down. Relating a performance measure to price is more important than which measure you select.

So I didn't have favorites until I discovered P/CFO. It's easy to calculate. Just find "Cash From Operating Activities" in any company's statement of cash flows, and divide that into market value (or divide per-share cash flow from operations into the current share price). P/CFO is based on price. So it includes what's best about traditional yardsticks. But the CFO component also captures a key quality-of-earnings benchmark: accounting accruals.

I discussed accruals in my August 2003 column, when I wrote about University of Michigan accounting professor Richard Sloan. The portfolio I selected based on his research has done remarkably well: It's up nearly 50%, versus 20% for the Wilshire 5000. But the technique I outlined for applying Sloan's ideas was complicated, and my column generated lots of mail both from readers who wanted to learn more about accruals and from those complaining that they were too complicated. P/CFO is a slimmed-down alternative.

A quick refresher: In a landmark 1996 study, Sloan looked at the noncash component of earnings which accountants call accruals. The largest component is usually depreciation, which reduces earnings. Other components are more subjective. They depend on how management values things like receivables and inventory, and can push reported earnings up or down.

Sloan discovered a link between accruals and share prices. Companies with high subjective accruals, i.e., lots of management decisions that boost earnings, tend to perform poorly. Companies with low subjective accruals tend to beat the market. The potential profits from his strategy are impressive: Hedged accruals portfolios (buying stocks with low accruals and shorting stocks with high accruals) beat the market by about 10% annually.

There are several theoretical explanations. One is that investors simply don't understand accounting. But all accruals are ultimately affected by what really happens. Suppose I'm an overoptimistic executive and don't create an adequate bad-debt reserve this year. I'll report more earnings, but I'll have to take a hit in the future. If the market doesn't catch on, however, my company will command a higher stock price than one run by my conservative competitor. He booked an extra-fat reserve and reported lower profits. Sure, he'll enjoy higher earnings later when he collects more bills than he anticipated. But now his shares are suffering and might be a bargain.

  Screening Out Shenanigans
These companies have made conservative earnings assumptions, which may mean they're bargains.
COMPANY SECTOR/
INDUSTRY
PRICE* 52-WK.
HI-LO
PRICE/
CFO
RATIO**
PRICE/
BOOK
RATIO
Aaron Rents
(RNT)
Furniture rental 24.79 25-12 3.12 2.60
Louisiana-Pacific
(LPX)
Forest products 25.05 26-8 5.20 2.00
Marathon Oil
(MRO)
Energy 35.32 36-22 4.08 1.90
Pilgrim's Pride
(PPC)
Processed poultry 20.48 22-13 5.13 1.70
Spinnaker Exp.
(SKE)
Energy 36.22 37-17 5.28 1.60
Talisman Energy
(TLM)
Energy 60.47 61-38 3.92 2.30
Teekay Shipping
(TK)
Ocean transport 66.93 70-36 5.08 1.60
Toys R Us
(TOY)
Specialty retail 16.75 17-8 4.50 0.90
S&P 500 median
(N/A)
N/A 39.5 41-25 11.51 2.90
* Prices as of 3/5/04.
** Share price divided by per-share cash flow from operations.
Data: Reuters via NetScreen Pro from Multex

Something more than misunderstanding could also be at work. If executives want to manage earnings, accruals are the place to start. Sloan's research tries to establish a connection between high accruals and management skulduggery. Perhaps companies with low accruals are better buys because the folks who run them are more honest.

This is controversial stuff, and Sloan isn't without critics. Some point out that companies with high accruals tend to be growth stocks. If sales increase rapidly, bad-debt reserves and inventory valuations expand too. In contrast, low-accruals companies often grow slowly, if at all. So Sloan may just have a different perspective on the classic value-versus-growth distinction.


Portfolios based on this new measure of stock value beat the market by 12.6% annually.

 

Regardless of who's right, accruals analysis is a powerful tool. But in his initial study, Sloan divided accruals by total assets instead of price one reason those calculations in my earlier column were so tricky.

What happens if you relate accruals to price? A paper just published in The Accounting Review provides the answer. Three accounting professors (Hemang Desai at SMU, Shivaram Rajgopal at the University of Washington and Mohan Venkatachalam at Duke) realized that CFO derived from the statement of cash flows, as I indicated earlier was a good proxy for Sloan's accruals benchmark. Think of CFO as earnings adjusted for accruals.

So the professors created what amounts to a horse race among screening variables. Using 25 years of data, they measured profits from portfolios constructed using Sloan's original accruals measure as well as conventional yardsticks like price/book and price/ earnings. They also used price/cash flow, calculated simply by adding depreciation to reported earnings. This is the old-fashioned definition, and it's different from P/CFO because it does not include accruals.

They also added the new entrant, P/CFO their attempt to combine conventional price-based screening with accruals-adjusted earnings. Based on a variety of statistical tests, P/CFO easily outperformed other screening variables. One example: Twelve-month hedged P/CFO portfolios beat the market by 12.6% annually. Comparable results for price/book and price/ earnings portfolios were less than 8% over the same periods.

I'd love to replicate those results. But even though calculating P/CFO is easy, most screening tools don't include this variable. So I cobbled together a version using NetScreen Pro from Multex. As usual, I limited my screen to companies with market values of over $500 million. I also tossed out banks and insurance companies, where CFO calculations are often misleading.

I wound up with 1,300 stocks and zeroed in on the bottom 10%, the companies with the lowest P/CFO ratios. Then I added two unrelated tests: I wanted debt/ equity ratios of less than 1, and I wanted consensus analyst recommendations to have improved steadily over the past three months another factor that predicts gains. My eight finalists are all cheap, based on real earnings and not accounting adjustments.

The roster includes Lousiana-Pacific and Toys "R" Us, both well-known companies dealing (successfully, I hope) with challenges. Teekay is a beneficiary of the tight shipping market, while shares in poultry-producer Pilgrim's Pride are depressed because of worries about Asian bird flu. Aaron Rents, meanwhile, meets anyone's definition of a growth stock. And my three energy outfits aren't look-alikes: Marathon is an integrated producer, Canada-based Talisman is big in natural gas, and Spinnaker drills in the Gulf of Mexico.

Let me offer a final tip. If this column intrigues you, check out StockDiagnostics.com. It's one of my favorite Web sites and a great place to get a broader perspective on accruals. The site features a statistic called OPS (operational cash flow per share), which is identical to P/CFO (per-share cash flow from operations) that I've discussed here. There's a charge for the best material ($50 per month for screening), but much useful analysis is free.

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