How To Find Honest Stocks

To avoid a personal Enron, get any skunks and overhyped companies out of your portfolio

NEWSWEEK

Feb. 18 issue

It's time to ask yourself the same questions that Congress wants to ask former Enron chief Kenneth Lay: What do you really know about your stock? If the answer is 'almost nothing'—um, how come? Your future depends on how well you save and invest. You can't risk living with a skunk in the garage.

AIR IS STILL COMING out of the stock-market bubble you thought you'd left behind. Two years ago sexy companies with no real earnings got the chop. Now the reality squad is gunning for stocks whose earnings were ginned up by management (not to mention accountants who couldn't add or subtract but sure knew how to multiply). You may have future Enrons and Global Crossings in your portfolio but haven't faced it yet.

Do you even know how well your stock-buying strategy has actually performed? Folks tend to assume that they'll do fine 'over the long term,' even if their current investments are a mess.

But consider this: in the past four years, the broad stock market took a complete round trip. From January 1998 through December 2001, Standard & Poor's 500-stock average returned a modest 5.66 percent a year. If you'd invested in safe three-month Treasuries instead, you'd have earned 4.96 percent—almost as much as investors got from stocks, according to a report from Towneley Capital Management in New York. Nasdaq lovers almost certainly did worse. Too few investors take the time to figure this out for their own accounts. You need to create your own annual reports, using software or the Internet, to track your performance versus the market overall.

As for Enron, its collapse is being treated as a huge surprise. But for analysts worth their pay and willing to talk (the world's shortest list), the market risk was clear—collapsing margins, negative cash flow, opaque financials, lots of hype, insiders bailing out.

Followers of price/earnings (P/E) ratios might also have guessed that Enron stock was on shaky ground. At its peak in mid-2000, the company sold at 267 times pretended earnings. Historically, high P/E stocks (the riskiest ones) haven't done as well as low P/E stocks, says Jeremy Siegel, finance professor at the Wharton School—and for him, 'high' is 50 times earnings, let alone 267. Stocks with super-high P/Es are time bombs. Sell them while you can.

But how far can you trust P/Es—the most basic measures of value for the average investor? You find them in newspaper stock listings and on the Web. When a stock price (the P) is high relative to the company's earnings (E), investors expect rapid growth in future profits. If growth slows, that stock will tank. By contrast, firms with low P/Es (say, under 12) face so many problems that investors aren't sure when (or if) they'll turn around.

The problem with judging stocks by P/E, of course, is the fairness of the 'E.' There are dozens of ways of figuring earnings legally, completely aside from fraud.

Most of the P/Es you see refer to a company's 'operating earnings,' which supposedly show how well the business runs. This calculation leaves out unusual expenses, such as restructuring costs. Unfortunately, scores of companies now inflate their bottom lines by calling certain regular costs 'unusual,' or pulling other tricks.

Here's something else you may not know: investment reports from brokerage firms often use predicted P/Es. They're lower than actual P/Es, which makes the stock sound like more of a bargain. But it isn't, of course.

Companies with no or poor earnings may create 'pro forma' profits. Those are imagined earnings, from the Land of Oz.

How should investors make their way through this mess? Don't accept pro formas or 'operating earnings' from outer space. Go with P/Es figured by Standard & Poor's, which are based on actual earnings and calculated in a consistent way. Ask your broker for them. S&P has proposed a standardized definition of operating earnings. That would not only help you compare various companies fairly, it also would help investors trust analysts more, says David Blitzer, chair of S&P's 500 index committee.

Also, cut and run if your company's financials fall under suspicion. An attack on Qualcomm last week, by numbers sleuth Howard Schilit of the Center for Financial Research & Analysis, took a fast bite out of its price. Says Schilit, 'You know something's wrong when a middle-aged accounting professor becomes a star.'

A note to all you market timers: the S&P stocks look expensive, at 29 times 2001 earnings (the historical median is just 15). Still, you always get high P/Es at the end of a business downturn, because profits plunge. No need for another crash to restore 'normal' valuations. Today's prices will look cheaper when profits start back up.

So much for numbers. You should also consider a softer way of deciding which stocks to shed or buy: is the company truly run in the shareholders' interest, at the top? The Enron board of directors disgraced itself, and of course its members sit on other boards. The AFL-CIO has urged companies not to keep them.

Checking the expertise of directors reveals a lot, says shareholder activist Nell Minow. What does it tell you about a company's concern for your money when it names O. J. Simpson to its critical audit committee (that was Infinity Broadcasting, 1993—later sold to CBS and then to Viacom)? How about a board so submissive to a CEO that his 1999 employment contract even specified the make and model of Mercedes the company would buy him (Global Crossing, for ex-CEO Robert Annunziata)? Minow also wonders if shareholders get full value from boards stocked with company insiders (her example: Carnival Corp.).

For executive-employment contracts and info on boards of directors, check Minow's Web site,. Good companies come from good character, as well as smarts.

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With Temma Ehrenfeld