To Avoid an Enron, Look at Cash Flow:[FINAL Edition]
James K. Glassman. The Washington Post. Washington, D.C.: Feb 17, 2002. pg. H.01
Full Text (1858 words)
Copyright The Washington Post Company Feb 17, 2002
Could the typical small investor have discovered a year ago that Enron Corp. was on the brink of
disaster? It's highly unlikely. Still, if you looked for the right thing, you never would have bought Enron
stock in the first place.
The right thing is cash. The earnings statements that obsess Wall Street analysts are based on
technical, arcane accounting conventions. But what truly counts for investors is how much cash they
can put in their pockets, and shareholder cash is inextricably linked to the cash that the company itself
generates and uses.
I have come reluctantly to the conclusion that massive corporate filings rarely illuminate the true state
of corporate health. Adding more requirements and plugging the latest Enron-inspired loopholes won't
help, either. Most large, publicly traded companies are simply too complicated.
Robert Olstein, who manages the successful Olstein Financial Fund by digging deep into financial
statements, says that detecting trouble is a job for professionals. When I asked him whether small
investors could ferret out the mess at Enron, he said bluntly, "The public has no chance."
He added: "I don't do my own refrigerator repairs, so why should you think you can do your own stock
picking? Instead, you should spend your time finding good people to manage your money." That
statement may be self-serving, but it is hard to imagine any amateur beating Olstein's own record. His
fund has returned 17 percent during last year's market debacle and an annual average of 21 percent
over the past five years, compared with 12 percent for the Standard & Poor's 500-stock index.
But don't despair. By concentrating on cash, investors can learn enough about a company to eliminate
it as a possible investment. For example, if you want to get a quick-and-dirty reading, look not at a
firm's "income statement" but at a more obscure -- but still readily available -- table of numbers called
its "statement of cash flows." In Enron's case, that statement -- part of the 2000 annual report,
published before the firm's problems were revealed -- showed troubling numbers.
First, add up the cash that Enron generated from its operations over the past three years. Then
subtract the cash that Enron devoted to capital investments -- that is, the big-ticket items, including
acquisitions, that eventually generate the operating cash.
Here is what you get: Cash from operations -- $7.6 billion. Cash used for investments -- $11.7 billion.
Subtract the bottom line from the top line and you find a deficit of $4.1 billion. That's not good. Then
subtract the cash that went to paying dividends and the deficit jumps to $5.5 billion. Ouch. By the way,
Enron made up that deficit, again according to the cash-flows statement, by issuing new stock and
taking on more debt.
Our quick-and-dirty analysis does not examine the question of whether Enron's investments -- in
excess of its operating cash -- were wise or foolish. That's an important matter, of course, and it
requires more study, but it's not unreasonable to dismiss out of hand any company with such a
lopsided difference between the cash it generates and the cash it invests.
By contrast, consider the 2001 annual report of Automatic Data Processing Inc., which handles payroll
processing for companies that employ 30 million Americans. ADP has raised its dividend for 28
consecutive years, so it is no surprise that from 1999 to 2001 the firm generated net positive cash flow
of $2 billion. ADP used $650 million of that to pay dividends and $1.2 billion to repurchase its own
stock (in effect, a tax-free dividend). In other words, it returned the profits to shareholders -- an
encouraging sign.
A company that plows all the cash it generates into capital investment is not necessarily shaky; the
money could be going to productive uses. In three of the past four years, for example, Cisco Systems
Inc., the Internet infrastructure giant, has run slightly negative net cash flows. By any measure,
however, Cisco is a solid, highly profitable company -- it's rated A (highest) for financial strength by
Value Line -- that gets considerable bang for every internally invested buck.
There's no hard-and-fast rule that separates a Cisco from an Enron, but check out the "return on
capital" line that you can find in almost any analysis of a company. even with last year's slowdown,
Cisco's returns were more than 20 percent between 1997 and 2001. In other words, for every dollar of
debt (loans) plus equity (stock), Cisco was bringing 20 cents down to the bottom line. That's
impressive. Enron, by contrast, was averaging returns on capital of a mere 7 percent -- hardly better
than a Treasury bond -- over the past five years, even before the company had to reveal some hidden
debt and restate its earnings downward.
Finding information like this is relatively simple. Most companies post annual reports on their Web
sites, and the SEC makes Form 10-K (and quarterly 10-Q) filings available through its Internet-based
Edgar database (www.sec.gov/edgar.shtml). In addition, sites such as MoneyCentral
(moneycentral.msn.com) offer detailed historical statements of return ratios, income, cash flows and
balance sheets.
A balance sheet tells what a company owns (assets) and what it owes (liabilities). Olstein says that all
investors should look at a company's cash (on the asset side) and its debt (on the liability side). If
there's more cash than debt, that's a good sign. Enron's cash at the end of 2000 was $1.4 billion, and
its debt was $10.2 billion -- again, a lopsided negative figure.
Enron executives have been accused of deceiving investors by moving debt off the consolidated
balance sheet -- which is the official statement from which those numbers above are drawn -- and onto
the backs of "unconsolidated" partnerships and corporations with which the company had a close
relationship. In fact, sketchy information about unconsolidated entities does show up on Page 77 of
Enron's 214-page 10-K. Debt, for instance, totaled another $9.7 billion.
But there's no need to burrow into the small print. As Olstein says, "when we looked at Enron, we saw
negative cash flow." That was a bad sign, and so was the huge difference between cash and debt.
Again, compare Enron with Cisco. At the end of fiscal 2001, Cisco had $7.4 billion in cash and no debt.
But Cisco is a powerhouse. A more surprising example of a well-heeled firm is Apple Computer, with
cash of $4.3 billion and debt of $300 million. Cash minus debt equals $4 billion, or about $12 for every
share of stock. Apple was trading Friday at just $24.76 a share, which makes it an intriguing candidate
for purchase.
Olstein's own investing style is more sophisticated than simply purchasing firms with lots of cash. "We
try to buy companies that are down and out but can keep their balance sheets intact," he says. In other
words, finding firms in robust health -- like ADP -- does not excite him. As a value investor, he wants to
own companies that are shunned by the market because they look shaky but which, on closer
examination, are pretty sound.
A good example is J.C. Penney Co. The company, at last report, had $1.7 billion in cash, and while its
debt totals $5 billion, that number has been cut in half in the past three years, and most of the loans
are not due for more than five years. In addition, net cash flow was positive last year by more than $1
billion. Penney's was Olstein's second-largest holding last year, and it rose more than 100 percent
over 12 months.
Other winners for the fund include Furniture Brands International, a company with deceptively strong
cash flow, and Mattel Inc., which last year suffered a loss on its income statement but maintained a
positive cash flow -- just the opposite of Enron. Typically, the official numbers reported to the SEC
don't tell you as much as statistics that companies use internally and rarely share with investors.
American Express Co. is an exception. It devotes a page of its annual report to such data as total
credit cards in force (52 million in 2000, up 15 percent from 1999), average basic cardholder spending
($8,229) and past-due loans to cardholders (1.9 percent between one and three months and 0.9
percent longer than three months). This material is meant to be informative rather than promotional,
and it helps investors decide whether Amex is a stock worth buying.
Berkshire Hathaway Inc., the Omaha-based conglomerate with businesses as varied as auto
insurance, candy and jewelry, produces an ideal annual report (available online at
www.berkshirehathaway.com). It includes not only the wit and wisdom of its chairman, investor Warren
Buffett, but also the statistics that investors need to decipher the activities of a large, diversified
company.
"At Berkshire," Buffett wrote last year, "full reporting means giving you the information that we wish you
to give to us if our positions were reversed." That's a credo that all CEOs should follow. Clear,
transparent statements, written in understandable English, attract investors. When you can't decipher
reports, it is safe to assume that the company has something to hide -- again, remember Enron.
Buffett also refers to the "limitations of conventional accounting" -- which are significant. "Consolidated
reported earnings may reveal little about our true economic performance," he writes. Investors need
more -- but often, as in the case of American Express, what they need varies with the business. For
that reason, trying to edify investors by writing new, more complex accounting rules is a futile pursuit.
Look for companies that want to tell you what's happening -- Walt Disney Co., for instance -- and dump
the obfuscators.
Two other pieces of advice: Favor smaller, simpler companies, whose businesses are relatively easy
to understand. A couple of good examples are retailers Urban Outfitters and 99- Only Stores; both are
top-rated by the Value Line Investment Survey, and they have strong cash flows and zero debt. And
remember, as I said last week, that dividends are the most certain evidence that a company is actually
earning money -- which is why real estate investment trusts (REITs), which consistently pay high
dividends, should be in every investor's portfolio.
You can't fake the checks you send to shareholders. In fact, you can't fake cash in general. In a world
of more and more complicated accounting rules, of fancy tax techniques and slippery footnotes, cash
is the real thing. Count the cash, and you won't go far wrong.
Corrections: Last week, I wrote that Crescent Real Estate Equities "cut its dividends in 1999, 2000 and
2001." In fact, the firm raised its dividend in 1999, froze it in 2000 and cut it in 2001. Also, I mistakenly
said that tax laws require real estate investment trusts to pay out 95 percent of their earnings in
dividends; a law passed in 2000 changed the minimum to 90 percent. I apologize for the errors.
Among the stocks mentioned in this article, James K. Glassman owns Automatic Data Processing and
Berkshire Hathaway. His new book is titled "The Secret Code of the Superior Investor" (Crown), and
he invites comments by e-mail to jglassman@aei.org.