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The numbers guy
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January 18, 2002: 4:56 p.m. ET
A lot of big fund managers got caught holding the bag on Enron -- not Bob Olstein.
By Money Magazine writer Adrienne Carter
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NEW YORK (CNN/Money) - Updated Jan. 31. A lot of supposedly smart investors blew it on Enron -- money managers at Alliance Capital, Janus and Putnam are just a few of the big names who got stuck holding the bag when the energy company imploded this past fall.
And now it looks like the Enron debacle was just the beginning. This week, new questions surfaced about Tyco International's bookkeeping. Williams Cos delayed the release of its fourth-quarter results, and PNC Financial said it would have to restate its 2001 earnings.
Suddenly, quality of earnings is on everyone's mind (as seems to happen every couple of quarters when another high-profile company blows up due to accounting irregularities).
But digging through the numbers is nothing new to Bob Olstein of Olstein Financial Alert. Olstein, a 34-year veteran of the industry, was obsessed with earnings quality long before most money managers had even graduated from business school.
Olstein first made his name in the 1970s as the co-author of a prominent Wall Street newsletter, The Quality of Earnings Report, which counted George Soros and Peter Lynch among its readers. The point of the newsletter was simple: Are the numbers that a company reports portraying the economic reality of the business. "I've always found that it's not important what management says, it's important what they do," says Olstein. "And what they do is already in black and white in the financials."
In 1995, Olstein set up his own shop, and over the past five years, the Olstein Financial Alert (OFALX: up $0.11 to $14.79, Research, Estimates) fund has returned an average of 21.6 percent, placing it in the top 1 percent of Morningstar's mid-cap value category and ahead of the S&P 500 by 12.2 percentage points.
The key has been in avoiding the catastrophes that have undone other hot funds. "There's a high correlation between long-term performance and error avoidance," says Olstein. "A fund that's up 80 percent one year and down 50 percent the second year isn't up 30 percent -- it's down 10 percent." To that end, the fund has had consistent returns, and in 2001, when the S&P 500 lost 11.9 percent, Olstein returned 17.2 percent.
How It Works
Olstein acknowledges it's easy to philosophize, but harder to put those words into practice. Olstein and his team of five analysts get ideas from any number of sources, including mainstream news publications and stock tables.
Once a stock sparks his attention, Olstein heads straight to the numbers, making sure there is no financial engineering masking problems. There are scores of warning signs if the earnings are of low quality, explains Olstein. "We might see inventory jumping quicker than sales; we might see a material deviation between reported earnings and cash flow from operations," says Olstein.
For example, if accounts receivables (found on the balance sheet) are increasing faster than sales, it could mean that a company is shipping more to retailers than retailers are selling -- and that could eat into future sales. "Basically, they're pushing goods out the door to make earnings estimates," says Olstein. "But the goods are not being sold to the ultimate customer, which is the most important person."
Back in the late 1990s, Olstein publicly criticized Lucent Technologies. As reported earnings growth remained strong, the stock soared. But Olstein saw a number of non-recurring write-offs that made earnings look better than they really were. "I went into the financials and found 15 different items like acquisition-generated sales and earnings and pension income, which led me to believe Lucent wasn't earning very much money." At the time, most everyone on the Street thought Lucent was infallible. Two years later, the stock has fallen from a high of $80.60 to a meager $6.50.
Clean Bill Of Health
Olstein awards plenty of high marks for conservative accounting. Most notably: the Washington Post, the New York Times and Chubb. Once Olstein is convinced the financials are clean, Olstein turns to valuation.
On those merits, Olstein has been a big fan of J.C. Penney. With hidden assets like Eckerd drug stores and a new management team that has reduced debt from $10 billion to $5 billion, the old-line retailer still looks undervalued, says Olstein. He's also eyeing a number of gas drillers, including Patterson-UTI Energy and Rowan Companies.
One of his more controversial picks is Gap, which has been slammed after four consecutive quarters of year-over-year earnings declines. Olstein remains confident in CEO Mickie Drexler, who has already made a number of smart moves including reducing capital expenditures as well as square-footage growth. "By our calculation, this is a company that is capable of generating close to $800 million to $1 billion in excess cash flow," says Olstein. "The key to whether we make money or not is if they can get their styles back in accord with the market, but that's a risk you have to take." 
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PASSING MUSTER
