NEW YORK (CNN/Money) -
Bernard Ebbers, the former CEO of WorldCom, was charged with securities fraud on Tuesday. Essentially, he was accused of telling Wall Street analysts what they wanted to hear.
There are lots of lessons one could draw from the story of Ebbers, who seemingly came out of nowhere to create one of the great growth companies of the 1990s -- only to preside over its downfall.
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Certainly, there are touches of Greek tragedy to the story -- all the over-reaching and a lack of self-knowledge. Or perhaps, it could be better seen as a Medieval morality tale -- with Ebbers' rise and fall reminding us of the vanity of all human endeavor.
But for investors, there's a much simpler lesson -- earnings quality matters far more than most people realize.
While stockholders obsess over quarterly numbers, worrying if a company comes in a few cents below expectations and rejoicing if it comes in a few cents above, they're inclined to treat all earnings reports as equally valid.
This is absurd, if you think about it for a moment. Why get upset about a shortfall of a few cents, when reported results might be inflated by an amount 10 or 20 times as large.
|†Projected growth based on forecasted earnings gains for the next five years. |
Squirrelly earnings come in three basic types -- fraudulent, obscured and distorted.
Earnings are fraudulent when business transactions didn't take place as described. If, for instance, a company ships excess product to a warehouse and records the items as sold, any profits attributed to those sales are likely to be fraudulent.
Earnings are obscured when a company makes frequent acquisitions or constantly restructures so that it can write down assets without recognizing them as costs. The result: Reported earnings don't give a clear picture of continuing operations.
Earnings are distorted, when a company uses the leeway in accounting rules to calculate earnings in ways that specifically inflate reported results.
Cutting through the clutter
Is there any way for investors to protect themselves? Remember that trees don't grow to the sky and that results that look too good are suspicious.
In addition, you should regard abnormally active dealmaking or constant restructuring as a warning sign, especially if the changes don't seem to have clear business advantages.
In the end, though, you can't always spot manipulation. Corporate managers who are really clever and determined can always find ways to bend the rules without attracting too much attention.
Your best protection against earnings fiddling is to diversify as broadly as possible and to look for very long track records of superior profits.
Investors generally underestimate the value of long records of unbroken earnings gains and prefer a stock with 16 percent growth for only two or three years over a company that has turned in 13 percent compound annual gains for a decade or longer.
But the fact is, a company with an exceptionally long record of rising earnings provides some assurance of two things. First, its businesses have real staying power; they can grow in a variety of economic environments and aren't subject to being quickly overtaken by new technology.
Second, there's a limit to how much the company can be manipulating earnings, because it's virtually impossible to turn in higher numbers year after year over a very long period of time, unless the growth is real.
There's no guarantee, of course, that a stock with a long, impressive earnings record won't disappoint. Even a company with a stellar history can have a bad year, and even a generally impressive record can include some debatable accounting calls.
But a long history of proven success should get more credit than a lot of investors give it. The four stocks in the table above, selected from the Sivy 70, all boast more than 25 straight years of higher earnings. In addition, they are all currently recommended by analysts and offer potential total returns higher than the historical average.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Tuesday and Thursday of Sivy on Stocks.