Eight 'Warnings' You Want to See
By Herb Greenberg

(FORTUNE Magazine) – Warning signs, in this column, usually point to impending trouble. But if you look at those same indicators in reverse, you get another kind of alert: Call it a positive warning. These are the signs that value investors like Bob Olstein of the Olstein Financial Alert fund seek out in contrarian stock picks. Since its New Year's Day inception in 1996, Olstein's fund is up an annualized 25%. In fact, he has eight positive signs that a stock may be worth buying, clues that led him to oil drillers when nobody else would touch them and to Dialogic before it was taken over by Intel for a fat premium. They're also why he's enthusiastic about J.C. Penney.

No. 1: Penney is the classic example of Olstein's first sign, the screen used by all value investors: tremendous pessimism. "Bad news creates the right price, which means if I'm wrong, the risk becomes less," Olstein says. "You don't get the right price unless the company is experiencing some problem." That describes Penney, whose stock has fallen from $50 to just $19 thanks to mismanagement and the Street's perception that Penney paid too much for acquisitions.

No. 2: Positive free cash flow. Olstein looks at a company's financials, specifically the 10-Qs and 10-K, and makes a beeline for the statement of cash flows. We're not talking about the stated cash flow from operations, investing activities or financings. We're talking about cash flow from operations minus capital expenditures--the amount of usable cash the company actually generates, which can be used to buy back stock, pay dividends, make acquisitions, and grow the business.

No. 3: Clean, conservative accounting. If only it was that easy to spot. But one of Olstein's favorite tricks is looking in the 10-K, where he heads to the "deferred taxes" item in an obscure footnote called "temporary differences." This is where the company shows any divergence between the earnings reported to the IRS and the earnings reported to the SEC. Those two numbers are sometimes different, with the IRS having the more stringent requirements. If there's a split, Olstein likes to see companies underreport earnings to the SEC without resorting to the shell game of manipulating one-time charges, the "earnings massaging" that the SEC has been cracking down on lately. (See our IBM story, this issue).

No. 4: A big buildup in raw materials and work in process compared with finished goods. This is especially true for manufacturers, and the greater the divergence, the better. "That's usually indicative of a production increase for future sales," Olstein says. "It means they're stepping up production." The comparable plus sign for retailers is that inventory is turning, or being sold, at an increasing rate. This describes Penney, whose inventory turn has jumped to 3.8 times a year from 3.5 in 1998.

No. 5: An increase in nonrecurring discretionary spending, such as research and development--or a large percentage of sales going to R&D or a new product. These can cause a company to miss its earnings estimates, but they suggest to Olstein that the company is making good use of its money. "Even though they're setting Wall Street up for a disappointment," he says, "they're setting a big opportunity up for me." A classic example was Dialogic, which, before being bought by Intel, spent about 25% of its revenue developing Internet telephony components.

No. 6: Hidden values (or undervalued assets) that suggest the company's stock is cheap. That's why Olstein bought into oil drillers like Santa Fe a year and a half ago when oil was $10 a barrel. Santa Fe's financial statements showed him that its stock price didn't even factor in the cost of its existing oil rigs. But the company still had positive free cash flow.

No. 7: An underleveraged balance sheet. Olstein likes companies that have little or no debt and a high return on assets. (By "high," he means a return at least 50% higher than the company's borrowing rate; you can find the company's cost of money in the financial statement's footnotes.) "We like companies that can pay off their debt in less than five or six years if they choose to," Olstein says. "It means they have that much extra cash flow."

Finally, No. 8: Continuity and intellectual honesty in the CEO's annual shareholder letter. Olstein looks at no less than three years' worth of these letters: "The annual report is their pride and joy. It's where they represent who they are." Among the issues on his checklist: how accurate has the company been with past predictions? And has it addressed problems and past errors? "We're looking for the subjective veracity of management," he says. "They're guilty until proven innocent." A motto all investors should live by.

HERB GREENBERG is a senior columnist for TheStreet.com. Send feedback to herb@thestreet.com.