Robert Olstein is Chairman and Chief Investment Officer of Olstein Capital Management and serves as Head Portfolio Manager of the Olstein All Cap Value Fund and Co-Portfolio Manager of the Olstein Strategic Opportunities Fund.
Olstein has long been recognized as one of the financial community’s most astute research analysts and money managers. Widely acknowledged as a leading expert in corporate disclosure and reporting practices, in 1971 Olstein co-founded The Quality of Earnings Report, which pioneered the use of forensic accounting techniques to identify positive or negative factors affecting a company’s future earnings power.
Olstein is also a past recipient of the Financial Analysts Federation (now CFA Institute) Graham & Dodd Scroll Award. The Graham and Dodd Awards were created in 1960 to recognize excellence in research and financial writing and to honor Benjamin Graham and David L. Dodd for their enduring contributions to the field of financial analysis.
Olstein is the go-to guy when it comes to a company’s financial analysis. A couple of years ago Olstein did an interview with Value Investor Insight where he shared his methodology and his checklist for looking at a company’s financial statements. It’s a must read for all investors.
Let’s take a look…
Following is an excerpt from Olstein’s interview with Value Investor Insight, to read this article you will need to become a subscriber here:
Your strategy is driven by an “inferential analysis” of financial statements. Describe what that means?
Robert Olstein: I’ve just always believed that the numbers are the most important and unbiased indicator of a company’s value. As we dig through the financial statements, we make adjustments to reported earnings in order to eliminate what we believe are management biases or unrealistic assumptions.
That allows us to not only have more representative inputs for our valuation models, but we also find it can provide insight that may not be so obvious to the investing public about the viability of a company’s strategy, the sustainability of its performance, and how management decisions might impact future cash flows. At the center of all that is an emphasis on free cash flow.
I still believe that over the long run there are real companies behind the stocks we own and cash flow is the air that those companies breathe. You can not value a company without a clear position on the evolution of its future cash flows.
As a result, most of our time is spent on how, or if, a company generates sustainable free cash flow, the level of ongoing investment required to maintain and/or increase free cash flow, and how much of a company’s free cash flow will be available to investors. My approach is predicated on the idea that the best long-term investors are those who make the fewest errors, both in magnitude and number.
I said this when we first spoke [VII, September 28, 2005] and it remains as true as ever: I have yet to hear a management team warn of an existing problem, that if not resolved would result in a dramatic drop in the share price. Given that that’s exactly what I most care about, I better do a lot more than listen to management to form my opinions.
Describe where you look first in researching a company’s financials?
RO: We begin by reconciling the difference between free cash flow and reported earnings under accrual accounting. The smaller the difference, the higher the quality of earnings. The bigger the difference, the more work we have to do to understand the makeup and sustainability of free cash flow. We look at the footnote on taxes, which reconciles the differences between earnings reported to shareholders and earnings reported to the IRS under cash basis accounting. The lesser the difference, the higher the quality of earnings.
We look at the balance sheet and calculate the ratio of total assets to shareholders’ equity. After learning some hard lessons during the financial crisis, we instituted a rule that any ratio above 2.5 to 1 is an exception, which doesn’t automatically mean we won’t buy it, but each individual position size will be limited and we won’t ever have more than 10% of the portfolio in such exceptions at one time.
That’s nothing more than a recognition that when you’re wrong with a leveraged business model, the hit to the stock price can just be too fast and too damaging. We always compare depreciation and amortization provisions to capital expenditures. This is particularly important today because a lot of expenditures pre-crisis on bad acquisitions and excessive expansions have caused a disconnect between what’s reported as depreciation and amortization and what’s really necessary to spend going forward.
We analyze receivables and inventories to determine changes in each relative to changes in sales. Inventories and receivables increasing faster than sales can be early warning signs of future slowdowns. Inventories building in the right places, like raw materials and work-in-process, can be signs of future strength.
This isn’t a comprehensive list, but another important factor is to review the content and frequency of so-called nonrecurring factors that have contributed to or reduced earnings. We want to know if what’s deemed non-recurring really is non-recurring.
Give some examples of errors you expect to avoid based on your reading of the financials?
RO: Revenue growth at Amazon.com [AMZN] has been impressive in recent years, but it concerns me that much of that growth has been financed by increased payables, that margins are so low, and that at the end of the day very little free cash flow is actually being generated.
It’s not obvious to me how that changes. It could certainly be through higher pricing or reducing the amount of free shipping, but how less competitive does that then make them if they take those paths? Given that I base my valuations on discounted future cash flows, I can’t get anywhere near the current stock price of more than $225 in my assessment of value.
I recently read an analyst report, before the latest spike in Amazon’s shares, saying the stock was going to $240. The analyst was expecting free cash flow in 2015 of something like $2.40 per share. So even if you believe cash flow goes from near zero today to $2.40 in a few years, why would you pay 100x that number for the shares?
I’m not saying the company can’t convert brilliant sales growth into brilliant growth in free cash flow, but let’s say I’m skeptical it can happen at the level required to justify investing in the stock today. It’s down sharply in the past few weeks, but I was scratching my head earlier this year at the big stock-price run in Sears [SHLD].
At the same time they’re talking up the brands and real estate they’re going to “monetize,” we believe they’re significantly neglecting capital expenditures – specifically spending on improving the stores – and therefore overstating earnings for the core retail operation.
Eventually shareholders will be left holding the bag with this overvalued, troubled business. I started talking about this a year ago, but I’m still not optimistic about the ability of cruise-ship operator Carnival [CCL] to generate free cash flow.
Over a several-year period its capital spending, for both maintenance and new expansion, has been significantly above depreciation. Reported earnings looked great, but it was in our view a false prosperity. The market buying into reported growth like that makes a stock quite vulnerable if there are any bumps in the road – and Carnival has hit a few such bumps in the past year.
Sometimes, of course, the numbers tell a more positive story. One of our happiest examples in recent years has been Macy’s [M], in which we still have a position. When we started buying the stock more heavily in 2009, the company was reporting $1 per share in earnings and the share price was around $12 or $13.
But the depreciation and amortization that was weighing down those earnings was far higher than the realistic needs for capital spending going forward. We thought the difference was on the order of $1.50 to $1.80 per share. So even at the depths of the recession, you had a company generating normalized free cash flow that was more than $2.50 per share, on a $12 stock.
As bad as the overall outlook was at the time, that was too cheap to pass up. [Note: Macy’s shares currently trade at around $41.]
Now, here is Olstein’s 14 point checklist for picking up warning signs in the 10K:
- Sizable negative divergences between cash flow and net income
- Questionable accounting for transactions with affiliates or joint ventures
- Material differences in tax accounting and GAAP accounting, as measured by deferred taxes
- Reversal of past reserves to artificially inflate earnings
- Realizing non-recurring gains, and netting these gains to hide past mistakes
- Lowering discretionary expenditures to meet earnings targets
- Continual characterization of material expenses as non-recurring
- Unrealistic depreciation schedules
- Capitalizing expenses based on unjustified optimism
- Serial acquisitions under purchase accounting that overstate internal earnings growth
- Lower inventory turns or negative inventory divergences from the past
- Accounts receivable rising faster than sales
- Unrealistic pension assumptions
- Non-disclosure of material information needed to assess company value
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