Financial statement doesn't tell company's story

By CHARLES JAFFE Market Watch - 11/4/2009


While not "The Da Vinci Code," the obscure footnotes of a company's financial statements hold information that David Trainer swears will tell you if a stock is worth buying or selling.

He has the record to prove it. Trainer, president of New Constructs, a Nashville, Tenn.-based independent research firm, uses an intensely bottom-up approach to analyze stocks. Each month, from the 3,000 stocks his staff dives into, New Constructs produces a list of the 25 most attractive and most dangerous.

If you bought the 25 most attractive each month and sold short the 25 most dangerous dating back to April 2006, your long/short strategy would be up 63 percent.

Trainer's philosophy is straightforward: "The economics of the business is what investors should care about, not the accounting," he said.

"Accounting rules were actually not designed for equity investors," Trainer explained. "They were designed for debt investors, so when you trust the financial statements on their face — if you trust the net income number or you trust the cash flow statement number — you're getting a very small piece of the overall picture with respect to the financial performance of the business."

Trainer digs to determine the economics of a business, looking for "everything that helps you understand how much cash flow the company is generating based on how much cash flow was invested in the business."

He frequently finds that good companies are bad stocks, improperly valued with what New Constructs labels "misleading earnings." That's where a company cites rising profits in its accounting, while the underlying figures in Trainer's research show that economic earnings in fact are moving in the other direction.

Couple an inflated stock valuation with misleading earnings and you have a stock that's a candidate for New Construct's "most dangerous" list. Of the stocks on that list for October — and you can get free downloads of lists that are three months old or older at tulsaworld.com/newconstructs — Trainer said Red Hat Inc. may be the epitome of the kind of trouble stocks that his research weeds out.

"That's a company whose stock price implies that their profits will be 400 percent greater, and we show in our model that it would take them more than 100 years of profit growth to actually realize what is embedded into the value of the stock already," Trainer said. "They show their accounting earnings rose by $2 million last year, even though we show that their economic earnings fell by $10 million."

Another dangerous stock is Sprint Nextel Corp., which has been bouncing on and off the danger list for months.

"The economics of the business have been horrendous for a long time," Trainer said.

On the flip side, two stocks from the most-attractive list include Dish Network Corp. and McDonald's Corp.

Dish has a valuation that "implies that its profits are going to be 30 percent lower than they currently are — forever, perpetually — while we see that their profits are very strong and rising," Trainer said.

McDonald's, he noted, is a stock with very low risk of being crushed by current market conditions.

Trainer's research isn't foolproof. His system sometimes produces a clunker or a stock that the market can sustain or depress despite all of the obvious signs. Part of the problem, Trainer said, is that corporations can hide a lot of information in footnotes and statements.

"In the last 10 years, corporations, auditors and Wall Street in many ways conspired to try and make the financial statement, the accounting statement, do what they need (the numbers) to do, which is to help them sell stock," Trainer said. "Just like any salesman, you're going to put your best foot forward and so the accounting statements are essentially a sales tool."





Chuck Jaffe, senior columnist for MarketWatch, can be reached at cjaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.




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