The Best Stock Picker on Wall Street?
By Lawrence Carrel

SmartMoney.com
http://www.smartmoney.com 

 

IS MICHAEL MARKOWSKI the 21st century's reincarnation of Benjamin Graham? 

OK, perhaps it's a bit of a stretch to equate the father of value investing - and Warren Buffet's mentor - with this small Internet publisher. Still, much like Graham's classic 1934 textbook, Security Analysis, Markowski's Web site, StockDiagnostics.com, offers a bold new way to evaluate stocks. Two years ago, Markowski created a new investing approach he calls stock diagnostics, or "the science of using financial-statement anomalies to identify investment opportunities." 

 

Since Graham's tome first hit the shelves, the foundation of investing has been to look for companies with steadily rising earnings and low price/earnings ratios. Do that, the conventional wisdom goes, and you'll likely end up with winners. It's the basis of fundamental analysis, which attempts to forecast the future based on past performance. 

 

But after three years of earnings blowups and restatements, corporate bankruptcies, and outright fraud, the public has learned that Wall Street can manipulate earnings figures like a Swedish masseuse. New times call for new approaches. 

 

Markowski, co-founder and director of research at StockDiagnostics.com, patented a proprietary algorithm he says measures a company's financial health more accurately than earnings per share. He calls it operational cash flow per share, or OPS. Markowski's company uses in-house software to examine the operational cash flows of 8,000 publicly traded companies, track trends and rate their general health. Subscribers are allowed to view the results. The company also offers buy and sell recommendations in its weekly OPS Newsletter. 

 

With a record of 75% accuracy for upside moves, the newsletter boasts possibly the best stock-picking record on Wall Street. Just as important, it helps investors identify blowups before they happen - sometimes saving them from big losses. How does it work? We'll explain. 

Profits, But No Cash
Even without a whiff of fraud, corporate earnings results include a lot of noncash items, such as receivables, payables, depreciation, amortization and one-time adjustments, either charges or gains. But a company that's profitable on paper may not be meeting its regular operating expenses. Wall Street's favorite cash-flow measure - Ebitda, or earnings before interest, taxes, depreciation and amortization - is supposed to track this. But Markowski says Ebitda excludes too much relevant information. "The accounting scandals show it's not a reliable indicator," he says.

 

By contrast, operational cash flow - based on the cash-flow statements companies file with the Securities and Exchange Commission - looks only at the money actually moving in and out of the company each quarter. How is this computed? Take their net income, add depreciation and decreases in payables back in, then subtract increases in receivables and inventories. That leaves cash flow from operations, or operational cash flow. Markowski simply takes this number and divides by outstanding shares to arrive at OPS. The result is often nothing like Ebitda. For instance, StockDiagnostics.com notes that IBM (IBM) recently hit a nine-year high in operational cash flow, while posting a three-year low in Ebitda. 

 

The key to OPS is that it takes away one big trick some companies use to bolster their earnings numbers: accrual accounting. This technique allows companies to book receivables (money owed to them) as revenue, before they actually receive the cash. The problem: IOUs can't be used to pay real operating expenses. And if a bankruptcy forces a customer to renege on or dramatically reduce payments, the company never will recoup that money. When companies count too many chickens before they're hatched, it can be disastrous - for them and for their shareholders. 

 

Markowski has come up with a simple way to identify potential blowups before they happen. He takes companies that are reporting big profits and examines their operating cash flow. If OPS turns negative compared with the year-ago quarter, it's time to bail out of the stock. "In 99% of the cases, [these] stocks are at all-time highs," says Markowski. "Everyone bids them up thinking everything is great, but there's no cash behind the EPS." Markowski calls this the EPS syndrome.

 

Thanks, Enron
StockDiagnostics owes its existence, oddly enough, to Enron. "If Enron hadn't died, Stock Diagnostics wouldn't be an entity today," says Markowski.

Markowski spent the 1980s and early 1990s working as an analyst at Merrill Lynch, then at Donaldson Lufkin & Jenrette, and then a venture capital firm. In 1995, he and his younger brother, David, founded Newsgrade, a Sarasota, Fla.-based Web site offering information about public companies. In 1999, with his brother running operations, Markowski focused on developing a system to detect anomalies in the finances of public companies. He completed it in 2001, just after Enron collapsed.

 

For its first test drive, Markowski and his eight researchers performed an autopsy on Enron to see if they could find out what killed the Houston energy company. They discovered it had been afflicted with a cash-flow crisis in the two quarters before its death, even as it posted record earnings - the EPS syndrome. Next, he back-tested the algorithm to 1997, and discovered the EPS syndrome was present in 248 public companies that saw their stock prices decline more than 90% during that time, including Sunbeam, Polaroid and Fruit of the Loom. 

 

Markowski wasn't finished. Comparing EPS with OPS, he assigned each quarterly result a value of between one and eight, with one being the safest level and eight a sign of imminent danger. A five-year graph of these values offers a useful picture of a company's financial momentum. A two-quarter change in these values, either positive or negative, often predicts a change in earnings, and hence stock price, weeks or months before it happens. By identifying a trend in the company's momentum, an investor can find a stock with a high probability of success or failure. 

"OPS is a good predictor of revenues and profits coming in the next two quarters,"says Markowski, "because the cash will show up in a business with a hot product before the revenues show up. One reason is because people put deposits down on products. These are great signals." 

 

The Holy Grail?
Still, in the never-ending quest for a stock-picking Holy Grail, investors are deluged with newsletters and half-baked trading systems. What makes OPS different?

 

Simple: We've seen it work. Last month, United Online's (UNTD) shares tanked 18% on news that America Online (a unit of Time Warner (TWX)) was moving into its niche of discount dial-up Internet service. That evening, Markowski's OPS Newsletter called the drop a buying opportunity and recommended readers pick up shares. United Online has since recovered all of its losses.

 

Of course, many people saw that opportunity - even on this site. A better example might be the one no one saw coming. 

On Aug. 16, 2002, when shares of Sears Roebuck (S) traded at $47.75, StockDiagnostics.com issued a cashless earnings warning for the retailing giant. On Sept. 29, the Chicago Tribune reported StockDiagnostic.com's alarm, noting that none of the seven Wall Street analysts covering the stock rated it a Sell. In the article, Sears Chief Financial Officer Paul Liska called Markowski's analysis flawed. But on Oct. 2, the SEC forced Sears to amend its first- and second-quarter results to reflect more accurately an increase in bad debt in its giant credit-card portfolio. On that news, StockDiagnostics.com said the retailer's practice of "increasing credit-card business, at a time when the economy is going further into negative territory where customers cannot pay their credit card bills, could be a major problem." 

 

On Oct. 4, the Hoffman Estates, Ill., company fired the head of its credit and financial-products operations. On Oct. 7, Sears warned that third-quarter earnings would fall short of expectations because of a profit drop in the credit card division. And on Oct. 17, the company posted earnings 27% shy of both the lowered guidance and the year-earlier results. It also warned that full-year profits would fall because of recently discovered uncollectible credit-card debt. The stock plunged to $23.15, a 12-year low.

 

There are other prominent examples of StockDiagnostics.com's prescience. In September 2002, while Dallas-based Fleming was still one of the nation's largest food distributors, StockDiagnostics.com diagnosed it with the EPS syndrome and predicted it would fall into bankruptcy. A year later, it did. That same month, after Fortune magazine named MCSI, an Atlanta-based audiovisual equipment and services company, as one of the 100-fastest growing companies in America for the second year in a row, StockDiagnostics.com put it on bankruptcy alert. Nine months later, it filed for Chapter 11 protection.

 

StockDiagnostics.com "is not a substitute for complete analysis," says Raymond Mullaney, portfolio manager and president of Conservative Financial Counselors, a registered investment adviser in College Park, Md., who subscribes to the service. "But in the majority of cases it will be an excellent warning system. If this system says something is wrong, then something is wrong. There are many times this company has alerted users to problems in the income statement that Wall Street missed." 

 

Gaining an Audience
StockDiagnostics isn't the end-all and be-all of stock evaluation. It's not particularly successful in evaluating financial companies, for example, because relatively little can be gleaned from their cash-flow statements. (They tend to make their money more from investment activities than operations.) And Markowski points out that companies with healthy operational cash flow aren't necessarily best buys. Drug giant Merck (MRK), for example, has an OPS Ranking of 1, yet faces declining earnings as the patents on its blockbuster drugs near expiration. 

 

Still, the OPS Newsletter's record thus far has been impressive. Since it began in August 2002, 123 of the 163 stocks it has recommended are up - a 75% success rate. And of that 163, 22 stocks have more than doubled, with nearly half of them up more than 200%. 

 

Its record on warnings looks less stellar. Of 86 stocks, only 32, or 37%, are down right now. But five of those companies, including Sears, have already taken their hits, and are on the path to recovery. Markowski also believes that the bull market has kept prices up for many companies - including Agilent (A) - that have serious negative OPS or operating-cash-flow problems. 

 

"They can run, but they cannot escape negative cash flow," says Markowski. "They either have to borrow more money or sell more shares, and both options are devastating to shareholders." 

 

On the Horizon
Two companies Markowski considers worrisome are computer-systems designer Cray (CRAY) and Helen of Troy (HELE), a maker of consumer products. "The market is valuing them based on their indicated earnings," say Markowski, "but they don't have positive cash-flow multiples, because they are throwing off so much negative cash." 

On a positive note, StockDiagnostics.com sees the following components of the Dow Jones Industrial Average hitting multiyear highs of free cash flow.

 

 

COMPANYMULTI-YEAR HIGHS OF FREE CASH FLOW
Alcoa (AA) 7 years
Coca-Cola (KO)7 years
ExxonMobil (XOM)6 years
Home Depot (HD)7 years
IBM (IBM)9 years
Intel (2 years
International Paper (IP)7 years
McDonalds (MCD)7 years
Merck (MRK)9 years
Microsoft (MSFT)8 years
Procter & Gamble (PG)8 years
SBC Communications (SBC)6 years
3M (MMM)8 years
Wal-Mart (WMT)8 years

 

 

Of the Dow 30, only Altria (MO) and AT&T (T) are posting multiyear lows. The bigger picture? "Based on free-cash-flow multiyear highs," says Markowski, "we believe the Dow will make an all-time new high in the next six months. Because you have such a diverse group, and all these different parts of the economy are firing off huge cash-flow increases, that's going to bode well for the market." He calls this a very good leading indicator of the economy, because companies have the cash to pay down debt or buy capital equipment 

 

He also says that while the earnings of the S&P 500 are far below their July 2000 peak, free cash flow is currently at a record high. So while Wall Street analysts worry the index may be overvalued based on its P/E ratio, Markowski says it is exceedingly undervalued based on its free-cash-flow multiples.