'Clean Stock' in a Sullied Business: T. Rowe Price

Now I know that outperformance by one stock no more makes a trend than one swallow makes a spring. But I can't help thinking there's a potential strategy here that deserves testing. Perhaps we can generalize from the T. Rowe Price example and say, "The best stock to buy when a scandal taints an industry is the cleanest stock in that industry."

The Clean Stocks Model

I launched this cooperative effort to build a list of clean stocks in July 2003. Over the months, readers helped me develop a final list and refine the set of eight rules that now form the test that stocks must pass to be added to the Clean Stocks portfolio.

In each Clean Stocks column, I put three stocks nominated by readers to the test. Those that make it get added to the portfolio. And I end each column with a request for nominees for the next round.

My June 23, 2004, column proposed putting three reader nominees to the test: Lennar (LEN Quote), Chico's FAS (CHS Quote) and Cincinnati Financial (CINF Quote).

The last of that group is an ideal test stock. Cincinnati Financial is one of those under-the-radar stocks that delivers market-beating returns year after year. For the last 10 years, the stock has an average annual return of 11.28%, a full 2 percentage points better on average than the annual return on the S&P 500.

But Cincinnati Financial, an insurance company, is operating in a troubled industry. Is it clean enough to survive the scandal and join T. Rowe Price in the Clean Stocks portfolio as a scandal survivor? I'll answer that question later in this column; first, let's take a closer look at Lennar and Chico's FAS.

Wrong on So Many Levels

What about Lennar? Let me count the ways this company fails the Clean Stocks test.

Executive compensation. CEO Stuart Miller, who succeeded his father Leonard Miller in 1997, took home a bonus of $12 million in 2003. Lennar is one of the few companies I've come across that links the CEO's bonus to total pretax income rather than income per share. That means any acquisitions or other transactions that dilute the stock by creating new shares don't have any effect on the CEO's bonus, although they certainly depress earnings per share, at least temporarily. That's not a minor issue for a company like Lennar that has acquired more than 20 other homebuilders and bought five title-insurance and mortgage companies in the last decade.

Accounting. The company's books are a maze of off-the-balance-sheet partnerships that hold about one-third of the company's inventories of land for development. That lets Lennar boost revenue and earnings by selling land to itself (in essence), and from the management fees that these partnerships pay to Lennar.

I'll be the first to admit that none of this matters to Wall Street and investors right now. As long as mortgage rates stay reasonably low and buyers keep stepping up to the plate, Wall Street will keep recommending the stock. Six of 10 Wall Street analysts now rate the stock a buy. That's unchanged from three months ago. But these are exactly the kinds of things that get a company, and investors, into trouble when sales growth starts to stall.