Paychex Should Keep Cashing In

Ted Williams was baseball's fussiest hitter. In The Science of Hitting, the former Red Sox left fielder explained that the key to doing well at the plate is getting a good pitch at which to swing.

To make his point, Williams said that in his mind's eye the strike zone was a rectangle seven baseballs wide and 11 baseballs high. On each of these 77 "baseballs" was a number -- his batting average if he hit balls pitched in that location. To Williams, the batter who can't "see" the strike zone in terms of percentages is at a disadvantage, because once pitchers find a batter who will swing at low-percentage pitches, he'll get nothing else.

Of course, the Splendid Splinter wasn't just interested in strikes; he wanted pitches in his "happy zone" -- an area in which he could hit .350 or better. This discipline helps explain why Williams batted .406 in 1941, becoming the last major leaguer to break the magic .400 barrier.

Williams' theory of hitting also works with stock selection. In this column, I'll look at a three-screen strategy from my upcoming book, It's Earnings That Count. If you're a growth investor, this approach may help boost your investment batting average.

To illustrate, let's examine Paychex (PAYX - commentary - Cramer's Take), which just filed its 10-K for the fiscal year ended May 31, 2003. The Rochester, N.Y.-based firm provides payroll-processing and related services for 490,000 businesses that have fewer than 200 employees. (Paychex's largest competitor, Automatic Data Processing (ADP - commentary - Cramer's Take), caters to larger businesses.)

Screen No. 1: Authentic Earnings Power

The first of my three screens is to make sure the business can self-fund and create value -- topics I've written about previously. As we see below, Paychex was profitable on an accrual and enterprising basis but had a defensive loss.

Sources: SEC; EarningsPower.com; BigCharts.com

Therefore, Paychex was situated in the lower-right box last year.

Sources: SEC; EarningsPower.com

Why the defensive loss? Because Paychex bought two companies in fiscal 2003 for $494 million. In the hard-money world of the defensive investor, acquisitions are immediately expensed, because they are a use of cash, and because you never know whether they'll generate higher sales and earnings.

Paychex, though, has a long operating history and has nary a speck of debt on its balance sheet. Therefore, I'll give management the benefit of the doubt and not expense the two deals. This turns a defensive loss into a profit. Now it's firing on all three cylinders.

Source: SEC; EarningsPower.com; BigCharts.com

What's more, Paychex moved in an upper-right direction last year, forging what I call an Earnings Power Staircase pattern. Staircase companies such as Paychex are the real blue-chip stocks of Wall Street.

Sources: SEC; EarningsPower.com

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman didn't hold any securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].

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