10 Investment Guidelines: Part 2

Last week, I discussed my admiration for the work of my former colleague Richard Bernstein and began to provide my own interpretation and commentary for 10 Guidelines Learned in 20 Years, Bernstein's final report at Merrill Lynch. That first article covered the first five guidelines, and in this installment, I'll go over the final five.

6. Balance sheets are generally more important than are income or cash flow statements.

Time and time again, I have about the importance of balance sheets. As a young auditor many years ago at Price Waterhouse, I learned to focus on the balance sheet as the central part of a company's financial condition. The profit and loss statement is merely a bridge between balance sheets from two different periods, while a statement of cash flow is just a reconciliation of cash balances between two periods.

While analysts and the media tend to focus on the income statement and get all caught up in consensus earnings estimates, the best investors scour the balance sheet. If the profit and loss is trumped up, the offsetting item will be buried in the balance sheet. Had analysts, auditors and investors focused on WorldCom's or Enron's balance sheets rather than their earnings, then the frauds may have become more apparent at a much earlier point in time.

7. Investors should focus strongly on GAAP accounting and should pay little attention to "pro forma" or "unaudited" financial statements. Bernstein has plenty to say in his seventh guideline. Let's take a closer look.

First, he says that "investors should focus strongly" but does not say "exclusively." I interpret this to mean that the emphasis should be on GAAP accounting without overlooking other forms of income statement presentation, because there may be some merits, however small, in those other accounting interpretations.