Hey home-gamers, don't beat yourself up for missing the options-backdating scandal. Even renowned stock sleuth Robert Olstein says it was nearly impossible to spot.
The recently unearthed scandal, which has revived Main Street's skepticism into corporate accounting practices, centers on how certain companies priced options granted to their executives. And despite all the sharp pencils wielded by Wall Street's analyst community, it took an associate professor of finance at the University of Iowa named Erik Lie to uncover it.
Employee stock options typically carry a strike price equivalent to the market price of the stock on the day they are granted. But more than a dozen companies so far have been identified as having suspiciously granted options on what turned out to be their stock's near-term or 52-week low. The accusation is that the companies set the strike price for the options after they were actually granted so as to take advantage of low prices, which yield a greater payout if the market value goes up.
Olstein, portfolio manager for the $1.7 billion
Olstein Financial Alert fund and a well-known digger into financial documents, explained to the
why even the savviest investor would have missed corporate America's latest disgrace. He threw in a few of his favorite stock picks as well.
TheStreet.com: What is your take on the recent scandal regarding companies backdating options? To the retail investor it seems like another example that the game is rigged in favor of the privileged few.
: This was a shock even to me. I never looked at this stuff. It escaped me to look at where option prices were during the year. We add back option expenses into our cash flow because it is not a cash flow item. When we value a company, we look into the dilutive effect of the options, but we add back the fictitious expense that goes on the books.
How prevalent do you think this problem is? Should investors be worried about it?
I think this is simply a case of a bunch of people with bad judgment. I don't think it's prevalent; maybe it happened in 20 or 30 companies.
It's similar to the stock market timing scandal in the mutual fund industry. A few firms broke the rules, but there are 5,000 funds out there. I don't think it's widespread and I would like to think there are people out there who have better judgment.
As a person who is known for digging into the documents, could you have seen any way the individual investor could have spotted these shenanigans ?
I would say it would be nearly impossible. I saw
collapse in advance. That was easy to me. I saw
problems coming as well. But this escaped me because I never even thought of it.
Let's talk about stocks for a minute and get back to scandals later. What names do you currently like?
One stock in our fund which I'd like to talk about is
. Xerox is a company we identified early as paying down a lot of debt. Plus they have a good leader in
Chairman and CEO Anne Mulcahy and great free cash flow.
The key to Xerox's success is that they transformed their business from black-and-white copiers to digitization and color. The margins are much higher now. And now the free cash flow yield is north of 10%. Now that the margins are higher, we think the free cash flow of this company is probably in the area of $1.25 a share. We think it is worth around $19 to $20, yet the market is focusing on the fact that there is excess depreciation instead of the tremendous transformation taking place.
How long have you owned Xerox? It's been stuck around $14 for nearly two years.
We've owned it since April 2005. Our average cost is $13.37, so we have not made too much money yet.
You mentioned that Xerox has a good leader in Anne Mulcahy. But I thought you don't usually look at management and just stick to watching the financials.
You can judge a good leader by how they manage their finances. This was a problem company. They had a bad leader, they had bad accounting, and they had a huge debt load. But all of a sudden you see debt coming down and other good things. And you can see it in the financial statements.
We judge management via the financial statements. We pay attention to how they act, not what they say. We look to see if they are conservative and if they care about free cash flow.
Any other stocks you want to talk about?
? That's the leading insurance company in the world. They got involved in a scandal where rates were rigged. They were fined and the stock fell sharply.
But we did not think the company was going to fall off the face of the earth. We thought they had earnings power and free cash flow power of $2 to $2.50 a share. We thought that the new leader was conservative. And we thought that Putnam, which was involved in the market-timing scandal, would right itself.
Where did you start buying this one? It's at $28.15 now, but Marsh has been stuck between $27 and $33 for almost two years.
Our average cost is $28.78 and we started buying it in October 2004. But I see what you are getting at, so let me give you the story of
We started buying J.C. Penney at $20 a share in 2001 and we bought it all the way down to $9 a share. Now we are selling out of that position in the $60s. So we sat there for a few years with an average cost of $14 or $15 until it finally moved up.
There is pain while you are sitting there. But the whole philosophy of the fund is that if you buy something that has some negativity in it, then if you are wrong the downside is maybe 20%, because the negativity is already in there. However, the upside can be more than 50%.
I originally thought AIG was too aggressive. They pushed the envelope. So I stayed away for a long time, but we own it now.
Almost all the sell-side analysts on Wall Street missed, or couldn't really understand, what was happening at AIG under Hank Greenberg. But they never seemed to dig deep enough to find the real story. Has Wall Street research improved at all?
It's gotten a lot better. I was a huge critic of Wall Street research in the late 1990's. Way before Spitzer took up the cause, I wrote a feature article on where analysts were going wrong. And they are still too much in the "now."
It's better because you see sell recommendations out there now and you never used to see that before. My biggest criticism today with sell-side analysts is that they are shortsighted. They are only worried about the next 90 days, as opposed to the next two to three years.
We don't read Wall Street research for their opinions. It's good for other things, like economic forecasts, but we do our own stock research.