The bad guys get all the headlines, but don't let them scare you into putting your money in the mattress.
So far, the "Clean Stocks" project
I launched last July has identified six stocks that are clean enough for investors who worry about the never-ending round of financial scandals, yet know they must stay in the markets to stand any chance of reaching their own financial goals.
In this column I'll add two more names to my list and nominate three other candidates for due diligence.
It's not easy to find the good guys. After all, CEOs like Dennis Kozlowski and mutual fund managers like Richard Strong get the headlines and the TV time.
The good guys are ignored, except by smart investors.
These investors know that not all mutual funds see Job No.1 as filling managers' pockets by ripping off shareholders. The Dodge & Cox family of funds, for example, combines above-average gains for investors with below-average expenses.
Rather than waiting for
Securities and Exchange Commission
regulations, the Fidelity group of funds rigorously applies fair value pricing to prevent stale pricing at its international mutual funds. The Tweedy Browne fund family makes a habit of fighting for shareholder value. Its successful efforts to oust Conrad Black as CEO of
( HLR) after Black and other company executives accepted $32 million in unauthorized payments produced a one-day gain of $30 million for shareholders of the company's funds.
And of course, there's the Vanguard group, which has a policy against late orders that's still way ahead of any of the reforms now being proposed by the SEC or Congress.
And not all CEOs of publicly traded companies behave as if the company belongs to them, either. For every Bernie Ebbers, Dennis Kozlowski and Richard Scrushy, there's a Peter Rose or a George Roche.
Rose, the CEO of
, earned a base salary of just $110,000 in 2002. Roche, president and CEO of
T. Rowe Price
, earned just $300,000.
Ever heard of Rose or Roche? Probably not, as all they've done is run their companies in ways that investors can trust. Digging to find companies that you can trust with your money is worth the effort. For the last 10 years, the cumulative return on the
is 126%, and it's 152% on the
. In the same period, shares of T. Rowe Price are up 539% and Expeditors International 2,156%.
Stocks of companies that behave well toward shareholders often are, but obviously not always, superior long-term investments.
That's the premise behind the growing list in my Clean Stocks project.
The process works like this: Each month or so, I nominate three candidates for inclusion on the list from suggestions readers have sent me. That lets us harness the combined knowledge of everyone who reads Jubak's Journal.
In the month after the nomination, I do due diligence on each stock and so do readers who send in whatever they know about them. At the end of that, I report which companies made the list and which didn't and why. And ask for another three nominations.
If at any point a reader or I come up with something that makes us question the company's place on this list, I'll review the selection.
Companies and their stocks are judged in eight areas: executive compensation, accounting, conflicts of interest, growth strategies, corporate structure, options accounting, pension accounting and potential return to investors. Clean Stocks almost certainly will have a blemish or two, but the bad marks should be limited and, ideally, immaterial to their investment quality.
Last month's nominees were
Let's see how they did.
Southwest Airlines: Grounded
I suspected options accounting might present problems for Southwest, and it did. I think the issue is serious enough to keep the company off the Clean Stocks list -- especially because it's facing future pay pressures that will put options front and center.
The problem isn't that Southwest is stuffing its executives' pay envelopes with options, an all too widespread problem these days. Executive cash compensation is below the airline-industry average at Southwest: Chairman Herb Kelleher received just $431,000 in salary and $170,000 in bonuses in 2002, and CEO James Parker was paid $305,000 in salary and $287,000 in bonuses. And Southwest doesn't overdo options to compensate. Kelleher and Parker each received option grants equal to just 0.02% of all options granted to employees in 2002.
That's about what I'd expect from a company that's up to the most exacting standards of corporate governance. Auditor Ernst & Young make almost all of their money from auditing the books without big consulting contracts as an incentive to look the other way on accounting infractions. Even by my conservative count, eight out of 12 members of the board qualify as independent.
The company's options accounting, however, doesn't meet the same high standards.
Southwest doesn't count options as compensation. In 2002, counting options as compensation to employees would have turned Southwest's earnings of 30 cents a share into 23 cents a share. That's a 23.3% swing.
And that's too much, considering that options are a key reason why Southwest's labor costs are below those of other airlines. The company historically has made up the difference -- and then some, considering the stock's performance -- with options. Employee gains from options have helped the company win the kind of flexible scheduling and high productivity from Southwest's intensely loyal employees that give the company a cost advantage over competitors.
The stock has faltered -- shares are down a cumulative 10% over the last three years -- and the pressure to increase salaries has grown. Will that mean Southwest will grant more options in an effort to keep cash compensation low or will the uncertainties in the airline industry make its employees demand more cash? It's hard to tell how future compensation issues will affect earnings because the company doesn't expense options as compensation now.
Bank accounting requires a lot of trust from investors. Are bad-loan reserves really enough to cover write-offs? Is the bank taking big risks in its hedging against risk? Are securities in the bank's portfolio really marked to fair value? There's really no way for most investors to tell so it all comes down to trust: Do you trust that the people running the bank are telling the truth?
I'd say yes at Trustmark, a bank with 150 offices in Mississippi and Tennessee. Here's why.
The company, headquartered in Jackson, Miss., set up its governance committee in 2000 before the issue became fashionable. The audit and finance committee meets with internal and outside auditors regularly without management, something recommended in the latest round of reforms. And the company has a clear and anonymous method for reporting fraud posted prominently on its Web site for employees and the public, along with a promise not to retaliate against whistle-blowers.
The rest of my due diligence supports that picture. Expensing options wouldn't change earnings per share. Ten of 12 directors are independent by my definition. Auditor KMPG makes $471,000 from auditing the books and only $73,000 from other work. Tricky categories that give banks a chance to fudge earnings, like gains on sale of loans, are a small part of total income. The company did grow by acquisition in 2003, but the deal was to add seven bank branches in Florida and put just $48 million in goodwill on the books.
Blemishes? Executive compensation needs watching, as does the concentration of power that combines the offices of chairman, president and CEO in one executive, Richard Hickson. Hickson's 2002 cash compensation isn't out of line at $550,000 in salary and $550,000 in bonus, but his 2002 grant of 45,000 options represents 11.5% of all options granted to employees that year.
I think Walgreens' management proved itself in the drugstore wars of the 1990s. While all of its competitors were busy bulking up by acquiring smaller drug chains, Walgreens concentrated on internal growth. Now that many of those same competitors are busy disgorging those acquisitions either through store closings or bankruptcy reorganizations, Walgreens looks awfully smart.
This is the kind of steady long-term thinking -- and execution -- that characterizes just about everything about Walgreens. The company has no long-term debt, but with Walgreens' cash flow, $1.5 billion from operations in 2002, the company has plenty of internal cash to use for expansion. Walgreens has doubled its store base to a current 4,200 over the last decade.
Management is homegrown. The company has had only five CEOs since Charles Walgreen founded it in 1901. Current CEO David Bernauer has worked for the company 35 years, and President Jeffrey Rein began his career as a pharmacist.
The company's governance looks solid, too. Independent members hold seven of 10 spots on the company's board. Auditor Deloitte & Touche is paid $455,000 to audit the company and $371,000 for all other work. And Bernauer's pay of $763,000 in 2002 and $490,000 in bonus is about average these days.
No company is perfect. Bernauer got 10% of all options granted to employees in 2002. That's extremely high, but 75% of those options were a special grant that he received upon taking over as CEO. So while it bears watching, it's not enough to make me bump the company from Clean Stocks. The company has $129 million in off balance sheet letters of credit to suppliers among others. While that also bears watching, it isn't too worrisome at a company with no long-term debt.
The addition of Trustmark and Walgreens to the Clean Stocks list brings membership to eight stocks. The other members are
, Expeditors International,
and T. Rowe Price.
Maybe next month we'll get to 10.
Nominees for due diligence for the next round are Warren Buffett's
-- is Buffett a shoo-in?;
-- can any tech company with its big lump of unexpensed options make the list?; and
The Washington Post Co.
-- can you trust the media when it comes to an investment?
Thanks to everyone who made these and other suggestions for the Clean Stocks list. Please remember to
email me with new nominees (old nominees are held over for future consideration) and with any comments you have on the stocks now on the list or those now under the microscope.
Expect the next report around mid-December.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does own shares in mutual funds Dodge & Cox International Stock and Dodge & Cox Common Stock. He does not own short positions in any stock mentioned in this column. Email Jim Jubak at