After Enron's high-profile meltdown, many investors are looking for some extra help in choosing which investments to dump, and which to keep.
Amid a crisis in confidence, it's tough to judge companies these days. Here to give us some tips is Hugh Johnson, chief investment officer of First Albany Asset Management. Johnson manages $640 million in assets for individual and institutional clients and is a consultant for more than $900 million in institutional assets. Among his instructions is to follow the cash and look past reported earnings to see whether a company's divisions are actually generating cash. Johnson's confidence in this approach is one reason why he's still bullish on Tyco ( TYC). TSC: In this environment, how can investors differentiate between complex and risky companies? Johnson: It's not easy to tell which companies are using accounting practices that are quite simply too aggressive. The only way you really know that's happening is if a company announces -- as in the case of IBM ( IBM) or Nvidia ( NVDA) -- that they're going to change their practices. My worry, and I think it's the worry of a lot of investors, is that there are going to be many companies that will restate earnings because they're
worried that their accounting practices were too aggressive. TSC: What can investors do to protect themselves post-Enron? Johnson: You'll hear a lot of analysts say follow the cash -- which means evaluating companies by the cash they're generating in their divisions, rather than by the earnings they report. But you need to dig that info from an income statement, which requires the ability to do some financial analysis. In the absence of it, the way for investors to defend themselves is to have a sell discipline. If the price of a stock breaks down -- and it breaks a certain tripwire -- investors have to follow their disciplines, and sell a stock. And after a while, they'll find out the actual problem. TSC: When do you think the confidence in crisis is going to end? Johnson: It's hard to say when it will be over. The issue now is not so much that investors are bewildered. They're really, quite frankly, assuming you can't believe anything. The real worry is that other companies will restate earnings, and no investor that I know feels very comfortable. Nobody knows when this will end. It is a cloud that will hang over the market for at least a couple of months. TSC: Which companies are on your radar screen for possible liquidity problems? Johnson: I don't have specific names on a "radar list." There are a number of companies with debt market securities -- either bonds or short-term commercial paper -- that are lower than investment grade. If you follow the junk-bond market, you'll notice there's enormous volatility. A lot of companies' paper is not only being downgraded these days, but is plummeting in price. Those are the ones you watch. TSC: How does the cash crunch inhibit the ability of the economy to recover? Johnson: It's very difficult to make the case the economy is going to recover when the credit markets are seizing. This raises serious questions about whether the economy will indeed recover in the first or second quarter of this year. Keep in mind: The events are not broad-based. There are specific companies running into problems in the commercial paper markets and long-term bond markets. The problems are not nearly as widespread as the financial press would lead us to believe. Hopefully, the price damage will be limited to companies in question. But there are signs the fears are contagious. There is a dark cloud of accounting practices hanging over the market. TSC: What are some companies that look good in your opinion? Johnson: The companies that look good are high-quality companies which may be using aggressive accounting, such as Citigroup ( C) and even Tyco. They're a lot better than the markets are showing. Also on my list are companies that are doing great jobs -- Harley-Davidson ( HDI) (despite the fact that there are those that question, improperly, what's going on), Target ( TGT), Pepsi ( PEP), Safeway ( SWY) and H&R Block ( HRB). Many health care companies are doing well. At the top of my list are Johnson & Johnson ( JNJ) and Pfizer ( PFE). Medical device maker Medtronic ( MDT) is also doing good things. I mentioned Tyco, which has been painted improperly with the Enron brush. Tyco's a good company, although they do use aggressive accounting. United Technologies ( UTX) is another exquisite company. TSC: So, after all the investigations, you still support Tyco? Johnson: Absolutely. This is a good example of where you should pay attention to cash and not earnings. Are there divisions -- the electronics, securities or health care units -- that are generating cash from operations? The answer is yes. The company is acquisition-minded, so it needs access to the credit markets. I understand the issues with CIT, the finance division. But this is a pretty darned good company. You're not going to like what I'm going to say: But if there's a problem, it's that companies are getting painted with an Enron brush, and there are opportunistic investors shorting the stocks when they don't understand the fundamentals. Not only that, these people are talking it up and spreading rumors. That's an unfortunate reality of our financial landscape today. TSC: What do you make of suspicions that Tyco might be artificially boosting earnings in marking down the value of assets in companies it acquires? Johnson: We've looked at it, and we agree that they're using aggressive accounting techniques. The SEC has looked at it, and they would say the same exact thing. But they're not illegal or misleading. Again, ask yourself, are there divisions that are doing good work? The answer is yes. TSC: What would you say is the common theme among the companies you like? Johnson: The common theme is they have stock price performance which has beaten the S&P 500 over long periods of time. This reflects either continued earnings or cash-flow growth. TSC: When do you predict an earnings recovery? Johnson: After-tax corporate profits on a year-over-year basis will turn positive in the second quarter; pretax corporate profits and S&P 500 earnings on a year-over-year basis will be positive in the third quarter. Next year is when you should see fairly substantial growth in earnings. TSC: When do you expect an economic recovery? Johnson: There's never clarity on an economic recovery before it occurs. I have never been in a recession where economists and strategists didn't question the timing of it. The index of leading economic indicators is rising, pointing to a recovery. Various other specifics, such as an overall rise in stock prices, the decline in jobless claims and the rise in money supply are well worth watching. If you're going to place a bet, the best bet to take is that there is going to be a recovery. The economic numbers are telling you that is the most likely outcome, even though you don't know it for sure. TSC: What are some other things investors should be thinking about? Johnson: There are three risks to this market. The first is the possibility of a confrontation with Iran, which is an important player in the international economic arena. It is not the same thing as Afghanistan or Iraq, and it could carry with it very significant implications for the U.S. Second, there's an extraordinary risk of Enronitis, which is that companies will restate sales and earnings because they change financial accounting practices. The third risk is a further decline in the Japanese yen vs. the dollar, and the possibility that it could lead to a new round of competitive devaluation in Asia. That would be a significant problem for the U.S. economy.
President and Chief Investment Officer,
First Albany Asset Management
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Charles W. Mulford