When A Skeptic Says, 'Buy!' If this natural-born accounting sleuth finds a stock he likes, it must be a good bet.
(FORTUNE Magazine) – The ultimate in going against the grain is when someone like Albert Meyer, whose specialty is raising red flags about corporate accounting, finds something good to say about a stock. Meyer may not be a household name, but he's a longtime favorite source for a number of financial journalists (including yours truly) for his prescient pinpricks to the bubbles of Tyco and Lucent. In fact, the report he wrote on Tyco while working at Behind the Numbers, a biweekly research publication run by famed short-seller David Tice, is widely regarded as the first published swipe at the company's governance and restructuring accounting.
Now general partner of 2ndOpinionResearch.com, an independent research-only service based in Plano, Texas, the CPA and former accounting professor is still spending most of his time scrutinizing financial statements in pursuit of trouble. But every now and then he stumbles upon companies that have not only clean accounting but also what he likes to call "insurance policies" that make a stock safe to own. They are "typical Buffett-type" qualities, such as being in a business that is hard to enter, having little or no debt, not having much in the way of outstanding employee stock options that can come back to haunt existing shareholders, and producing plenty of "unfettered free cash flow"--something we'll explain in a moment.
Take, for example, Meyer's positive report on manufactured-home builder Clayton Homes, which came out three weeks before Warren Buffett's Berkshire Hathaway offered $1.7 billion to buy the company for a 10% premium to the stock's price. "It figures," Meyer says, "because it has the characteristics Buffett looks for."
To determine whether to pick or pan a stock, Meyer usually starts with the proxy statement. "I want to see that management owns a lot of stock and has modest salaries by industry comparisons," he says. "I also don't want to see any self-dealing or related-party transactions where the CEO owns an airplane the company leases from him." It was in Tyco's proxy that Meyer first became suspicious after reading that former CEO Dennis Kozlowski received a $65,000 fee to serve on the company's board.
After the proxy Meyer usually bounces to the cash-flow statement. Rather than looking only at free cash flow, which is usually described as operating cash flow minus capital spending minus dividends, he takes it one step further to arrive at his "unfettered free cash flow," which takes into account the cost of making investors whole after employee stock options are exercised. "I'd like to see no stock options," Meyer says.
Then, of course, there's the balance sheet, where Meyer is looking at the growth of each line item. When, for example, he sees inventory rising faster than revenue, "I start comparing that to competitors, and if I don't see the same kind of phenomenon, I must take into account the possible change in industry trends--or it's a huge red flag!"
Finally Meyer hits the income statement: "I look at the growth of numbers, margins, and special charges. I won't invest in companies that are prone to take charges." (You never know what they're throwing in there.)
So after scouring the books, which stocks would Meyer buy now? Two favorites that have surged recently are Tootsie Roll (TR, $29), one of the only remaining big, independent candy makers, and homebuilder Toll Brothers (TOL, $23). One safe stock Meyer says remains undervalued is small-cap radiation-detection device maker Landauer (LDR, $38). He especially likes Landauer's 20%-plus net margins and the fact that the company has "built a moat" to protect itself from competitors.
Perhaps Meyer's most controversial pick, however, is drugmaker King Pharmaceuticals (KG, $13), which is being investigated by the SEC regarding drug pricing. This is just the kind of company you would expect to be the focus of his wrath. (Meyer says he tries not to put himself "in a box.") "Sure, this has more risk," he says, "but from my analysis I think the risks are priced into the stock, and this could turn out to be a good story." Especially since King has a healthy $500 million in net cash and a rich product pipeline. Hard for even a born skeptic not to like.
Enron never happened, part two: In my last column (see fortune.com) I used Tyco as an example of post-Enron arrogance for having the gall to announce that it would take a $325 million charge for improper accounting shortly after raising $4.5 billion in cash earlier this year. That followed an audit that produced a charge of $382 million. Hate to say I told you so: Tyco recently announced yet another charge, for more than $1.3 billion. Care to guess how much money Tyco could've raised if it had taken all those charges from the start? Hint: You wouldn't need an abacus to add it up!