Monday Morning: Honest-EPS stocks found to fare better

Honesty really is the best policy, especially when companies report their earnings.

That’s the conclusion of a study done by Douglas Cote, portfolio manager at Aeltus Investment Management in Hartford, Conn.

Noting the recent focus on legal but questionable accounting by companies, an issue that was bubbling even before the Enron scandal, Mr. Cote wondered whether companies that reported their earnings honestly were rewarded by the stock market.

“I wondered: Could I take advantage of companies’ dishonesty in reporting their earnings to make money for my clients?” he says. After all, he adds, earnings are the key to valuing companies.

strategy mapped

Mr. Cote decided to identify companies with honestly reported earnings and compare the market performance of their stocks with the performance of stocks of companies about whose earnings investors might reasonably have doubts.

His first problem was identifying which companies were reporting their earnings honestly and which were not. He developed a measure he called “honest EPS,” which subtracts primary earnings per share from reported earnings per share.

“Primary earnings per share” is developed using the strict generally accepted accounting principles and is found in all official company financial statements.

Reported earnings per share are what companies put in press releases. They often are called pro forma earnings per share, and Mr. Cote notes they often are widely followed on Wall Street and often form the basis for comparing “actual” results with analyst consensus estimates of what a company will earn.

The idea is that a company that excessively inflates its reported earnings per share relative to its primary earnings per share might come to be seen as misleading investors and therefore be punished in the market.

Mr. Cote looked at eight years of results for stocks in the Russell 1000 Growth universe. He calculated each stock’s honest EPS, ranked them from best to worst and divided the ranking into quintiles.

He then calculated each quintile’s subsequent one-month return every month for a year. He found that the stocks with the best honest-EPS rankings outperformed those with the worst rankings by a compound annual return of 11%.

Over the eight-year period through 2001, stocks with the most honest earnings per share returned 14.92% compounded annually, while those with the least honest earnings per share returned only 3.95%.

During the first quarter of this year, the stocks with the most honest EPS outperformed the worst by 14.6%. The biggest margin between the most honest and the least honest stocks was 33.14% in 2000.

What were some of the best – and worst – stocks?

The list of the best included Fannie Mae (FNM), Freddie Mac (FRE), Comcast Corp. (CMCSK), Electronic Data Systems Corp. (EDS) and MBNA Corp. (KRB). The average difference between primary EPS and reported EPS for those companies over eight years was only 99 cents.

Among the worst: Qwest Communications International (Q), JDS Uniphase Corp. (JDSU), Broadcom Corp. (BRCM), Agere Systems Inc. (AGRA) and VeriSign Inc. (VRSN).

The average difference between primary and reported EPS was -$26.33; i.e, their reported earnings per share overstated their primary earnings per share by more than $26 over the eight years.

Mr. Cote notes that companies will often give their “reported earnings” at the top of a press release and earnings according to GAAP – i.e. primary earnings per share – farther down in the release. Even if a company does not report primary earnings in its press release, the number is quickly obtainable from a financial service such as Compustat.

“You can make money from this even a month after earnings are released,” he says. And he has seen no change in the level of honesty in reporting, although earnings have been questioned for some time.

“This is going to be a persistent factor,” he says.

Until we change human nature, some corporate managers will continue to try to exaggerate their company’s earnings. But the market won’t be fooled for very long.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.