The Best Stock Picker on Wall Street?

OK, perhaps it's a bit of a stretch to equate the father of value investing — and Warren Buffet's mentor — with this small Internet publisher. Still, much like Graham's classic 1934 textbook, Security Analysis, Markowski's Web site, StockDiagnostics.com, offers a bold new way to evaluate stocks. Two years ago, Markowski created a new investing approach he calls stock diagnostics, or "the science of using financial-statement anomalies to identify investment opportunities."

Since Graham's tome first hit the shelves, the foundation of investing has been to look for companies with steadily rising earnings and low price/earnings ratios. Do that, the conventional wisdom goes, and you'll likely end up with winners. It's the basis of fundamental analysis, which attempts to forecast the future based on past performance.

But after three years of earnings blowups and restatements, corporate bankruptcies, and outright fraud, the public has learned that Wall Street can manipulate earnings figures like a Swedish masseuse. New times call for new approaches.

Markowski, co-founder and director of research at StockDiagnostics.com, patented a proprietary algorithm he says measures a company's financial health more accurately than earnings per share. He calls it operational cash flow per share, or OPS. Markowski's company uses in-house software to examine the operational cash flows of 8,000 publicly traded companies, track trends and rate their general health. Subscribers are allowed to view the results. The company also offers buy and sell recommendations in its weekly OPS Newsletter.

With a record of 75% accuracy for upside moves, the newsletter boasts possibly the best stock-picking record on Wall Street. Just as important, it helps investors identify blowups before they happen — sometimes saving them from big losses. How does it work? We'll explain.

Profits, But No Cash
Even without a whiff of fraud, corporate earnings results include a lot of noncash items, such as receivables, payables, depreciation, amortization and one-time adjustments, either charges or gains. But a company that's profitable on paper may not be meeting its regular operating expenses. Wall Street's favorite cash-flow measure — Ebitda, or earnings before interest, taxes, depreciation and amortization — is supposed to track this. But Markowski says Ebitda excludes too much relevant information. "The accounting scandals show it's not a reliable indicator," he says.

By contrast, operational cash flow — based on the cash-flow statements companies file with the Securities and Exchange Commission — looks only at the money actually moving in and out of the company each quarter. How is this computed? Take their net income, add depreciation and decreases in payables back in, then subtract increases in receivables and inventories. That leaves cash flow from operations, or operational cash flow. Markowski simply takes this number and divides by outstanding shares to arrive at OPS. The result is often nothing like Ebitda. For instance, StockDiagnostics.com notes that IBM (IBM) recently hit a nine-year high in operational cash flow, while posting a three-year low in Ebitda.

The key to OPS is that it takes away one big trick some companies use to bolster their earnings numbers: accrual accounting. This technique allows companies to book receivables (money owed to them) as revenue, before they actually receive the cash. The problem: IOUs can't be used to pay real operating expenses. And if a bankruptcy forces a customer to renege on or dramatically reduce payments, the company never will recoup that money. When companies count too many chickens before they're hatched, it can be disastrous — for them and for their shareholders.

Markowski has come up with a simple way to identify potential blowups before they happen. He takes companies that are reporting big profits and examines their operating cash flow. If OPS turns negative compared with the year-ago quarter, it's time to bail out of the stock. "In 99% of the cases, [these] stocks are at all-time highs," says Markowski. "Everyone bids them up thinking everything is great, but there's no cash behind the EPS." Markowski calls this the EPS syndrome.

Thanks, Enron
StockDiagnostics owes its existence, oddly enough, to Enron. "If Enron hadn't died, Stock Diagnostics wouldn't be an entity today," says Markowski.

Markowski spent the 1980s and early 1990s working as an analyst at Merrill Lynch, then at Donaldson Lufkin & Jenrette, and then a venture capital firm. In 1995, he and his younger brother, David, founded Newsgrade, a Sarasota, Fla.-based Web site offering information about public companies. In 1999, with his brother running operations, Markowski focused on developing a system to detect anomalies in the finances of public companies. He completed it in 2001, just after Enron collapsed.

For its first test drive, Markowski and his eight researchers performed an autopsy on Enron to see if they could find out what killed the Houston energy company. They discovered it had been afflicted with a cash-flow crisis in the two quarters before its death, even as it posted record earnings — the EPS syndrome. Next, he back-tested the algorithm to 1997, and discovered the EPS syndrome was present in 248 public companies that saw their stock prices decline more than 90% during that time, including Sunbeam, Polaroid and Fruit of the Loom.

Markowski wasn't finished. Comparing EPS with OPS, he assigned each quarterly result a value of between one and eight, with one being the safest level and eight a sign of imminent danger. A five-year graph of these values offers a useful picture of a company's financial momentum. A two-quarter change in these values, either positive or negative, often predicts a change in earnings, and hence stock price, weeks or months before it happens. By identifying a trend in the company's momentum, an investor can find a stock with a high probability of success or failure.

"OPS is a good predictor of revenues and profits coming in the next two quarters," says Markowski, "because the cash will show up in a business with a hot product before the revenues show up. One reason is because people put deposits down on products. These are great signals."