Dow Dogs Rule
Plus, a Look at Balance Sheets

by Chris Rugaber (TMF

Alexandria, VA (April 15, 1998) -- Our Foolish Four stocks continue to power ahead. It all comes back to earnings -- real or anticipated.

For some really real earnings, let's take a look at J.P. Morgan (NYSE: JPM), whose stock has increased by about 3% over the past couple of days. Yesterday, J.P. Morgan blew away estimates of first-quarter earnings, reporting EPS of $3.01, almost double analysts' estimates of $1.73. Earnings rose 64% from last year, but much of the good news seems to have already been factored into the price. J.P. Morgan has been rising steadily all year.

Caterpillar (NYSE: CAT) has also jumped in response to positive remarks made by the company at its annual shareholders' meeting and due to several analysts upgrades. Caterpillar will release first-quarter earnings Friday morning. We'll be looking at all our companies' earnings reports in the weeks ahead.

Today, let's go back to the discussion of the fundamental analysis that I began in earlier articles. As stated previously, while Foolish Four companies are selected mechanically, it's worth looking at their businesses as learning exercises. Investors who are interested in branching out from the mechanical screens of the Foolish Four should know how to analyze income statements, balance sheets, and cash flow statements. Since I am continuing to learn about this myself, we might as well learn together. (Isn't that nice? No need to all hold hands and sing Kumbaya, though). Questions on reading financial statements should be posted on our Reading Financial Statements message board.

We have already looked at Caterpillar and its income statement. Let's begin considering balance sheets, which provide a more in-depth look at a business. First of all, investors interested in understanding them should start with our Fool's School series on balance sheets. The Motley Fool Investment Workbook is also an excellent source of info, of course, and finally, I found John A. Tracy's How to Read a Financial Report (available in FoolMart) to be an excellent primer as well.

There are many things to consider on a balance sheet, but for now we'll just focus on accounts receivables and inventories. Accounts receivable (also abbreviated as A/R) are sales that the company has not yet been paid for. Inventories, of course, represent unsold parts and products. Let's look at why these things matter.

Receivables are important because not all sales immediately result in cash in a company's pocket. Many companies record sales that they have not actually been paid for, and those sales are placed in the accounts receivable part of the balance sheet. Generally, this is a harmless practice, since a balance sheet is simply a snapshot of a company at a particular time, and it is natural that a company might have invoices outstanding that haven't yet been paid. Nevertheless, if accounts receivable grows sharply, or if it grows faster than sales, then a company may be running into serious trouble.

There are many examples of this phenomenon. Safeskin (Nasdaq: SFSK), a recent one, was discussed by Warren Gump in an excellent Evening News article last month. In addition, both The Motley Fool Investment Guide and Rule Breakers, Rule Makers discuss case studies of companies relying on accounts receivable to pump up sales. Essentially, what happens in these cases is that the rapid growth in sales causes a stock's price to rise, until investors notice that accounts receivables are also growing rapidly and the stock's price collapses.

Another reason that these are interesting metrics is that technology has increased the potential efficiency of both A/R and inventory management. The Internet, for example, enabled (Nasdaq: AMZN) to have zero accounts receivable in 1998, since its customers pay for their products before they receive them. Barnes & Noble (NYSE: BKS) reported $66 million in A/R in their most recent quarterly statement. This is not bad in and of itself, but relative to, it indicates at least part of the reason the market has gone gaga over Amazon and e-commerce generally.

Regarding inventories, supply chain management software has enabled retailers, for example, to more accurately track their sales and their future merchandise needs, helping them reduce the amount of inventory they carry. Other companies, most famously Dell (Nasdaq: DELL), have used e-commerce to reduce inventories, since they don't assemble their computers until a customer orders them (though they still must carry parts). Dell's "just-in-time" direct marketing business model, imitated by many, has given Compaq (NYSE: CPQ) fits, and that is reflected in the companies' respective stock prices.

This is all simply a quick sketch, of course, but efficient companies that can keep accounts receivables low and inventories down, both of which free up capital, are being rewarded by the stock market, even if their competitors may be larger in terms of revenue or book value. These changes have been covered in more detail in many other articles on our site, of course. For example, see Alex Schay's A Tale of Two Bookstores, or anything in the Rule Breaker Portfolio on, or Dale Wettlaufer on Traditional Valuation.

So how does this relate to the Foolish Four? Now that we know why A/R and inventory management is important, we can evaluate how well our companies handle them. Of course, our F4 stocks have different business models than the Dells and Amazons, but we can compare companies like Caterpillar to their competitors and get a good sense of how our companies fare within their industries. Next week we'll start doing just that.

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Today's Stock Lists | 1999 Dow Returns

04/15/99 Close
Stock  Change   Last
CAT  +1  1/16  61.75
JPM  -   3/8   132.50
MMM  +4        79.25
IP   +3  1/8   55.38

                Day   Month    Year   History
        FOOL-4   +3.00%  20.86%  24.29%  26.14%
        DJIA     +0.49%   6.91%  14.34%  13.89%
        S&P 500  -0.42%   2.84%   7.94%   8.20%
        NASDAQ   +0.59%   2.48%  15.05%  16.59%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     61.75    43.34%
 12/24/98   22 Int'l Paper   43.55     55.38    27.15%
 12/24/98    9 JP Morgan    105.51    132.50    25.58%
 12/24/98   14 3M            73.57     79.25     7.72%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1482.00   $448.00
 12/24/98   22 Int'l Paper  958.12   1218.25   $260.13
 12/24/98    9 JP Morgan    949.62   1192.50   $242.88
 12/24/98   14 3M          1030.00   1109.50    $79.50

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $5045.55