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HEROES

Pittsburgh-based commercial bank and asset management and trust company Mellon Bank <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MEL)") else Response.Write("(NYSE: MEL)") end if %> gained $2 3/8 to $60 1/8 on rumors from "industry sources" that the company is close to getting together with Bank of New York <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BK)") else Response.Write("(NYSE: BK)") end if %>. Bank of New York has been getting rid of credit card relationships and has been following a strategy of increasing its securities processing and trust business, both of which are not highly dependant on having huge amounts of regulatory capital sitting in low-yielding accounts. Mellon has also been concentrating on strengthening its noninterest income sources of revenue in the securities business, so investors see this as a natural fit. At 17.8 times annualized cash EPS of $3.37 and a cash return on equity of 23.5%, Mellon isn't especially pricey relative to similar banks, such as State Street Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: STT)") else Response.Write("(NYSE: STT)") end if %>. With First Union <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FTU)") else Response.Write("(NYSE: FTU)") end if %> storming into its region, Mellon might be looking for a merger partner to help it compete effectively with the change in its homestate competitive landscape, though it denies today's takeover rumors.

Black & Decker Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BDK)") else Response.Write("(NYSE: BDK)") end if %> gained $4 1/2 to $47 5/16 on reporting Q4 revenues of $1.52 billion and EPS of $1.00, beating estimates of $0.96. The company says it will restructure by selling non-core businesses such as the True Temper sports division. It will also sell its household products division and cut up to 3,000 jobs. Those assets sales will finance today's other good news for shareholders -- the company's board authorized a repurchase of 10% of the company's stock. The company says it will take a $200 million charge in the coming quarter, which will cover most of the costs of the restructuring and that the cost savings will "enhance" the company's ability to meet its goal of 15% compounded annual EPS growth.

Hambrecht & Quist and Cowen & Co. today both raised their estimates on the size of the U.S. stent market. Stents are medical devices used to help keep arteries open. The two brokerages raised their estimates of market size by 75%, from $800 million to $1.4 billion. Analysts say the technological merits of new stents are expanding the market and that revenues are growing as stents become longer. With that, H&Q raised its rating on Arterial Vascular Engineering <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AVEI)") else Response.Write("(Nasdaq: AVEI)") end if %> from "hold" to "strong buy," sending that stock up $8 5/8 to $64. Guidant Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GDT)") else Response.Write("(NYSE: GDT)") end if %> gained $5 7/8 to $62 on the analyst move and on introducing a new implantable defibrillator in the U.S.

QUICK TAKES: Disney <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %> gained $5 3/8 to close at a new all-time high of $102 3/4 after reporting a 6% increase in fourth quarter revenues of $6.3 billion. EPS of $1.10 (before charges) rose 18% from last year's pro-forma level of $0.93.

Accounting software company State of the Art <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SOTA)") else Response.Write("(Nasdaq: SOTA)") end if %> gained $5 3/16 to $21 11/16 after agreeing to be acquired by U.K.-based Sage Group plc for $22 per share in cash. State of the Art also reported Q4 earnings of $0.33 per share, beating the two-analyst mean estimate of $0.32. The Sage Group offer prices the company at 4.1 times trailing revenues and 39.3 times EPS... Missouri-based Pulaski Bank <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PULB)") else Response.Write("(Nasdaq: PULB)") end if %> jumped another $5 1/4 to $40 following yesterday's announcement that the bank will convert from a mutual holding company to a stock holding company... American Bankers Insurance Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ABI)") else Response.Write("(NYSE: ABI)") end if %> jumped $9 5/8 to $55 7/8 after receiving a buyout offer from Cendant Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %> for $2.7 billion in stock and cash. This tops a bid made previously by American International Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AIG)") else Response.Write("(NYSE: AIG)") end if %> of $2.2 billion. The value of this deal is around $58 per American Bankers share.

Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> rose $1 5/8 to $49 7/8 on reporting Q4 EPS of $1.45, up 46% over last year and much higher than the analysts' mean estimate of $1.28. Unit sales rose 4.4% year-over-year... Teen retailer Claire's Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CLE)") else Response.Write("(NYSE: CLE)") end if %> gained $1 3/4 to $17 3/4 after the company confirmed that its Chief Operating Officer, Les Dunavant, has retired effective immediately. The company also reported fiscal 1998 revenues of $500 million and earnings of $58 million... Telecom equipment company DSC Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DIGI)") else Response.Write("(Nasdaq: DIGI)") end if %> rose $3 1/16 to $21 1/16 after yesterday reporting Q4 EPS of $0.30 (before charges), up 100% over last year. Analysts were expecting EPS of $0.32, but given the havoc that ADC Telecommunications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADCT)") else Response.Write("(Nasdaq: ADCT)") end if %> has caused in the sector recently, investors were relieved that earnings were in the range of expectations.

Travelers Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRV)") else Response.Write("(NYSE: TRV)") end if %> traveled $2 3/16 higher to $49 1/4 after Chief Operating Officer Jamie Dimon updated investors at the company's Salomon Smith Barney conference on cost savings the combined Salomon and Smith Barney are realizing. Yesterday the company reported fourth quarter EPS of $0.60... Canadian company Northern Telecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %> gained $3 9/16 to $43 9/16 on announcing Q4 revenues of $4.81 billion (US$) and earnings of $0.74 on a post-split basis. This beats First Call estimates of $0.73 and represents a 21% increase over the fourth quarter of 1996. The company said that revenue increases were largest in its broadband and wireless divisions... Zapata Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: ZAP)") else Response.Write("(AMEX: ZAP)") end if %> rose $1 15/16 to $8 7/16 after the food processor, formerly an energy company tied to President George Bush, announced that it will sell part of its marine protein business in an initial public offering for $14 and $16 a share.

GOATS

Help desk software company Remedy Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RMDY)") else Response.Write("(Nasdaq: RMDY)") end if %> fell $3 15/32 to $15 21/32 on reporting Q4 revenues of $38.8 million and EPS of $0.27, well short of the Zacks mean estimate of $0.32. BT Alex. Brown analyst Christopher Mortenson told Bloomberg News this morning that IBM's acquisition of competitor Software Artistry <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SWRT)") else Response.Write("(Nasdaq: SWRT)") end if %> hurt Remedy's results and that "a number of senior sales people left in the quarter..." Mortenson added, in talking with Reuters, that he "...had expected a $3 million [revenue] shortfall [from earlier forecasts] and the number they reported was $10 million short of forecasts." NationsBanc Montgomery Securities cut its rating on the company to "hold" from "buy" based on the company's guidance that revenues for the first half of 1998 could be flat to down compared with last year.

Forest products giant Georgia Pacific <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GP)") else Response.Write("(NYSE: GP)") end if %> was chopped down $3 15/16 to $54 5/8 after reporting a loss of $0.27 per share before a number of charges. Earnings missed by a mile the Zacks mean EPS estimate of $0.42. The company blamed the loss on increased wood costs in its manufacturing business, falling lumber prices (due in part to a weaker Canadian dollar), and continuing losses in its distribution division. Those results are distinct from Georgia Pacific's The Timber Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TGP)") else Response.Write("(NYSE: TGP)") end if %> results. That timberlands unit is traded as a separate "letter stock" and reported Q4 EPS of $0.33, slightly below the I/B/E/S estimate of $0.35. The Timber Co. finished down $3/8 at $22.

Finance company Green Tree Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GNT)") else Response.Write("(NYSE: GNT)") end if %> fell $2 13/16 to $19 1/4 after reporting a larger-than-expected loss of $0.12 per share for the quarter. The company also missed its EPS target (before asset revaluations) of $0.84 to $0.94, which it set out in November when it pre-announced fourth quarter earnings. EPS before asset revaluations came in at $0.72. Due to faster-than-expected loan pre-payments, the company had to write down by $190 million the value of securities on the balance sheet. Those securities represent the net present value of revenues the company expects to receive from servicing asset-backed securities it has sold to institutions. That's 27% larger than the upper-end of guidance on write-downs that the company gave in November. In addition, the company announced that it would re-state downward by $200 million 1996 pre-tax earnings of $497.96 million. That re-statement wipes out 40% of last year's pre-tax earnings. Green Tree has been representing these charges as "non-cash," which is convenient since many assert that a good deal of Green Tree's earnings are non-cash to begin with.

QUICK CUTS: JPM Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: JPMX)") else Response.Write("(Nasdaq: JPMX)") end if %> plunged $8 1/4 to $12 1/4 after the manufacturer of cable assemblies and wire harnesses for computer, datacom, and telecom companies reported Q1 EPS (before a charge) of $0.15, down 40% sequentially and below the Zacks mean estimate of $0.31. The company said that it expects revenue growth for the second quarter to be below growth seen in the quarter just ended... Specialty semiconductor company Benchmarq Microelectronics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BMRQ)") else Response.Write("(Nasdaq: BMRQ)") end if %> slid $3 1/8 to $11 after reporting a 45% decline in Q4 EPS of $0.21, below expectations... Semiconductor wafer cleaning equipment company CFM Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CFMT)") else Response.Write("(Nasdaq: CFMT)") end if %> lost $2 11/16 to $13 1/4 after the company said that a Korean customer has requested a push out (delay) of orders worth $4.9 million.

Offshore oil services company Trico Marine Services <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TMAR)") else Response.Write("(Nasdaq: TMAR)") end if %> fell $1 15/16 to $16 3/8 following yesterday's slide in the shares of Tidewater <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TDW)") else Response.Write("(NYSE: TDW)") end if %> on fears that capacity in the supply boat industry is increasing. Ship builder and overhauler Halter Marine Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: HLX)") else Response.Write("(AMEX: HLX)") end if %> gained $1 1/2 to $19 15/16, as that's good news for the company... Metals processing and environmental services company Philip Services Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PHV)") else Response.Write("(NYSE: PHV)") end if %> fell $4 7/8 to $8 1/4 after the company said it will write down the value of goodwill on its balance sheet by $175 million to $200 million on an after-tax basis. The goodwill is associated with acquisitions made between 1993 and 1996... Security Dynamics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SDTI)") else Response.Write("(Nasdaq: SDTI)") end if %> lost $3 1/2 to $32 1/2 after the computer network authentication and encryption software company reported Q4 EPS of $0.17 (before one-time charges), in line with the Nelson's mean estimate. Revenues for the quarter were up 50%, below the company's 62% revenue growth trend for the year.

Book publisher Houghton Mifflin <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HTN)") else Response.Write("(NYSE: HTN)") end if %> reported a loss of $0.59 per share in its fourth quarter, beating estimates by a penny. Revenues increased to $127.2 million, up 5.9% from Q4 in 1996. The stock was hammered though, down $8 13/16 to $28 11/16 because of guidance for 1998. Apparently the company sees lower revenue in the K-12 market... Utility company Peco Energy <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PE)") else Response.Write("(NYSE: PE)") end if %> powered down $2 1/2 to $20 after announcing a 44% reduction in its quarterly dividend. The company reported a loss of $8.51 per share in the fourth quarter due to heavy restructuring charges to comply with public utilities regulations.

EARNINGS MOVERS

Paraxel International <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PRXL)") else Response.Write("(Nasdaq: PRXL)") end if %> down $3 7/8 to $32 1/2; Q2 EPS: $0.19; Estimate: ($0.32)

FOOL ON THE HILL
An Investment Opinion
by Randy Befumo

Security Analysis, Part 3 -- Quality:
A Measure of Excellence

Rule 5: Cheap crap is still crap.

Rule 6: Excess returns come from buying moderate to high quality businesses at low to moderate prices.

Rule 7: Higher-risk excess returns come from shorting low quality businesses when they attain high prices.

Much of the investing media is preternaturally intent on valuation. The price/earnings ratio and growth rates routinely grace the pages of even the most podunk and picayune business section, but very little ink is spilt on the issue of business quality. This may be the result of "quality" being a much more esoteric and diffuse issue than valuation. Or it simply may be out of ignorance. While all you need to do valuation is the numbers and a calculator, determining the underlying quality of the enterprise actually requires that you know more than simple math. It requires that you understand what a business is and how it functions as a conceptual, capitalist construct.

Valuation as a discipline benefits the most from the systematic exposition found in Ben Graham's seminal text Security Analysis -- a text that even today is widely used in business schools across the country. Unfortunately for students of business quality, there has been no similar work that neatly circumscribes the issue of business quality. A few books and other publications cover the major issues -- the most readable and comprehensive of which include Phil Fisher's Common Stocks and Uncommon Profits; G. Bennett Stewart's Quest for Value, and Robert Higgins' Analysis for Financial Management. Many more books exist beyond this, as the emphasis on business quality has enjoyed many fathers -- with maybe a mother or two thrown in for good measure.

What kinds of measures look at business quality? Certainly Pierre DuPont's breakdown of return on equity is the most comprehensive (described in the Fool School's Return on Equity series), but the development and widespread use of return on invested capital in the '60s and the emergence of Economic Value Added (EVA) consulting in the '80s have focused investor attention on quality issues in the last decade or two. Widely used asset management ratios like inventory turns, days sales outstanding, overall asset turnover, growth, margins, leverage, and interest coverage also contribute equally to the qualitative picture. In fact, every ratio you are familiar with that does not neatly fall under the category of "valuation" is a business quality ratio.

Business quality is important because in the end, cheap is not enough. Investors who routinely buy shares because they trade at low price/earnings ratios or low price/sales ratios often find that the earnings are in a state of decline or the sales are quickly disappearing. Although various studies indicate that you can marginally beat the market if you buy a diversified basket of distressed securities at low valuations (a la Ben Graham), gigantic returns like those posted by the patron saint of investing, Warren Buffett, come from buying high quality businesses at low to medium prices. Taking the last few puffs from a cigar butt you find in the street might seem like a good deal, but actually getting a case of premium cigars for a relatively moderate price is not only more sanitary, it creates more in the way of value.

Surprisingly, business quality is not hard to evaluate once you understand the basic principles. The important inputs are the amount of cash required to run the business and the amount of cash the business spits out relative to that cash. Return on equity, for instance, just measures the after-tax earnings a company generates relative to its net investment in assets. Return on invested capital tries to be even more precise, tracking the actual dollars invested in a company through the proxy of total assets less non-interest bearing liabilities and compares this number to the after-tax earnings. Even inventory turns and days sales outstanding end up being measures of how much money is tied up in the business at any one time. If you carry a lot of inventories or don't collect your receivables very quickly, you have to put more into working capital than a similar business operated more efficiently.

Not all qualitative factors are reducible to cash in versus cash out, although they are related. Leverage, for instance, simply tells you how much you have borrowed to get the cash out that you are enjoying. Interest leverage tells you how affordable this debt is. Growth of sales, cash flow, and the various flavors of earnings tell you how quickly the cash out is increasing. The various margins tell you how much cash out you are getting relative to every dollar taken in. Despite the fact that none of these are as obviously a measure of cash in versus cash out as return on equity, return on invested capital, return on assets, or return on capital, they are all intended to demonstrate how efficient the company is in deploying capital and collecting the returns. To these clear measures I normally also consider "intangibles" like proven (not perceived) management savvy, the conservative value of trademarks or brand, and the soundness of the company's capital allocation policy. Capital allocation, in short, is how a company uses the money its creates -- acquisitions, dividends, share buybacks, debt repayment (all good), or if they just leave that cash sitting on the balance sheet (bad, very bad).

Intuitively, it seems clear that investors should assess valuation and compare this with business quality. While this is a process that is difficult to completely convert into numbers, it may not be all that awful to leave human judgment squarely in the process. While much has been made of mechanical models and automated trading strategies in the computer-crazed 1990s, the consistent and patient application of intelligence to the process of value creation is what creates millionaires according to the actual statistical evidence. If you only draw one lesson out of Stanley and Danko's The Millionaire Next Door: The Surprising Secrets of America's Wealthy, it is that these people own quite a bit of common stock, they apply the same logic to buying this stock as to running the small businesses most of them control, and they do not really trade all that often.

In the world of human judgment (judgment that we must parenthetically emphasize sits squarely behind Shakespeare's entire corpus, Beethoven's symphonies and Einstein's Theory of Relativity as well as Jenny McCarthy's rise to marketing superstar from second banana on MTV's game show Singled Out), the comparison between valuation and quality is quite straightforward. Just do the math on the valuation side and determine whether the stock has a low, moderate, or high valuation. On the quality side, do the math there as well, add in whatever bias you want for management savvy, trade brand value, or market dominance and assess this as being low, moderate, or high as well. Then compare the two with an eye toward buying companies that carry low valuations that are of moderate or high quality or, if you are a little more of a risk taker, buying companies that have medium valuations that carry high quality. Conversely, a great short is a company of low business quality with a high valuation.

By comparing valuation and quality, you identify areas where excess returns -- returns over and above the market average -- are possible. Tomorrow we will look at how to pinpoint even more finely where to make investments by considering the depth of your knowledge about a company.

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Randy Befumo (TMF Templr), a Fool One

Dale Wettlaufer (TMF Ralegh), Fool Two

Alex Schay (TMF Nexus6), Fool Three
Contributing Writers

Brian Bauer (TMF Hoops), Fool Four
Editor