BusinessTN

Oman Sloan and David Trainer, who launched a stock research firm called New Constructs from a converted tobacco barn in Franklin, Tenn., in May 2003, have found that Wall Street has far less interest in their services than they expected. It's perplexing given that New Constructs has collected several accolades for stock picking. In October 2005, for instance, Institutional Investor magazine highlighted New Constructs for being the #1-ranked research firm for stock picking over the prior four-year period. That ranking included the small independent research firms as well as the Wall Street sell-side firms.

Why the silence? As Trainer sees it, the established investment banks and brokerage firms prefer research that falsifies corporate earnings and sacrifices investors' returns to fill their own pockets. "Most people do not realize that the opportunities marketed to 'Main Street America' have been passed on by many people higher on the financial food chain," Trainer says. "The super-rich hedge-fund managers usually get first dibs, leftovers go to their fund, any additional leftovers go to the managers of the large sell-side firms, any additional leftovers go to the large sell-side firms, any additional leftovers go to the super-rich clients of the large sell-side firms, any additional leftovers go to the small buy-side firms, then, finally, any additional leftovers go to the individual investor. Wall Street is focused on making money for themselves and their super-rich clients, not the investing public."

As a result, Trainer says, there are very few money managers who actually care about performance and even fewer that do any real analysis. That hardly appears to be the case with Trainers' research offerings. New Constructs eschews company press releases and Wall Street research reports, most of which tend to focus on accounting earnings, and devotes its efforts instead to actually reading, or "scrubbing" the reports that companies submit to the Securities and Exchange Commission. Once New Constructs gets its hands on those reports, it parses all relevant financial data to understand the true profitability of the company. That, according to Trainer, means much more than pulling the Net Income from the Income Statement or Cash Flow from Operations from the Cash Flows Statement. "There are far too many accounting loopholes that enable companies to manipulate those numbers," Trainer says. "To get to the truth about the profitability of the company, one must gather data from all statements—most importantly, the Notes to the Financial Statements." Those financial footnotes, Trainer says, are like buried financial treasure—the place where accountants are required to disclose all the dirty financial details that are omitted from the Financial Statements.

Once again this year, as part of BusinessTN's annual tn250 coverage, New Constructs has provided its research on the Tennessee public companies it covers. Company snapshots combine five equally weighted criteria: economic versus reported earnings per share (EPS), return on invested capital ranked by quintile, two-year average free cash flow yield, price-to-economic book value ratio, and the market-implied growth appreciation period (GAP). The results are used to construct a risk/reward investment rating for each company. In this system, companies are ranked "1" through "5" as either "very attractive" (1), "attractive" (2), "neutral" (3), "dangerous" (4) or "very dangerous" (5). Each individual criterion is ranked 1 through 5 against the performance of over 3,000 companies. These rankings identify disconnects between the market's expectations for future cash flows and current cash flows. A very dangerous company, then, has poor economic profits versus misleading accounting profits that exaggerate earnings. This has the potential to artificially increase stock valuation. A very attractive company, on the other hand, has a cheap valuation with strong economic profits, suggestive of a hidden value the market did not recognize.

The accompanying chart, then, depicts New Constructs' findings for 50 publicly traded Tennessee companies it scrubs, along with some notes from Trainer himself. (Note, this analysis took place around May 1.)

In the absence of a major Wall Street splash, where is the New Constructs business going? Under-whelmed by its experience selling New Constructs research, Trainer and Sloan have launched a hedge fund. "We are quite confident that our competitive edge over the marketplace will last for some time," Trainer sums up, "given that we offered our product to our competitors in the money management business and they could not utilize it."

Disclosure
(New Constructs has received funding from several Tennessee investors, including Solidus Co., an investor in the company that publishes BusinessTN.)

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