Interview With Author Thornton Oglove
By Tom Gardner
December 9, 2004

Thornton Oglove is the author of one of my favorite investment books, Quality of Earnings, published in 1987. His work is responsible for my use of positive inventory divergence in locating and evaluating small companies for investment. He's one of the true gentlemen of the investment business, and I recently had the chance to talk with him in detail about his life, his investment career, and how his investment approach has changed over the past decade.

Tom Gardner: Thornton, thanks for joining us today. I want to start by letting you know how much I've enjoyed re-reading Quality of Earnings over the years. It's timeless.


Thornton Oglove: Well, thank you very much, Tom. Please call me Ted. I've been retired now since 1990, but I've been investing in the market as an individual investor from the time I was 18. So we've got some good ground to cover today. When you talk about Quality of Earnings, you've got to remember I haven't been publishing the Quality of Earnings newsletter now for many years.


Tom Gardner: Yes, yes. I'm referring here to the book.


Ted Oglove: Ah, and the book goes all the way back to 1987. So some of my thinking has changed since then.


Tom Gardner: Well, let's start with your background. Tell us about what led to you to investments and investment writing in the first place.


Ted Oglove: Well, Tom, I'll start with the fact that I never did have a real accounting background. I'm an example of how somebody with practically no accounting training can, if they want to apply themselves, learn to read financial statements and understand the fine print. You can go a long way. I had only one year of formal accounting. I really started to get interested in so-called "quality of earnings" in the fine print when I was a stockbroker.
I was actually a stockbroker for a number of years, from about 1958 to 1964. I specialized in selling new offerings companies coming public. At that time, there were a tremendous number of IPOs accompanied by prospectuses. Interestingly, I was probably the only one from that brokerage office that ever bothered to read the 100-plus-page prospectuses, including all the footnotes. That's because the total focus at the brokerage house was on sales, not on research. That work experience is where things began to fall in place for me.


Tom Gardner: Because you learned that you wanted to do stock research.


Ted Oglove: Yes. What I did was I left the brokerage business and its sales focus, because I was interested in research. And my first stroke of luck was that I decided to go back to school. I'd graduated from San Francisco State with an undergraduate degree in finance. But I then went to the University of California Business School for two years. That was a great help studying finance, company management, and all that. I really had some great professors.
And during that time, I was fortunate to get to know Leonard Spacek well. Spacek was managing partner of Arthur Andersen from 1947 to 1963, chairman from 1963 to 1970 and senior partner from 1970 to 1973. I wrote my thesis on the investment tax credit, which was very controversial back then. There were two diametric ways of accounting for the investment tax credit. That was the big deal of the day. A corporation could run $20 million of tax credits through there, offsetting their taxes immediately, or they could amortize them over the lifetime of the equipment. In other words, seldom do you see an accounting issue where you had such a dichotomy, where the decision would lead to such different accounting results.
I called up Leonard Spacek, who was headquartered in Chicago, to interview him. He was always an advocate of conservative accounting. He was against flowing through the investment tax credit. He was for amortization. And he really helped me with the thesis. I was surprised that, as the managing partner, he even took my call! He then spent about an hour with me, detailing his views. That conversation really ignited my enthusiasm about this area of research.


Tom Gardner: And where did that take you?


Ted Oglove: I finished my thesis, which incidentally was forwarded to Leonard Spacek, who in turn distributed it to his partners. After graduating from business school, my first job was with Bank of America (NYSE: BAC) as a security analyst. I was naïve about what was expected of me. Bank of America in those days had an investment committee of loan officers. The loan officers really didn't know much about the stock market. I began to look at the firms they assigned me.
Now, for a couple of the companies, the accounting did not look good. So in my reports, I'd write up my negative opinion on the accounting. Then the chief trust officer came and warned me. He said, "You know, we can't sell these stocks. When we buy them, we've got to keep them for quite a while. You have to understand, the trust committee is going to wonder why we purchased them in the first place if we're publishing negative reports on them. They're going to ask us why we didn't know the bad news when we bought!"

Tom Gardner: Don't tell the truth!


Ted Oglove: Exactly, yes, yes. Let's not see things as they are is what they were telling me. Fudge it. But I couldn't. I wrote another negative report, and, Tom, that was it. The chief trust officer called me in, and he said you'll never be a successful security analyst. I was then fired on the spot.
Believe it or not, I view that as a stroke of luck!


Tom Gardner: Still, that's unfortunate.


Ted Oglove: Well, there was some bad news. In San Francisco back in those days, there were very few analysts and very few positions for analysts. So I was forced to go to New York. The second firm I wound up with, I was hired to pioneer in the analysis of footnotes in corporate financial statements. That's where my focus on the quality of earnings came in. I began publishing what would become Quality of Earningsreports. Unfortunately, I couldn't do all this research and sell at the same time. So I was in danger of being laid off. The revenues weren't coming in. It was time for my second stroke of luck! This is where Bob Olstein came in. You're familiar with Bob Olstein, right?


Tom Gardner: Yes, I am, a great investor. He's the head of Olstein & Associates.


Ted Oglove: Yes. He had a very strong accounting background. He worked for Arthur Andersen. He majored in accounting at the University of Michigan, and he also taught accounting at Hofstra [University]. He was down on Wall Street, too, but he was a stockbroker. And he got caught in the bear market. So when I met him, there I was, publishing reports that called into question the quality of corporate earnings. And I'm looking good because the market is going down. Lucky timing for me, because if the market were going up, there would have been less interest in this type of research.
But Bob Olstein became familiar with my work and told me that he wanted to try to sell these reports to institutions. I remember he went out to Chicago. That was the first place he went to. And right away, he signed up six new accounts. We charged $15,000 per year in soft dollars. So we were on the way right off the bat.
Here again, I think I enjoyed some more luck. Bob was an extrovert. Most accountants are introverts, but he was an extrovert. And I call him a double genius because he put the Quality of Earnings report on the map. He got us out there. But his second stage of genius came because he wanted to manage money. He left to do that in about 1981. He went even though we were very successful. And it really did take Bob Olstein a number of years from a standing start to get assets under management. But you can see where he is today. He owns his own management company, manages $2 billion, and he has an excellent investment record.


Tom Gardner: Indeed he does. Ted, when did Quality of Earnings reports first come out?


Ted Oglove: The first report came out in about 1969. And here's where Leonard Spacek of Arthur Andersen comes into my professional life again. I encourage you to read about him if you don't know much. He was a man of very high ethics and an outstanding thinker about business and accounting.
I wrote a paper for The Financial Analyst Journal [in] about 1968 on finance company accounting, and I sent it on to Spacek. He thought it was an excellent paper. In those days, these finance companies were really playing accounting games. Some very famous finance companies back then actually went bankrupt. My article was published in The Financial Analyst Journal, and Spacek wrote the foreword to it. That was a great honor. Spacek wrote the foreword to my paper, which then won a Graham and Dodd Award.
Leonard Spacek meant a great deal to my professional career.
Just going back a step, before Olstein came along, I visited Spacek in 1969 in Chicago. That was the first and only time I ever met him in person. It was amazing talking to him in his office for an hour. It was like talking to a magician. In my life, there's never been anybody like him and never will be as far as a prophet in the financial world. He gave me a book that changed my life, entitled A Search for Fairness in Financial Reporting to the Public. It was a compilation of 156 addresses that Spacek had made crisscrossing the country between about 1956 and 1968. The addresses were all openly critical of the accounting profession. What's incredible, here's a managing partner at one of the big accounting firms, just beating up his own industry. And then some of his speeches attacked inflation, as well.
Spacek was a prophet on inflation. In 1959, he warned about how inflation was an insidious disease, pointing out that companies weren't accounting accurately for inflation. He also told me, he said, "Ted, if you're only going to read one address in this book, read my 'Accounting Magic' address before the Harvard Business School," which took place in 1959. Tom, I sent you that address, and as you saw, Spacek shows exactly what you can do with generally accepted accounting. And this will never change. It's always been this way, legally. And there's no stopping it. You can always legally manipulate financial statements.
Spacek shows how a large company announces that they've earned a dollar and a half per share. But they could have announced earnings of a dollar per share. They could have earned two dollars. They could have earned three or none. They could earn 100 different sets of earnings, depending on how they stretched or squeezed accounting guidelines.
Even today, I don't care how sophisticated people are, who they are, whether they're accountants or just beginning investors, it just boggles their minds when I show them how much leeway there is in generally accepted accounting. And I'm talking about legal manipulation of accounting principles by public companies.


Tom Gardner: You've mentioned Leonard Spacek. Are there other prophets or mentors in your financial career?


Ted Oglove: Well, you've had only three observers in the 20th century who really stood out when it came to looking into accounting manipulation: two from academia and only one from public accounting. (Incidentally, my Quality of Earnings book was dedicated to Professor Abraham J. Briloff and Leonard Spacek -- the consciences of accountancy.) The first was Professor William Ripley of Harvard. Do you have some time on Ripley?


Tom Gardner: Yes, sure.


Ted Oglove: OK, Professor Ripley wrote a book called Main Street and Wall Street back in the 1920s. That's really the first book I read on accounting. Ripley was a well-known economist of the day. Calvin Coolidge knew him very well. When Coolidge was lieutenant governor of Massachusetts, then later became governor, he made Ripley one of his economic advisors. Ripley personally met with Coolidge in the White House around 1928.
Ripley wrote critical articles about accounting. Back in those days, they were watering stock, diluting it. You talk about the problem with stock options today! The big deal in those days was to overissue stock, thereby substantially diluting the shareholder interest in common shares.
President Coolidge would mention Ripley favorably in press conferences, which is unparalleled today. I conclude that one reason Calvin Coolidge chose not to run again is because Ripley warned him that the American economy was infested with many termites. You'll remember that the most brilliant decision Coolidge ever made and the most important words he ever spoke came in 1928, when he said simply, "I choose not to run again." Ripley had warned him. Ripley couldn't forecast the Great Depression, no. But he saw that things weren't looking good the way they were going.
So that's financial mentor No. 1.
Then we go on to Leonard Spacek, whom I've spoken about.
The third is Professor Abraham Briloff, whom I also got to know very well. He came on the scene in the 1960s. I told him several times, "You're the reincarnation of Dr. Ripley." Briloff wrote three books on accounting, covering many of the accounting scandals of the 1960s and 1970s. His main writing outlet was Barron's. And, in fact, within the last year, The Financial Analyst Journal ran a research report on Briloff's work, showing what happened to the companies and stocks that he critiqued. It turns out that they substantially underperformed the market. Not only right away, but for years afterwards. Many of them were never the same.
I met Briloff in 1968, and he was really the first one to start criticizing the accounting of the conglomerates, calling many of them a house of cards with all of their serial acquisitions. And in those days, they issued a massive amount of convertibles and warrants that didn't have to be fully accounted for on a diluted basis. The accounting board then promulgated a rule that corporations would also have to account for their share earnings on a fully diluted basis. Back then, you could dilute your existing shares, without really disclosing it.


Tom Gardner: Yes, we follow share dilution closely in Hidden Gems. Ted, how much do you think the environment has changed today vis-à -vis accounting. In Quality of Earnings, back in 1987, you exposed numerous accounting problems that cropped up again at the turn of the century. For example, you criticized auditors for deriving consulting fees from their public-market clients. And that turned into a complete disaster that SEC Chairman Arthur Levitt tackled a little more than a decade after the book.
Should we still distrust the financial reports of public companies today, or do you believe new standards exist that protect investors?


Ted Oglove: Tom, this is the third wave of accounting reform in America. In the 1930s, the SEC was formed to tackle the abuses of the roaring 1920s. At that point, the SEC created a whole new set of security laws you didn't have before, so that was the first wave.
Then came the second wave in the 1960s and 1970s, when William Casey was chairman of the SEC. You know, Casey came out and tightened up the reporting requirements, and he actually labeled them "the quality-of-earnings rules." Now we have the third wave of reform, coming under the name Sarbanes-Oxley.
What's crucial to understand is that all these reforms have no control over the ability to manipulate accounts legally. I stand on Leonard Spacek's observation of accounting magic. I'm not talking about fraud now, about crossing that line. No. There are companies with impunity, just like before, that can manipulate their share earnings and inflate share earnings, legally.
And the problem is that bad currency has a tendency to drive out the good currency. How on Earth is a company really going to account conservatively when its competitors are not? If their stock rises because of aggressive accounting, well, you can really fall behind as a competitor if you do not similarly engage in liberal accounting. That's the real world.
Also I should mention the concept of materiality. I used to write papers on materiality. Any time a company tells you they've done something that is immaterial, run for your wallet. They may be doing something that they don't want investors to know about. Like IBM(NYSE: IBM). IBM made their quarter a couple of years ago. Remember when The New York Times flagged down IBM? IBM didn't break out the sale of a plant for hundreds of millions of dollars. They debited "general administrative costs." They made it look like a normal, repeating aspect of operations. But it was a one-time sale!


Tom Gardner: Yes, I remember it.


Ted Oglove: This one was so blatant that Roger Lowenstein wrote it up in Money Magazine. But this goes on and on. Most of the time you never know what's considered immaterial. What they deem not important enough to reveal. There is a generally accepted 5% guideline. At those levels, you can get away with not disclosing items, even if investors would be highly interested in them. Say 5% of gross earnings.
I'll never forget, years ago, I testified to the old Accounting Principles Board, the one and only time they tried to tackle materiality. I asked how come they weren't looking at it incrementally? I remember a well-known accountant on the board said, "Well, suppose we got a penny-stock selling at 50 cents and they are only earning a penny per share. And we got an item that we deemed not material for another penny. You want them to disclose that?" I had to ask, "Do you know what you're talking about? What you're calling one penny isn't just a penny of immateriality, it represents a 100% gain on the first penny per share of earnings."


Tom Gardner: It's huge.


Ted Oglove: Absolutely. And I said, "You must look at it incrementally." In fact, I published a paper in Barron's. I found a lot of items that I dug out that companies and their auditors were claiming to be immaterial. I told the reader, "Yes, I agree, this was 4% or 3% of the total earnings. But it was 15% or 20% of the incremental increase!"
With IBM selling that plant and embedding it as a normal part of operations, it had a meaningful impact on the incremental growth for the quarter. So you have this leeway to play with the numbers, and of course, you have executives preparing to sell their options, looking to get stock prices higher over the next few months.
The only answer is that nothing has changed and never will. Public companies will find a way to degrade the quality of earnings in order to push stock prices up in the short term.


Tom Gardner: Ted, I note that the average tenure of CEOs at American public companies is around four years. During that tenure, the CEO only has to work over the accounting for 12 quarters in order to boost the stock price and earn very high compensation, in the millions or tens of millions of dollars. That CEO then leaves the mess to the next executive, who gets a real bad break. She inherits a company with aggressive accounting and a high stock price and a high price-to-earnings multiple. A disaster in the making. She has to decide whether to clean things up, and possibly cream her compensation, or to accelerate the aggressive accounting even more. That high price-to-earnings multiple should always be a yellow flag.


Ted Oglove: Here again, Tom, Leonard Spacek was amazing. He was one of the few managing partners in accounting that had such a profound knowledge of the stock market. In some of his speeches, he would talk about the market and cash flow and the effects of aggressive accounting on valuations.
I learned this firsthand in that one hour in Spacek's office. He told me to be aware of audit risks. I asked: What did he mean by audit risks? He said to be very careful about generally accepted accounting, since companies and their accountants can go a long way toward inflating and manipulating earnings. He said something that startled me at first, but then it made complete sense. He said, "Ted, ignore fraud. Ignore it. There's always a risk of fraud. Period. But these firms with inflated P/E ratios, be careful there."
Tom, it's just what you mentioned. The higher the price tag on the business, the more its executives will be tempted to inflate their earnings. To legally massage them. This is not fraud. But it's also not good news for long-term investors. Spacek pointed out that these high-P/E stocks can rise for years. But eventually, aggressive accounting will come back to nail their investors. Not all of them. But be careful. Here's the key. Spacek said: Look for the firms with quality earnings priced at low multiples. Look there for great investments. Conversely, look out for companies with poor earnings quality and high multiples. Stay away!
Out of this conversation with Spacek, I got the idea for the Quality of Earnings newsletter. It's where I learned that I needed to tell my subscribers to be aware of the combination of inflated price-to-earning ratios and very aggressive accounting. The market eventually will take down the price/earning ratio, perhaps simultaneous to the earnings declining, and that can hurt very, very badly.
Tyco, by the way, was a great example. From a very high perch, the price-to-earnings ratio began to go down on Tyco (NYSE: TYC). It fell to a point were this guy, the CEO, [Dennis] Kozlowski, announced he was going to split the company in three. He felt he needed to do something about that falling P/E ratio. He was beginning to manage and engineer the stock price rather than the business. And the price tag kept falling. Management got more and more agitated. And the ratio went lower and lower, the price-to-earnings ratio. And so the financial department got more aggressive, and then, boom, there was a disaster for the outside shareholders. That's not the first time, and it won't be the last time.
I've read Professor Briloff's work closely, and so many of the stocks he wrote critically about, from the conglomerates on down, the history of those were stocks with high price-to-earnings ratios that steadily eroded even as management got more aggressive with the reporting.


Tom Gardner: It turns out that millions of dollars in compensation, mixed with rising investor expectations and a high P/E, can produce declining ethics.


Ted Oglove: (Laughs.) Yes. And, Tom, I'd like to make one more observation on accounting. This is a very contrary point. But I believe that, hypothetically, if all corporate officers could make no more than a million dollars a year, I still claim that the earnings would be inflated. I'm not talking about fraud now. I'm talking about legal manipulation, working the numbers over.
Why would executives inflate their earnings if there were no compensation incentive to do so?
Do you know what the answer is?
Grade inflation. Grade inflation is pervasive. Academic grade inflation is all across America. It starts early. And these executives are used to getting good grades.
Take Harvard, for example. Do you realize that it's far, far easier to graduate with honors at Harvard than it is to get into Harvard. The statistics are that 91% of Harvard's graduates and undergrads graduate with honors. 91%! At Stanford University, in the International Business Department, with about 500 students, the average grade is an A. The average, mind you! That means they could be giving out some A-pluses.
Newsweek magazine wrote up the story of a valedictorian at Morristown High about a year ago because her grade average through high school was a straight A+. So this is a badge of honor, to excel with perfection. And that continues into Corporate America. It's a matter of ego to keep the earnings growth going. The economic motivation you mention is part of it. But a big slice of it is . . .


Tom Gardner: Psychological.


Ted Oglove: Oh, yeah. That's a lot of it. It isn't all about financial capital. There's a lot probably even more that has to do with emotional and psychological capital.


Tom Gardner: You write in Quality of Earnings that almost from the first, you didn't trust management. Here's a quote from the book: "Management is often trying to hide something, and it's the investor's challenge to figure out what."Ted Oglove: Yes. In the barriers they put in front of you, management holds the upper hand. Tom, people think the outside auditor compiles the footnotes. That isn't the case. The auditor doesn't compile the financial footnotes. Management prepares them for the auditor!
People ask me, "How can I best train myself to read footnotes?"
My answer's accurate, but they laugh. I say get a hold of the New England Journal of Medicine. Get a hold of The Lancet. Read the papers by research doctors and scientists on medical diseases. They're written like the footnotes in annual reports. They're obtuse. They're hard to understand.
The most important corporate footnotes have to do with taxation. It is very hard for me, even with decades of experience, to understand these footnotes today. They're written in a more and more obtuse fashion each year. Then you begin to realize, Tom, that many of these companies don't want anybody to easily read their more crucial footnotes.


Tom Gardner: Showing that they actually resent their outside owners.


Ted Oglove: Do you know that in the Sarbanes bill, they've actually required that a certain section be written in plain English. But one of the failings of Sarbanes is that they should have demanded that allcorporate footnotes be written in plain English, in easy-to-read English. It can be done. They should no longer permit obtuse footnotes.


Tom Gardner: Ted, you realize that what you're saying might be very discouraging for a new investor, given that you've been at this for more than 40 years. If you're saying that things have become so obscure that you struggle to decipher them, what hope is there for new investors?


Ted Oglove: First of all, it's true, everything is more complex today. In the old days, you didn't have all these off-balance-sheet entities. So the financials are much more complex. Some companies today have more than 100 pages of footnotes.


Tom Gardner: Yes, how much of that has to do with how large a corporation General Electric is today? In Hidden Gems, with small caps, the financials are much easier to work through.


Ted Oglove: Yes, a lot of it has to do with how large the business is. The larger it is, the more you've got derivatives, foreign reporting. You've got more accountants fighting through the tax code and more auditors working over the rules of generally accepted accounting (GAAP). You see, generally accepted accounting involves maybe 3,000 pages or more of different guidelines. Thousands and thousands of pages. And when you look at a particular accounting item and the way you account for it according to GAAP, you have as much latitude as taxpayers have with the IRS.
I talk before investment groups, and often somebody will say, "I can't understand how, under generally accepted accounting, a company can earn a dollar per share, or two dollars per share, or anywhere between." I answer by noting that there are a few hundred people in the room. And let's say everybody made a salary of $500,000 pre-tax for the year 2003. Let's then say that we all have exactly the same expenses. Everything is the same. But guess what? We are still going to find 20 to 25 different outcomes as far as what they report in taxes. Why? Because the tax code, which is now over 40,000 pages long, creates the same opportunities with individuals as with corporations to find the angle. You can defer an item, you can accelerate an item. All of this just on your personal taxes alone. Do you follow me?


Tom Gardner: Yes.


Ted Oglove: So if anybody thinks that generally accepted accounting for corporations is ever going to change as far as flexibility, they need to reset their expectations. If individuals with the same salary and the same expenses can file very different tax returns, just imagine the differences for large corporations. Do you see what I mean? We go on and on.


Tom Gardner: Given that, how do you make yourself comfortable investing in stocks?


Ted Oglove: Tom, this is where there's been a major change for me. To cut through the underbrush, I no longer spend much time on the footnotes.


Tom Gardner: That's a revolution in your thinking.


Ted Oglove: Well, in the old days, when I was on Wall Street, I spent a ton of time on the footnotes. And I've come to believe that's one reason why I didn't do as well as I should have. I spent too much time looking at the footnotes, sifting through every fact. Yet, to be a practical investor, I should have only worried about major deviations in accounting.
In looking back on my investment returns, I found that I sold way too early on what ended up being some truly great stocks. Why? Because I'd found a minor issue that concerned me. After enough mistakes of selling too early, I finally changed my approach. It's made a very big and very positive difference in my returns.
An example is Fibreboard. Fibreboard became a Peter Lynch stock. The stock was a wonderful performer. I owned it. Then one quarter, I found that management changed their accounting on depreciation. They slowed down the depreciation to juice earnings higher, in order to meet Wall Street expectations. Now, in the old days, I would have said, "Aha! They're accelerating their earnings by slowing down the depreciation. Sell the stock! This is manipulation." But today, I just highlight that as a concern without knee-jerk selling. With Fibreboard, it was a good thing I didn't sell. Because it just kept going and going, until finally they sold out to Owens Corning. The CEO was a business genius. He had turned around the company. He sold out for cash. Later, Owens Corning collapsed because of asbestos litigation. Fibreboard had its share of asbestos cases, but it turns out that management had covered themselves with insurers paying them for the adverse cases.
So, what's my advice to investors today?
In reality, you really aren't going to understand those footnotes very well. Instead, I think you've got to spend time finding leadership that you can trust. That's better than buying stocks and trying to verify integrity by religiously reading every footnote. With me, the stocks I own, I own in part because I trust management and consider them to be in the right investment sector. I know that with the great majority of public companies, there is some level of legal earnings manipulation. I just try to avoid those that have major accounting deviations.


Tom Gardner: Can you give an example of a major deviation?


Ted Oglove: Sure. One way to acquire expertise as an investor is to study the disasters, carefully, then avoid the things that led to their destruction when you look for stocks to own.
On the balance sheet, I hate seeing companies that are top-heavy in terms of short-term debt vs. long-term debt. This is what happened during the march up to 2002. You had all this commercial paper out. That's the cheapest form of financing: commercial paper.
You get an example like Rite Aid (NYSE: RAD). My God, Rite Aid could be a case study at Harvard Business School. The guy, Martin Grass, ran that company into the ground. And you ought to see the debt he incurred. Most of it was short-term vs. long-term debt, with this guy making huge acquisitions. It was like lighting dynamite - making some acquisitions with short-term debt. When the bills came due, they closed in on him, and bang! He couldn't refinance fast enough. Rite Aid fell apart.
Remember that when the market really sagged, all these companies that had credit lines were forced to call on them and refinance. The banks would no longer let them have the commercial paper out and they had to refinance. I don't know if you remember that. So one major deviation is an overload of short-term debt vs. long-term debt.
Second, you can find plenty of things to avoid just by studying Enron.
I didn't own Enron but, postmortem, what a company to look at! Let's start with this. Their CEO left after a short stay. I mean, the stock had been at $80. It was down to $36, and [Jeff] Skilling left. Why did he leave the company? C'mon here, when's the last time a man takes over management of a company he always wanted to run, then quickly leaves? Ken Lay turned it over to him, and he hadn't been there that long, and he bails? I mean, sure, sometimes CEOs are fired, or they're forced to leave, or the board of directors gets rid of them. But this guy couldn't get out fast enough at $36. Overnight executive departures should really distress investors.
Now, here's what else is interesting. You know why Skilling left at $36 per share? Because there was a footnote there about debt. Enron had some outstanding debt with price triggers. You've got to remember, Enron was selling for $70 and $80 per share then. Well, it turns out that at $40 a share, the debtors could call in some of the debt. So when the stock hit $36, Skilling knew the game was up, debt-wise. It was going to be called, and Enron was really going to be in trouble.


Tom Gardner: Is that an example of a major deviation that someone could have foreseen by reading the footnotes?


Ted Oglove: Well, that actually isn't my point. Here you've got this sudden departure of a CEO. That should be very concerning. Mind you, the note about price triggers on debt was written very clearly. Footnote readers would've found that and, my gosh, get out of this stock if it gets anywhere near those triggers. But for everyone else, just watch the sudden, unexplained change in management. Very problematic.
Here's another thing you can learn by going back into the history of a disaster and looking for signs to avoid in future investments. Enron earned about $1.10 per share before its demise. Yes, it was recording profits even as it was approaching bankruptcy. Now, what is incredible, Tom, is that this was the greatest corporate fraud ever perpetuated since maybe Sam Insull and his utility empire went down in the '30s. This was fraud across the board; the company really had no earnings.


Tom Gardner: It's amazing it took so long to catch on.


Ted Oglove: Absolutely. Evidently, Enron had a lot of short-term debt that was well hidden. Do you know what's also interesting about Enron? All the board of directors had to do was ask one question of management: "Can we have all the income statements and balance sheets of your off-balance-sheet entities?"
Why didn't anybody on the board of directors ask Arthur Andersen for these? I mean, those off-balance-sheet entities were very controversial. The game would have been over immediately. Because if you look at the balance sheet of these entities, then you'd have seen all the hidden debt that wasn't consolidated. If you looked at the income statement, you'd have seen the earnings were fictitious. Yet no one did.
I just find it fascinating that nobody on Wall Street, nor any of these distinguished members of Enron's board of directors, caught it. Tom, that board included the guy from Stanford, who once was head of the business school for Christ's sake, a professor of accounting. No one asked. How can that happen? It's disgraceful. Was it that the board didn't know, or was it that they didn't want to know? You see what I am driving at?


Tom Gardner: Yes.


Ted Oglove: Also look at something else they did. Enron was capitalizing software. Can you imagine a utility deferring software expense? See, this is what I mean about generally accepted accounting. You can defer software expense to a degree. It is legal. But it's very unusual for a utility to do it. So in their last year of existence, to come up with an extra dime of so-called earnings, Enron capitalized an extra $150 million of software. That was 10 cents a share after tax. Amazing.


Tom Gardner: Ted, to what extent do you think following free cash flow rather than earnings would help you get around that? Because if you take operating cash flow and back out capitalized software expenses and capital expenditures, you have a clearer look at real profits. And you catch or at least avoid Enron.


Ted Oglove: Yes, yes, but even cash flows can be manipulated. We can talk about that in a second. But I want to note one other item. Even with all these manufactured earnings, Enron was paying a dollar dividend per share, equal to hundreds of millions of dollars per year. But the dividends were paid out of borrowed cash. Enron wasn't earning cash to pay out the dividends.
That's another thing to be careful about. Be wary of companies that pay dividends and yet carry significant debt. You don't need to read the footnotes to see that. You just need to keep from being blindly seduced by dividends, thinking that they automatically indicate a prudent business. If there's a lot of debt, well, then a dividend may actually precede the discovery of fraud.


Tom Gardner: Ted, we talked about cash flow a moment ago. I want to give you my calculation for free cash flow or what I call owner earnings and have you pick it apart, if you would. OK?

Ted Oglove: Certainly.


Tom Gardner: OK, it's simply net income plus depreciation and amortization ...


Ted Oglove: Let's see. I am going to write it out. This is income, yeah.


Tom Gardner: Yes, so net income plus depreciation and amortization, plus or minus any one-time items.


Ted Oglove: You are subtracting out one-time items, OK.


Tom Gardner: Yes, any non-recurring items are out. Then subtract capital expenditures.


Ted Oglove: Minus capital expense. OK. And dividends, right?


Tom Gardner: Hmm. I haven't done that. Because I'm dealing with small caps that pay, at most, marginal dividends, I haven't been doing that. But I can see the purpose of it.


Ted Oglove: Yes, I think you should.

Tom Gardner: OK, yes. So back out dividends.
Overall, the key in this approach is that I kick out working capital from operating cash flow. Having helped run two businesses for ten years, I've seen firsthand how working capital can be a timing issue. My two companies are very conservative with our accounting, and of course, we're private. But at a dishonest public company, I can see working capital getting worked over for a period of time to drive up free cash flow and boost the stock with executives selling into the rise. So this equation for owner earnings is about getting down to the cash flow generated by the structure of the business.


Ted Oglove: OK, so I want to be sure I have it, Tom. This is income, plus depreciation and amortization, minus capital expenditures and dividends, right?


Tom Gardner: Yes, exactly. Now, can you help find any weaknesses?


Ted Oglove: I would say that I don't see a weakness. That equation, that's what I'd recommend. My only argument would be that you've got to be careful with these extraordinary items.


Tom Gardner: Yes, agreed, that can get tricky. From there, Ted, I want to build on that equation for owner earnings, and I want to give an example of the sort of company I look for in Hidden Gems to see if this would interest you as an investment.
It's a smaller company with accelerating sales growth and growth in owner earnings. The company is debt-free. It pays a small dividend. It regularly buys back stock. And it trades at a multiple below multiples for the overall market and its industry. And, finally, insiders own 30% of the stock.


Ted Oglove: Well, yes. Let me start here. I'm a Hidden Gems member and I read with interest the professor you interviewed in July, on insider trading. Boy, I tell you, that was interesting.

Tom Gardner: Yes, Dr. [H. Nejat] Seyhun.


Ted Oglove: And yes, he really came across strongly on something I agree about. A lot of people think that the more stock the insiders own, the better. They think that it's good if a family owns 60%, 70%, 80% of the stock. But, in my experience, the professor is right. That's too much. He says 30% or 40%, if you had to pick, is a good figure.


Tom Gardner: Ted, another factor I wanted to home in on is debt. I really think that a high level of debt is more dangerous for an investor than we often realize. It makes companies do strange things that can be very unfriendly to long-term owners.
If I'm following the Ted Oglove of today, who says he likes to trust management, who looks for companies that don't have any major accounting deviations, I figure I'm really trying to avoid debt. Because there were investors who bought Enron stock, saying, "Oh, I trust Enron. I saw Ken Lay on television. The company is growing. I'm not going to scour the footnotes." If there are two things that would've steered them from Enron, I'd say it is, first, looking for positive owner earnings and, second, avoiding companies with heavy debt.

Ted Oglove: Yes. And here, I think people should visually and mentally understand what they're investing in. In the materials I sent to you before our conversation, I laid out classifications for companies, like roll-the-dice, speculative, and blue chip.
Now, if you run the company through a sound analysis, my argument would be that Enron never was a blue chip to begin with. I would call it speculative.


Tom Gardner: Right. What's an example for you of a solid blue chip, priced attractively today?


Ted Oglove: International Paper (NYSE: IP). Now there's a stock that I like for the long term. I say this even though they're loaded with an awful lot of debt. They were taken out of the Dow. International Paper had made all these acquisitions, and Wall Street has been down on them for it. But while they do have an awful lot of debt, most of it is funded long term. And what I like about International Paper is that it really is a hedge against inflation with all those timberlands. And I think they're going to work down the debt, which they're starting to do.

Tom Gardner: Yes, yes.


Ted Oglove: Regarding debt, if you're running a company prudently and you are no longer going to make major acquisitions or incur added debt, then as inflation rises, you're going to pay off debt in cheaper dollars. Kind of like a mortgage on your house. Do you see what I mean? It works both ways. So I'm just singling out International Paper as a stock I believe in today.


Tom Gardner: Do you consider it a blue chip, or is it speculative now that it carries a lot of debt?


Ted Oglove: I consider International Paper a blue chip. I would call it probably an A- blue chip. It's not a speculation. It's a huge entity with a vast amount of timberland, and it's an oligarchy. Most of the paper industry is consolidated. I'm not trying to give out investment advice, I just wanted to highlight where I think a company can have a lot of debt but still be a blue chip.


Tom Gardner: And part of that must be because International Paper backs that debt with a ton of tangible assets. They aren't borrowing to build intangible dreams.


Ted Oglove: Yes, they have very valuable tangible assets. And I think this stock will be helped by inflation. More investors should be aware of inflation than they are. If I could have talked to Peter Lynch 15 years ago, I would've told him to put one additional chapter in his magnificent book. Talk about inflation, and deal with stocks that are more likely to be successful because of inflation.
Now, one industry that does well with inflation, I've actually never bought into. I should have. It's almost a no-brainer. Inflation always leads to more money, more dollars to spend. So look at the money management business. You not only have a vast increase in assets because inflation has generated more money to be managed. You also have favorable tax laws. One thing Congress has done no matter who these presidents are, even when they're liberal, even if they're big taxers they always do something for retirement planning. They increase what you can put into the tax-deferred plans. So the vast increase in these retirement plans, along with inflation, have led to some great money management opportunities in Franklin Templeton, Legg Mason, T. Rowe Price, etc.


Tom Gardner: Ted, shifting gears, I want you to talk a little bit about positive and negative inventory divergence. I've found this to be incredibly useful. You advise investors to break out the inventory. You say that if raw materials make up the bulk of the inventory growth, don't worry if inventories are outpacing sales. In fact, quite possibly you should be getting excited.


Ted Oglove: I agree. Bob Olstein and I, in Quality of Earnings, we were focused on bad news at corporations. But then once in a while, we'd flag these positive inventory divergences, because it was worth looking at. So, Tom, I think you're right. It matters, especially with small-cap stocks. You can really find some hidden gems out there.


Tom Gardner: Well, I wouldn't have found it without your work.


Ted Oglove: And what can I say? I'm pleased that even today, you're still referring to this ancient book. It's almost 20 years old.


Tom Gardner: Yep. Well, 20 years ago you had chapters telling investors "don't trust your auditor" and "be your own analyst." These principles are timeless. I 
expect to be referencing the book 20 and 40 years from now.
Ted, you mentioned Peter Lynch's book, One Up on Wall Street. Tell me why you love it. It's also on my short list of the truly great investment books.


Ted Oglove: Yes. But first I start with The Millionaire Next Door. I think it's a great book. Let's say people don't even invest in the market. I think it's just a great book on a style of living that I believe in. It's no accident that most of our nation's millionaires do not buy a new car every year. Are you following what I mean?


Tom Gardner: Yes.


Ted Oglove: If they have that lifestyle down, of not overspending beyond their means, then they can start thinking like Peter Lynch. And that's how you should think as a stock investor. I've given speeches to a roomful of doctors, and the majority of them give their money over to brokers. And I ask them why they don't invest the money themselves, emphasizing medical-technology and pharmaceutical companies. They're too busy, though, to emulate Peter Lynch.


Tom Gardner: Yes.


Ted Oglove: What I think is great about the Peter Lynch book is that if somebody just looks around and takes some time to evaluate corporations in America, they can find some spectacular investments.
Another thing I like about Peter Lynch is that he usually stayed fully invested. One reason he had such fabulous success is he didn't let bear markets sway him. He just remained fully invested. He kept buying companies he loved. He made his shareholders at Fidelity a lot of money because of that. And he taught investors a great lesson.


Tom Gardner: Stay invested and add new savings.


Ted Oglove: Exactly, both of those put together. It's so important. A disappointment in my investment career is that I let the 1987 bear market knock me out of stocks. By the way, back in your interview with the professor, (Dr. Seyhun), he said the low on the Dow was 1,738. Actually, the low was 1,450 in that bear market. But you'll never see it because it was intra-day.


Tom Gardner: Right. It was very momentary.


Ted Oglove: I still remember the stock market crash of 1987. In August of that year, the DJIA tacked on 500 points to reach an all-time high, at the time, of 2,722. On September 30, the Dow closed at 2,596. Then came a selling deluge of such magnitude that many investors thought the famous crash of October 1929 was repeating itself. In just four days, October 16, 17, 18 and 19, the DJIA plummeted 769 points, landing at 1,841. On October 19, the four-day selling wave was culminated by a record 508-point decline, a decrease of 22%, an all-time record. This drop surpassed the previous one-day record of 12.8% on October 28, 1929, the famous Black Friday crash.
Shortly afterwards, the Dow's low for the year was 1,739; however, the intra-day low hit 1,450. The market rallied that same day to close at 1,739.
There is a myth that the stock market in 1987 was overpriced and therefore due for a major correction. However, the earnings per share of the Dow came in at $114 in 1986, advanced to $161 in 1987 and increased to $228 in 1988. After reaching a yearly high of 2,722 in August 1987, the DJIA was selling at 17 times earnings and for only 12 times earnings on a forward ("leading") P/E ratio calculation for the year 1988.
The catalyst for the 1987 market crash was the use and misuse of "portfolio insurance" strategies by institutional investors. Mathematical theorists, using computer-activated stock option programs, told their clients that, by buying put options on individual stock and market indices, they could protect their portfolio against a major market sell-off. However, when the market began skidding, it set off a chain reaction of selling on the way down, and when everyone wanted to sell at the same time, it created a self-fulfilling prophecy, culminating in the crash.


Tom Gardner: Yes, it was painful. So, how can new investors stick with the market in the face of such declines?


Ted Oglove: Well, there are alternatives. You can try to time the market. You can trade the market. You can let bear markets flush you out of stocks. You can decide not to invest. I don't like any of those. Alternately, you can be completely passive. Just invest in mutual funds. That's fine.
As for stocks, I think the longer you are invested in a particular stock, the lower your risk is. If you're invested in a blue chip and it remains a blue chip, stay invested. If you own a company you like and the overall market gets beaten down, stay invested. The market rewards patience and perseverance. Investors need to know that.
All of that said, let's not kid ourselves. There are going to be very tough times, and you will make mistakes. If one of your investments falls into a lower category, from blue chip to speculative, you've already lost half the value. Don't kid yourself. Ford Motor (NYSE: F)and Eastman Kodak (NYSE: EK) didn't go into the speculative category without already coming down halfway in price by the time you even knew it.
Furthermore, look at the overall market. Go back 30 years, you have recessions, Gulf Wars I and II, you almost had a bout with hyperinflation. And looking ahead the next 10 years, it's not going to be any better. I think we could have a period of severe inflation. The war on terrorism will never end. Not in anybody's lifetime, I don't think. Going forward, you also will have recessions.
And yet look back, and what do you have? Look at the graphs of the S&P 500 and the Dow. There is plenty of evidence that you should remain invested, and add money all the way along.


Tom Gardner: Ted, before this conversation, you sent over materials that demonstrated your new investment thinking. You included information about the long-term performance of America's greatest companies. That includes that Southwest Airlines(NYSE: LUV) was up 26% per year for the last three decades. Amazing. You have Wal-Mart (NYSE: WMT)up 26% per year. Walgreen (NYSE: WAG) is up 24% per year. Intel up 23% a year. This played out over decades.
Now, none of these could be classified back in the 1970s as a blue chip. This is a primary reason I'm so enthusiastic about managing Hidden Gems. Back in the '70s, those companies were small caps.


Ted Oglove: Yes, that's definitely true. Now, that list came out in Money Magazine. They were making the point that it's incredible that Southwest Airlines led the parade. Southwest Airlines went up more than Wal-Mart.
By the way, Tom, when you look at that list, notice how few technology companies there are. Warren Buffett doesn't really invest in technology. It is just too fast-moving for him. It can be tough to find the great long-term winners in that category. But back to your point, yes, these companies were not blue chips when they started their rewarding ride.


Tom Gardner: Ted, are you familiar with Shelby Davis Sr., the founder of the Davis Funds?


Ted Oglove: Was he the insurance man in the old days?


Tom Gardner: Yes, and the book analyzing his life and investment career is entitled The Davis Dynasty.


Ted Oglove: I should read that. That fund, his son took it over, right?


Tom Gardner: Yes, let me tell you why I think you'd enjoy the book. The principles outlined are very consonant with yours. His approach, interestingly enough, was essentially to buy and never to sell. His belief was the best time to invest in stocks is whenever you have the cash. He focused almost exclusively on companies that had no inventory, no factories. He concentrated on insurance companies and banks, businesses inside his circle of competence, in an industry he had worked in for many years. When he passed away in the 1980s, he was in his 80s. And when he died, he owned more than a thousand different stocks.


Ted Oglove: Isn't that something!


Tom Gardner: And the top few dozen made up a major portion of his wealth. So to an extent, he ended up with a focused portfolio, having started with a completely diversified one. In the end, his portfolio had risen from $50,000 when he started in 1938 to around $900 million when he passed away in the 1980s.


Ted Oglove: Oh, my gosh.


Tom Gardner: Davis earned something like 23% annual returns simply by buying and holding. He accepted that some of his stocks would dive-bomb and never come back.


Ted Oglove: I agree. I agree with that. Do you know Fisher, the famous Philip Fisher?


Tom Gardner: Yes.


Ted Oglove: He recently passed away. His son is a money manager. Well, the father just about never sold a stock. His father specialized in technology to a degree.


Tom Gardner: Right. Motorola (NYSE: MOT) was one of Philip Fisher's big investments.


Ted Oglove: As far as I know, he never sold.


Tom Gardner: So, Ted, given all that, I'm seriously considering an almost-never-sell investment approach. Rather than trying to time a perfect exit, instead, just use the dips to buy more stock. Sit through the tough spells. Obviously, if you just don't like a company anymore, you get out. But I'm coming to believe that you should rarely sell a strong business simply because of the temporary overvaluation of its stock. Finally, when you do have losers, don't worry. They're not going to amount to very much relative to your winners.


Ted Oglove: Yes. Short-term valuations are tough to predict. Now, if you tell me what the earnings are going to be, the price-to-earnings ratio and the rate of inflation, I'll tell you what your stock or the market is going to do. But you don't get to know that! That's why the great ones don't waste time trying to forecast the market or individual stocks in the short term. John Bogle's one-liner is, "The market knows. We don't."
By the way, when Bogle testified before Congress this year, about the mutual-fund scandal, a U.S. senator asked him, "Well, then, how should I invest, Mr. Bogle?" It was a good question. Bogle, as one would surmise, is the high priest of index funds. He said, "You should invest in a stock market index fund, and I am going to give you further advice. Don't look at how it's doing until you retire."


Tom Gardner: Just keep adding.


Ted Oglove: Yes, keep adding, and don't worry about it year to year. I have to say, whether you're going with individual stocks or index funds: dollar-cost average. Add money regularly along the way. Just go back to the old Graham and Dodd. Ben Graham was the advocate of dollar averaging.
And people today have never had more opportunity to dollar average, with the multitude of retirement plans. You can easily add money every year. So you needn't try to outguess the market. If I was one of these younger people with retirement plans and so on, I would just add every year. I wouldn't worry whether the market is too high or whatever. The most powerful thing is just to add every year. And the dividends, even a small amount of dividends, can really add up.


Tom Gardner: But compound that over 25 years, alongside capital appreciation, and you'll be quite happy.


Ted Oglove: Exactly.


Tom Gardner: Ted, a question that arose, as I looked through the additional materials you sent over, has to do with extended bear markets. You quote the return from the high in 1961 to the low in 1979, where investors only earned total growth over the entire period of 22%. And during that period, the P/E for the overall market contracted from 22 down to 7. Now I'm a strong proponent of dollar-cost averaging. And I know we're taking the highest highs and lowest lows to come up with that tough performance above. But I also think to myself, well, if the P/E is 22 on the overall market, is that a time to either not add too much capital or to think about pulling some off the table?


Ted Oglove: The problem is, I don't think the P/E is any more predictable than earnings are, and vice versa. I just don't think this is a primary game investors should play. If you mix the lifestyle of The Millionaire Next Door with all this investment thinking we're talking about, then I say that steady investing leads to two great things. First, you'd have lower cost bases along the way. Second, you'd be building up a giant base of savings. In 1979, you would have been in great shape to go forward. You would have had a tremendous base of savings, ready for the great bull market of the next 20 years.


Tom Gardner: So you're saying that it's much easier to master the discipline of savings and perpetual investment than it is to figure out whether the market is priced too richly or not richly enough.


Ted Oglove: Yes, yes. Even when something looks overvalued, I'm OK if an investor has plans to keep on adding money over time. Take this example. People in investment clubs I talk to, they'll ask me about REITS. Real-estate investment trusts. I tell them on a yield basis, these REITS across the board, they're overpriced by one-third. They really are. If you buy a REIT today, you're paying a 33% premium based on any kind of historical overview. And when they come down, they won't fall by just a third. They'll probably drop in half before the market sees them as undervalued.


Tom Gardner: Right.


Ted Oglove: And it's happened before. So here's my unusual advice, Tom. I say it's better to invest in them today than never to invest. When I say they're overvalued, investors I talk to ask me if I still believe in allocating 20% of your portfolio to real estate today. I say, yes, I recommend putting 20% of your portfolio into overpriced real estate today rather than never to invest in it. Why? Because inflation will bail you out over time. I would rather they get started right now, add money each year. The real challenge is just getting into the game, staying in it, adding every step of the way.


Tom Gardner: Better that than to be whittled to death by inflation.


Ted Oglove: Yes, and even though they are overpriced, you are still getting a 5% dividend. Look at what 5% compounded will do year after year.


Tom Gardner: Ted, over your 50 years' investing, you've spent a very substantial amount of time in evaluating the quality of earnings looking for things that were going wrong. But now your approach, outlined in the materials you sent and in our conversation, suggests to me that you've counterbalanced those concerns with optimism. You've taken years of training in what to be worried about and matched it up with faith in management, belief in the long term, a love for the power of compounding, and the importance of dollar-cost averaging. What changed your thinking?


Ted Oglove: What changed me? Simple. The 1987 bear market. I sold too many good stocks way too soon. The 1987 bear market was a real lesson. I learned that, sure, sell stocks if individually they concern you or if they're too much of your overall portfolio. But try not to let the market drive you out! In that situation, you're almost certain to get a bad selling price.
And that can be crippling. Why? Not just because they got a bad selling price once. No. Because they're demoralized when the market rallies, and they never come back to investing. I've run into so many people who had bad experiences and they got out of the market. And that was it. They never went back.


Tom Gardner: That's the tragedy.


Ted Oglove: So, here's my last thought about the market and about the future. I think inflation, renewed inflation, is the greatest danger. I have no idea when we'll have an extraordinary amount of it. Nobody can really predict that. But I look at this one Federal Reserve governor. Do you see how he gloats about the printing press? He may be the next Fed chief. But I think this is a very dangerous guy. This is what you're dealing with when it comes to the problem with inflation. And you have elected officials that promise and promise and promise. And, unfortunately, they're going to carry out some of their promises. It's going to lead to higher deficits and more inflation.
And the bad news is that the quality of earnings was worse during the inflationary climate in the '70s and early '80s ...


Tom Gardner: Worse than they were during the late '90s?


Ted Oglove: Yes, because of the inadequate depreciation, the inability to replace the plant and equipment adequately. Now, the good news is that earnings multiples have come down today. I think General Electric (NYSE: GE) is down to 15 times earnings. And also IBM. During the stock-market bubble, their price-earnings ratios were over 30 times.


Tom Gardner: Right. It's similar with Cisco Systems(Nasdaq: CSCO).


Ted Oglove: Oh, Cisco is a great example. Cisco, right before the deluge, was trading at 80-90 times earnings. My gosh. It's come way down with a current price-earnings multiple around 25.


Tom Gardner: As a generalization, if you back out one-time items, and you find a large-cap company trading at two times the market's P/E, that's pretty scary. Conversely, if you find a promising small-cap company trading at half the market's P/E, take another look.


Ted Oglove: Well, one reason that that may be interrupted temporarily is that small caps, retailers and technology companies are more sensitive to recessionary conditions than most other categories. You notice how heavily they fall.


Tom Gardner: Yes. That's why, knowing of that threat, I think you've got to find the low-multiple, underfollowed and unloved small companies. Those with low multiples. I submit that they'll fall less, but they're still going to fall.


Ted Oglove: Yes. The only thing I'll say is that the smaller the business, the more heavily it'll be affected by a recession than perhaps a Dow-type stock.


Tom Gardner: Yes, they have fewer tangible assets to back their valuation.


Ted Oglove: And, therefore, if your small cap is selling at 30 times earnings and you get into one of these recessions, you could go to 15 overnight.


Tom Gardner: That's the short-term danger.


Ted Oglove: That's why you run into periods, some much better than others. And that's why you have to be prepared to just keep adding money, particularly when your favorite stocks are down.


Tom Gardner: Yes, exactly. And the principle of dollar-cost averaging is a wonderful way to end our engaging, extended conversation. Ted, thank you very much. Next time I'm out in San Francisco, I'm going to drop you an email to grab a coffee and ask more questions about International Paper.


Ted Oglove: (Laughs.) That would be great, Tom. Hey, you know I subscribe to Hidden Gems, so I'll be looking forward to reading my interview! It really has been a treat talking to you. Your newsletter, boy, I'll tell you, your letters are great. The way you have got the long-term outlook down, going right back to Peter Lynch. Hey, do you have two more minutes there?


Tom Gardner: Sure.


Ted Oglove: I want to tell you about the best stock I've had in recent years. It's right out of Peter Lynch. I found it because I used to own a racing stable. When I was in New York, I owned some racehorses that ran at Philadelphia Park. And, well, racing is a dying business. Racing fans are an aging population. The innovation is that they now have simulcasting. So you go to one of these racetracks, if you go to Philadelphia Park, you can wager on Saratoga, or the Midwest, you name it.


Tom Gardner: Right.


Ted Oglove: Well, what's happened in recent years is that the only thing that can really make these tracks viable is slot machines. Churchill Downs (Nasdaq (SC): CHDN) could be a great example. Churchill's earnings have gone nowhere. But it's an interesting stock because if they ever wind up with slot machines in some of their racetracks, the picture could improve quickly. If you put slot machines into these racetracks, it's a whole new ballgame. But it's hard to get them in.
Years ago, I decided to invest in a sleepy, marginally profitable racetrack called Penn National Gaming(Nasdaq: PENN). At the time, they owned a racetrack in Harrisburg and a trotting track in the Poconos resort area, both in Pennsylvania. It seemed to me that with Atlantic City, N.J., next door to Pennsylvania, it would only be a matter of time before Pennsylvania would enact legislation allowing racetracks to install slot machines. So I bought the stock at about $3. But what happened was Tom Ridge, then the Republican governor of Pennsylvania, was anti-gaming and never allowed legislation to permit slot machines.
Meanwhile, as luck would have it, Penn National acquired Charlestown Raceway in West Virginia and received a license to engage in slot-machine gaming. They started with only 500 slots and later expanded to 4,000. The cash flow from the gaming operations enabled Penn National to make other casino-type acquisitions, and the result was Penn's share earnings and price went up manyfold, even though in its home state of Pennsylvania slot machines remained nonexistent.
In a major break for investors, Tom Ridge, the anti-gaming governor, resigned to head up Homeland Security. In a subsequent election, the voters of Pennsylvania elected a highly pro-slot-machine governor. Within two years of his taking office, the state legislators passed a bill authorizing a massive 60,000 slots, most of them at racetrack sites. So now Penn National will incrementally benefit by the potential addition of 5,000 slots to be allotted at their flagship racetrack, which is located in Harrisburg, the capital of Pennsylvania. Recently, Penn National offered to buy Argosy Gaming Corp. (NYSE: AGY). If this acquisition goes through, Penn National will be the third-largest gaming enterprise in America. The pending acquisition resulted in Penn's price rising 10 points to a new high of $53.
This is an example of Peter Lynch's investment philosophy. If I hadn't owned a racing stable or been a racing fan, because one of my hobbies is going to the races, I would have never thought twice about the stock. That's where it landed in my lap, à la Peter Lynch.


Tom Gardner: A beautiful example. In our next conversation, you'll have to share your racetrack betting strategy! I know some Princeton professors have worked up a strategy.


Ted Oglove: Yes, we can certainly talk about that.


Tom Gardner: Ted, thank you very much for the conversation. And thank you for your investment work and writing and for sharing the new thinking to your investment approach, which has you more focused on great investment situations and quality management teams than a line-by-line investigation of the footnotes. All of your work through the years has been tremendously helpful to me. Thanks for taking time to talk.


Ted Oglove: Well, Tom, thanks a million. I enjoyed our talk. Best of luck.