Real Earnings – April 2002

April 20, 2002

Dow Jones Average: 10,257
S&P 500 Index: 1,125


Real Earnings


When investors buy shares of stock in a company they become part owners of that company’s earnings stream. The challenge for investors is figuring out whether the earnings are likely to grow or decline in future years. In making estimates and investment judgments, investors rely on the reports that corporations file with the Securities and Exchange Commission. These reports and the corporation’s books are audited by well known accounting firms. If these quarterly and annual filings are inaccurate or deceptive there is no valid basis for investment decisions.

In recent months the accuracy and honesty of reports filed by dozens of leading corporations have been called into question. The most notorious case has been that of Enron, a company that obfuscated its true condition by establishing hundreds of partnerships. Through these partnerships the company was able to hide losses and enhance revenue. As the truth about Enron’s dealings emerged the company quickly lost its entire 100 billion stock market value. Alarmed by the Enron experience investors started asking hard questions of other companies. In many cases the answers they received were not encouraging. It seems that many companies, including some of the largest and most admired, have used aggressive accounting to enhance the earnings statements. While no other cases have been as egregious as Enron, deceptive practices have been uncovered. Investors are left wondering if they are paying too much for earnings that may not be as real as reported.

In a competitive business world the pressure to produce high earnings is intense. Companies that report higher earnings are held in high esteem by investors, customers, and competitors. The corporation’s stock price goes up as a result. The stock is used to reward top executives who are typically paid more in stock options than in salary. Corporations that enjoy a rising stock price have a competitive edge in hiring, as potential recruits are attracted by the possibility of valuable stock options. Using stock in lieu of pay reduces a company’s payroll expenses, making earnings look even better. Perhaps the greatest benefit of a high stock price occurs when a company is making an acquisition. Shares of stock can be substituted for huge amounts of hard cash when companies decide to merge. With so much at stake it is not surprising that corporate executives spend much of their time strategically massaging the earnings numbers.

The interests of investors in a company and corporate executives of that same company are not always aligned. Investors want to buy or hold shares of stock that are reasonably priced and are supported by a sustainable, growing earnings stream. Corporate executives are frequently under pressure to produce the best looking results in the near term, at the risk of being distanced or acquired by a more aggressive competitor. Some of the more unscrupulous executives simply want to enhance results long enough to cash in their own stock options. Investors have to realize that aggressive accounting practices are not going to be repealed. In fact standards have become looser in recent years. Investors can protect themselves by comparing the filings companies make for tax purposes with the filings issued to the investment community. If there is a big difference between the two reports a red flag should be raised. In addition, the strength of a company’s balance sheet tells a lot about its true condition. Successful companies should be building up cash and paying down debts in a consistent fashion if the earnings are real.

Current Strategy

The broad stock market remains about 30 percent below its level of two years ago. The technology stocks as measured by the NASDAQ are still down 65 percent and showing little signs of life. In spite of punishing losses in stocks, investors are remarkably optimistic. This optimism seems to spring more from desire and need than from reasoned analysis. Investors are committed to stocks, because the alternative is historically low rates of interest in bonds and money market funds. We do not believe that a lack of alternatives is sufficient reason for buying stocks. To warrant purchase a company should be attractively valued based on its current operations, balance sheet, and future competitive position. Based on those criteria few companies are attractive at this time.

The position of the stock market and the economy portend more tough times ahead. Economically sensitive stocks such as housing, autos, steel, airlines, appliances, etc. are already priced for full economic recovery. Technology and telecom stocks are much lower than the absurd levels reached two years ago, but still expensive by any other measures. Medical stocks, usually a safe haven, have been hit by one earnings disappointment after another. There are no sectors in the stock market poised to lead it higher. A similar situation exists in the economy. Housing and autos have been the engines behind economic growth over the past two years. When housing and autos sales begin to fade, the economy will slow significantly. There are no other industries experiencing the kind of demand that would propel economic growth. Alan Greenspan seems to realize that the situation in the stock market and the economy is extremely fragile. He is reluctant to raise interest rates even 1/4 of one percent from the current 40 year lows for fear of tipping psychology in a negative direction.

Our strategy over the past few months has been to take profits in economically sensitive stocks such as Nucor Steel. We always try to sell positions when they become market favorites. Two years ago we sold a lot of Cisco Systems, Texas Instruments and IBM when technology stocks were ascendant. Now we are pruning our holdings in basic materials and transportation stocks. For possible buys we are studying companies in less economically sensitive businesses, such as precision instruments, smaller medical companies, food and consumer products, and education. While awaiting the right entry prices we are holding a majority of client assets in government mortgage paper, inflation indexed treasury bonds, municipal bonds, and cash reserves.

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