<<<The New Risk Factor: Credibility
04-Feb-02 10:24 ET
[BRIEFING.COM - Robert V. Green] If you suddenly heard that half of all $20 bills were counterfeit, you would likely stop taking $20 bills as change. The collapse of faith would hurt the value of genuine $20 bills. A confidence problem is the single greatest threat to the market at this time. Whether it becomes a full fledged crisis or not, faith in company reports now needs to be listed as one more risk to equities.
The Elements of Doubt
There has always been a list of "standard risks" for equities. These include:
Economic risk: the country or world heads into a recession, hurting the performance of your company's business.
Sector risk: The economic sector in which your company contracts, hurting business.
Industry risk: The industry within the sector contracts, hurting business.
Company risk: Your own company fails to execute, and therefore becomes worth less
Market risk: The market simply refuses to pay up for performance in your company, for whatever reason.
Now, as a result of recent events, it seems wise to add one more risk to this list:
Credibility risk: the faith the market puts in management and reported numbers lessens, hurting the valuation multiple placed upon earnings and revenue.
This new risk is going to be the natural consequence of all of the following:
The Enron (ENE) scandal, which emphasizes distrust of management and corporate structure.
Revenue recognition issues: Global Crossing's 20-year contract accounting is only the most visible example.
The fall of sell-side analysts, whose analysis of business possibilities is now mistrusted.
It all boils down to one thing: Is information on which investment decisions are based, trust worthy?
Unfortunately, we now have an environment which is likely to cast doubts on all companies, not just "crooked" ones. The credibility risk is going to have an impact on all stocks.
Discounts For Risk
It is natural to assume that the Enron scandal will not affect your own stock. But it will.
The rise of the credibility risk is not likely to be undone by sending some Enron management to jail or by shareholder lawsuits. Because the issues involved in Enron and Global Crossing extend to all companies, a risk of "bad-information" is possible in all companies.
The market discounts current value for all perceived risks.
You can now add a discount for credibility to the price of all stocks. Even a solid, revered company like General Electric (GE) has now come into focus as a potential confusing financial portrait. GE was one of the first stocks profiled as "confusing" by the Wall Street Journal soon after the Enron collapse.
What are the likely consequences of an increased discount for credibility risk? Here are a few possibilities:
Complexity of financial structure will be discounted, not valued, as it is now.
Greater than expected revenue growth will face higher scrutiny, and carry less value.
"Pops" on beating earnings expectations will probably lessen, as rushing into positions based on small pieces of information may not be immediately rewarded, as it has in the past.
Debt will get increasingly more focus, and companies with higher debt will be devalued.
In short, the market is likely to demand a discount for the possibility that investment information is not entirely credible. Anytime information is closer to complex than it is to simple, a discount will be demanded.
Likely Suspects
Investments on which this discount is likely to be demanded in the short term (which means the stock price is likely to decline in the absence of any underlying fundamental driver) are the following:
Companies with a high debt/equity ratio
Companies with labyrinthine financial structures
Companies whose revenue models are of a long-term nature
Is it any wonder that Tyco wants to break themselves into four separate companies? Doing so will avoid being painted as a complex financial structure that no one can understand, and therefore won't pay for. Tyco is only the most prominent example of this trend.
Possible Action
The loss of faith in the capital markets during the 1930's hurt the country deeply, and lead to the hallmark Acts that still govern the financial markets: The Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisors Act of 1940. Congress is anxious to avoid any broad loss of faith in today's market. Although it is too early to know what concrete action will be taken, other than a public pillorying of Kenneth Lay, major new regulation could be forthcoming.
For example, it is entirely possible, we believe, that the role of the Financial Standards Accounting Board (FASB), is altered. The FASB is a private sector organization that establishes rules for proper accounting practices. The FASB is officially recognized by the Securities and Exchange Commission (SEC) as the entity to establish accounting rules. However, the legal authority to establish accounting rules belongs to the SEC, not the FASB.
If the FASB becomes viewed as "not strict enough" because of its private sector self-police role, it will not likely survive intact. If this were to happen, the discount demanded by the market during the transition period would increase. Who knows what a companies financial picture would look like if new revenue recognition rules and reporting requirements were put into place in a single year?
Treading Water
In summary, the credibility risk argument has two components.
We are entering a period where published financial information by all companies will come under increased scrutiny.
The market will demand a discount in valuation multiples until it is clear that the scrutiny period is over.
It will take some time to build in a "credibility discount" into stock prices. Such an adjustment is likely to take several months. During that time, it is likely that Congressional action to "get to the bottom of this" and debates over new accounting principles will intensify. A new set of regulations, from accounting principles to 401(k) transaction rules are likely. The only unlikely scenario is that nothing happens.
Much as a swimmer going against the current expends a lot of energy to stay in one place, the stock prices of the best companies are likely to tread water during this period, even as they grow their businesses. The Enron/Global Crossing events may not be picked on as the reason for a market-wide stagnation, but the forces they have unleashed will be omnipresent nonetheless.
Comments may be emailed to the author, Robert V. Green, at rvgreen@briefing.com >>>
Namaste!
Jim |
