Accounting worries are in the news everyday and are having a negative impact on the stock market, because they make stark the accounting manipulation that has been going on since the mid-1990’s, which made it appear that companies are making more money than they really are. People are beginning to realize that the fundamentals and promise of technology companies are not what they thought they were.
But this process has been going on since April of 2000. The only difference is now after Enron even the average investor realizes something is wrong. But they are still in denial, thinking that they can pick “strong companies” and be immune.
There is another change that is taking place, which hasn’t been mentioned at all in the press, but is just as important: that is the problem faced by conglomerates. Tyco, GE, and Cisco are all conglomerates. All three are caught up in the accounting worries, with Tyco being accused of outright fraud in some quarters.
All three however have issues that go beyond just accounting worries. Almost every other large conglomerate on the stock exchange, including companies such as AOL-Time Warner, and Merck, shares these issues.
They have reached a limit to how much faster they can grow.
Conglomerates are creatures of bull markets.
Let me explain.
People buy stocks for earnings growth. Small companies can often post huge earnings growth rates just because they are small or are in new and growing market niches. Conglomerates can post large growth rates too(Cisco in the 1990’s for example), but they don’t do it the same way. They do it buy acquiring other companies and buying earnings, and ironically the more overvalued and hyped their stock the easier they can do this.
The 1960’s saw a wild bull market that was led by a group of conglomerates. Once the bull market ended the stock prices for the conglomerates crashed and many of them simply disappeared. You never hear of Ling Electronics anymore, even though it went from 2.25 in 1955 to over 1000 split unadjusted in 1967. In 1969 Fortune Magazine called it the 14 largest industrial company in the United States. It no longer exists.
Neither does Rapid-American or Riklis. Gulf and Western still does, but its stock doesn’t trade anymore. It started out as a car parts store until it borrowed $84 million dollars from Chase Manhattan bank and bought the New Jersey Zinc Company, Desilu prodocutions, and Consolidated Cigar. It went up a like a rocket until the SEC investigated it for accounting fraud.
But all of these were once hot stocks that were growth stock favorites of analysts and fund mangers. And they posted growth numbers. The Ling conglomerate announced a 75% rise in EPS in 1967 alone. Cisco didn’t even have to do that in 1999 to be called a “new economy” stock.
How did the conglomerates of the 1960’s do it? They bought earnings.
John Brooks, who wrote a history of the era called The Go-Go Years tell us in his book:
“The simple mathematical fact is that any time a company with a high multiple buys one with a lower multiple, a kind of magic comes into play. Earnings per share of the new, merged company in the first year of its life comes out higher than those of the acquiring company in the previous year, even though neither company does any more business than before. There is an apparent growth in earnings that is entirely an optical illusion. Moreover, under accounting procedures of the late nineteen sixties, a merger could generally be recorded in either of two ways – as a purchase of one company by another, or as a simple pooling of the combined resources. In many cases, the current earnings of the combined company came out quite differently under the two methods, and it was understandable that the company’s accountants were inclined to choose arbitrarily the method that gave the more cheerful result. Indeed, the accountant, through his choice and others at his disposal, was often able to write for the surviving company practically any current earnings figure he choose…All of which is to say that, without breaking the law or the rules of his profession, the accountant could mislead the naïve investor practically at will.”
Cisco played this game in the 1990’s in order to become a darling of the “new economy.” So did Tyco and many others. The problem is this is a game that cannot last forever.
For one thing it is dependent on a rising share price in the conglomerate. If the stock of the conglomerate begins to decline than few companies will accept buyouts from it and without acquisitions there is no earnings growth. What is worse, if scandal envelopes the company then the game is completely over.
That is why Tyco is now proposing to spinoff its divisions. This proposal tells us that the CEO of Tyco no longer believes that he can continue to grow the company through mergers and acquisitions – no one will accept them anymore. That means its earnings growth is finished. The only way he can try to maintain some of his company’s value of is to break it up. It is a move of total desperation.
Anyone buying Tyco right now as an investment simply doesn’t know what he or she is buying. The same goes for Cisco. Cisco will never again be able to increase its earnings per share by 30% a year through creative accounting, mergers, and acquisitions. Consequently the fundamentals of the company will languish and the stock will never again be called a “growth stock.” These creatures only flourish during bull markets and are killed by bear markets. And with the Enron and accounting scandals all over the news the game is over. But as you can see the problem for these companies is much deeper than just accounting.
For now no one seems to realize this. Well I’m sure some people do - the people selling and getting out of the stocks that is. But despite the fact that shares of Tyco have fallen over 50% since January 1st only 1 out of 14 analysts that cover the stock have downgraded it. And people still fantasize about Cisco.
It’s just like the correction. No one believes it but its here. In the back of everyone’s mind people sense trouble because of Enron and the widespread accounting games, but people want to hope that it won’t make the market drop. In the same way people just want to hope that Cisco and Tyco will go back up.
Accounting scandals are nothing new. The 1960’s bull market brought accounting scandals with it. The difference now is that the biggest stock market bubble in world history created the current scandals. That is why they seem to be so horrible. They’ll fade away as the bear market brings caution and honesty back into the market. But new rules and regulations won’t stop Wall Street from fleecing the public once the next bull market comes. It’s a cycle that seems to repeat itself.
A must read article from TrinTabs, a source Maria Bartiromo used to use almost everyday, but now ignores because it has become negative:
"CONVENTIONAL WISDOM SAYS RECESSION OVER & SUNNY SKIES AHEAD. CORPORATE INVESTORS AND KEY LIQUIDITY INDICATORS SAYS BIG STORM APPROACHING."
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