LONDON (FT Investor) - The flow of accounting horror stories from Wall Street is far from over, US-based fund managers fear.
New York has been rocked by major frauds at major corporations from Enron (ENRNQ: news, chart, profile) to WorldCom (WCOME: news, chart, profile) in recent months, and now the market is gripped by fears that dubious accounting practices may be commonplace, rather than limited to a few bad apples as many hoped.
But a lot of the scandals emerging now were in the public domain all along for those who looked hard enough, fund managers believe.
Mark Beale of New Star, who is shorting the likes of Cisco (CSCO: news, chart, profile), IBM (IBM: news, chart, profile), GE (GE: news, chart, profile), Amazon (AMZN: news, chart, profile) and Computer Sciences (CSC: news, chart, profile) in his hedge funds, says: "I think there are more of these out there."
Mr Beale points out that using pro-forma "business as usual" measure so beloved by companies and analysts, the stocks on the high-tech Nasdaq Index made a combined profit of $40bn in the last financial year.
$100bn black hole
However the actual figures reported to the Securities and Exchange Commission for the same period showed a net loss of $60bn - revealing a $100bn back hole from one year alone.
"In certain hot businesses over the last four or five years some rakish companies have come along. Any company that has made a lot of acquisitions you have got to be suspicious of. They have overpaid for them and they are trying to hide the poor earnings," he says.
Frederic du Murode, portfolio strategist at Fidelity International, the UK's largest investment house, concurs with this view.
"When you have had a long bubble that has ended, it tends to be during the period of economic recovery that a lot of the bad news comes out.
"We are at an early stage of recovery, so history tends to suggest that there will be more [bad news] to come."
Long-only fund managers are refusing to panic about the growing number of accounting scandals plaguing their marketplace, arguing that these scandals are not unique to the US.
Small is beautiful
However, there is a growing trend for these funds to eschew complex multinationals in favour of smaller and mid-cap stocks with more straightforward financial structures.
Simon Melluish, manager of Gartmore's American Growth (F1:GEAM: news, chart, profile) and American Focus funds (F1:DBAFC: news, chart, profile), says: "I'm particularly focusing on the small and mid cap end of the market.
"A lot of these companies are family-owned, they don't have the problem with stock options and they are less complicated, so it's harder to cook the books."
Ian Cooke, manager of the Schroder North American fund (F1:SZNAI: news, chart, profile), adds: "We knew when Enron came out that it was going to start a wave, but a very small percentage of small companies are involved. There's no need to throw the baby out with the bathwater."
Fund managers argue that apart from out-and-out frauds of the likes of Enron and WorldCom, the bulk of dubious, albeit legal, accounting tricks are well telegraphed.
Turning a blind eye
New Star's Mr Beale says: "People have known for years that the US is playing fast and loose with its numbers, but for years investors have turned a blind eye to it.
"In the hedge funds we started shorting IBM and GE back in April. Now we are shorting Computer Sciences . . . We are also shorting Amazon. Revenue recognition for a company like Amazon is so difficult."
"We have been suspicious and mistrustful of companies that have overstretched themselves. Cisco, I think, has to look suspicious, and I wouldn't want to own them."
Referring to issues such as GE's (perfectly legal) trick of drawing down pension fund surpluses to bolster its bottom line, Gartmore's Mr Melluish adds: "A lot of these things have been in the public frame if people wanted to look."
Nothing new
Mr Cooke of Schroders argues accounting scandals are nothing new, and are not restricted to the US.
He points to the Robert Maxwell and Asil Nadir/Polly Peck episodes in the UK in the early 1990s, and a spate of controversies in the US three years ago, centring on Waste Management (WMI: news, chart, profile), Cendant (CD: news, chart, profile) and Xerox (XRX: news, chart, profile), which has also become embroiled again this time around.
"Companies stretch their accounting practices within the laws, and that happens in every country. It's not unusual," he says.
But most commentators agree with Gervais Williams, the manager of the Gartmore Irish Growth fund, that this particular episode will essentially be a US one. See the views of Mr Williams
Mr Beale notes: "Some of these issues apply to Europe, but UK and European accounting is a little bit tighter. I've had my European colleagues chiding me for years about how loose these things are in the US."
Sheltering from the storm
So how are US fund managers reacting to these troubled markets?
Schroder's Mr Cooke is standing by the views he outlined to FT Investor in November: that those companies which slash costs aggressively will lead the recovery. See this story
He is confident we are now witnessing a normal economic recovery, with US productivity up 8 per cent in the first quarter of 2002.
As a result his portfolio is becoming more cyclical, with chip companies such as Applied Materials (AMAT: news, chart, profile), Teradyne (TER: news, chart, profile), Oracle (ORCL: news, chart, profile) and Micron Technology (MU: news, chart, profile) to the fore, alongside industrials and basic materials.
He is confident that the S&P 500 (SPX: news, chart, profile), currently languishing below the 970-point level, will hit 1,100 by the end of the year.
Lacklustre S&P
Gartmore's Mr Melluish forecasts a more "lacklustre" S&P due to the continuing accounting worries, and is largely avoiding the 50 largest stocks in the index as a result.
His portfolio is overweight healthcare, housebuilders and, since September 11, defence. However he remains underweight technology, arguing that value has yet to emerge, despite two years of falling stock prices. Furthermore he believes estimated growth rates are still unrealistically high.
The Focus fund, which contains his 30 "best ideas" has defence contractor General Dynamics (GD: news, chart, profile), metal producer Phelps Dodge (PD: news, chart, profile) and student loan provider SLM Corporation (SLM: news, chart, profile) as its largest holdings.
As well as his hedge funds, Mr Beale runs the long-only Luxembourg-based New Star Global North American Portfolio (F2:TDNAP: news, chart, profile), as well as a freshly launched Dublin-based Oeic.
Defensive bias
The funds are strong on defensive stocks, such as consumer staples like Coca-Cola (KO: news, chart, profile) and Procter & Gamble (PG: news, chart, profile), consumer cyclicals, from autos to department stores, and energy stocks such as Exxon Mobil (XOM: news, chart, profile). These are largely considered immune to accounting issues.
Financials also have a role to play, although he prefers regional banks to the likes of Citigroup (C: news, chart, profile), which are likely to be holders of bonds issued by the Enrons and WorldComs of this world. Utilities are also avoided amid fears of further scandals to come.
Fidelity's fund range includes the top performing Fidelity American (F1:FIAM: news, chart, profile) (although star manager John Muresianu recently stepped down) and Neal Miller's Fidelity American Special Situations (F1:FIAMSS: news, chart, profile).
Fidelity American is very strong on energy stocks and mining companies, particularly gold miners. Newmont Mining (NEM: news, chart, profile), Burlington Resources (BR: news, chart, profile) and Barrick Gold Corporation (ABX: news, chart, profile) are the three largest holdings.
Special Situations is more biased towards technology and data services, with the likes of Micron Technology and Intel (INTC: news, chart, profile) to the fore. |
