Vitas,
According to Smithers, adjusted for the true cost of stock options, the S&P had a P/E ratio of nearly 55 at the end of 1997 and 63 at the end of '98.
Does put the market in a slightly different light, doesn't it?
(Barrons) April 12, 1999
Crepehanger's Lament
By Alan Abelson
Once upon a time, there was a French Prime Minister named Mendes France (what'd you expect, Mendes Germany?). An earnest fellow, M. France fretted about his countrymen's legendary fondness for wine and sought by public exhortation to wean them from the grape in favor of milk. Happily, his efforts were an udder failure.
As part of the campaign, signs were posted in the Paris subways warning the citizenry: "Stop drinking alcohol because it will kill you slowly." Which prompted some oenophile to write under that mordant message, "That's okay. I'm not in a hurry."
We're indebted to Jacob Frenkel, governor of the Bank of Israel, for relating this fey story in his informative and lively Frank M. Engle Lecture on globalization. What appealed to us particularly is that it so nicely encapsulated the stock-market saga of these past three or so years.
Sober Street savants and other cockeyed pessimists have been haranguing the masses about the dire consequences of addiction to equities, predicting that the bull market would come to an early and terrible end. The masses, to their enormous profit, have yawned, scratched their noses and cheerfully continued to pour their dollars into the market. While, for its part, the market has demonstrated a complete lack of interest in hurrying to fulfill those dire prophesies.
Frankly, as a charter member of the Crepehangers of America, we think it's quite unsporting of the market to act so contrary. Has it no compassion? Can't it put itself in our miserable paws for a second? Must it be so darn bullheaded and refuse to go anywhere but up?
If we skeptics have been guilty of a certain absence of positive thinking about the stock market in recent years, it's not because we've been blind to the astonishing changes that have so transformed and invigorated the investment climate. We're happily aware the economy's been on a marathon run (over eight years and counting), that inflation is de minimis and interest rates benign, that liquidity runneth over and 401(k)s mount inexorably toward $2 trillion, that massive corporate buybacks and mergers are soaking up the supply of stock, that consumers are flush with bucks and confidence, that unemployment is a speck, that technology advances with the speed of a click, that Alan Greenspan's on our side-that, in short, this has been the best of all possible worlds.
Our beef is simply that the market has discounted not only all such earthly delights but most of those presumably to be found beyond the Pearly Gates.
At last tally by our trusty statisticians, the S&P was selling at 34 times trailing 12-month earnings and nearly seven times book value, yielding an improbably anemic 1.3%. And, of course, that literally isn't the half of it. For not a few of the great drivers of the surge to the foothills of heaven have been stocks with near-infinite or infinite P/Es-all P and no E-that have few tangible assets and proudly pay no dividends.
Perhaps we ought to mention, too, that, much as it's fun to watch, the growing antic quality of the market is something of a putoff. Last week, for example, a company called Rhythms NetConnections Inc. went public at $16. The stock immediately ran up to $75 before pausing for breath. The company provides businesses with, yes, Internet connections.
At $70, where the shares have temporarily roosted, Rhythms is being valued at $4.7 billion, a sum that's a tidy 8,900 times last year's total revenues. Earnings? Surely, you jest.
For all this market has Rhythms-or, really, because it has Rhythms-it doesn't cut it for us. Besides the pervasive presence of animal spirits, the rocket rise of the shares illustrates again the sharp division between a relatively small roster of issues, dominated by big-name techs and wildly speculative Internet numbers, on the one hand, and the legions of ordinary shares, on the other.
Or, as John Hotchkis, of West Coast money managers Hotchkis & Wiley, reflects with a touch of bemusement: "Never have we seen such a divergence between overvalued stocks and undervalued stocks." He goes on to remind that last year, maybe a baker's dozen stocks accounted for half the S&P 500's total return, and 10 stocks were responsible for 40% of Nasdaq's gain (ex the 10, Nasdaq would have been off 18%).
We've had occasion before to quote John's graceful and breezy prose, and his current communique from the trenches addresses a familiar question, which, we can only infer, somewhat restive clients have been addressing to him: Is this really a new era?
Rather than keep you in suspense, we'll tell you John's answer is "no." Which won't shock you when you realize he's a confessed value investor.
Despite that considerable handicap, he's still a sensible fellow with some sensible things to say. After running through-and running down-most of the reasons offered for this time being different, John singles out the growth of technology as the most plausible, and the decline in interest rates as the most tangible, of the arguments. Technology can't do much "about the granny-knot government in India or the promissory-note society of Russia or whatever is bothering Brazil," he notes, but it has wrought enormous changes in the way we live and work and the tools available to us to do both.
"The Internet," he says, "has achieved the same significance in our lives as eating, sleeping and making love." (Speak for yourself, John.) Obviously awed by its growing influence in Wall Street, he marvels that "there are by now probably six million accounts handled by online brokerage firms, whose owners, incidentally, will no doubt have left the country when the selling wave starts."
The large reduction in interest rates, which he dubs "the mother milk of equity price appreciation," is a major reason for the Dow's current skein of 16 years in a row in which the venerable average has finished higher than the year before (the previous record was eight years). And the conviction that low interest rates will be around for a while, he suggests, is why the new paradigmers contend that "what you pay for a stock is irrelevant (as long as everyone else is buying it)."
What John isn't buying, as we said, is that there is such a thing as a new paradigm. It's just a new bubble, inflated beyond belief by some old misconceptions.
In his view, the only thing that distinguishes the current mania from many earlier manias is that it's so focused on stocks "with an unusually large P/E and a huge cap rate." That the combined capitalizations of GE and Microsoft are bigger than the entire Russell 2000 reminds him of the "heady days of Japanese real estate when the Imperial Palace sported a value greater than the State of California."
Through thick and thin (and for value investors, alas, there has been a lot more thin than thick of late), John has kept the faith. And when this bubble collapses, he confidently predicts, the righteous will prevail. Or, if not the righteous, at least companies with "real earnings, real growth of book value, solid management and a policy of providing shareholders with an ever-increasing dividend."
Obviously, poor John ain't got Rhythms.
Mind-blowing valuations and speculative frenzy by no means exhaust the list of things that trouble us about the present elevated level of the stock market. Earnings -- more specifically, purported earnings -- are very much a sore subject as well.
In particular, we've long had a gripe about the cunning corporate practice of taking huge anticipatory charges in a bad year or a bad quarter (after carefully preparing an eagerly complicit Street) so as to puff up earnings the next. Equally irksome is the rampant practice, particularly among high-tech, high-P/E outfits, of hyping earnings via a kind of no-cost approach to compensating employees by using options instead of cash to pay them.
We're scarcely alone in taking issue with such devious doings. In his most recent epistle to shareholders, the sainted Warren Buffett had nasty things to say about both.
The tendency of even otherwise estimable CEOs -- whom "you would be happy to have as spouses for your children or as trustees under your will," as he neatly puts it -- have come to believe it's okay to manipulate earnings by wilful abuse of restructurings and merger accounting. All in the name of pleasing Wall Street and enhancing shareholder value.
Those corporate chieftains easily become addicted to massaging the numbers, Buffett observes, and are unable to summon up the willpower to stop. They remind him, he relates, of Voltaire's comment on sexual experimentation: "Once a philosopher, twice a pervert."
Buffett's objection to options is summed up tellingly by three questions he has posed before: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
Andrew Smithers, the very bright and engaging Brit, quoted a fair bunch of times in this publication, has bravely sought, aided and abetted by a learned colleague, to determine the impact of the use of options on corporate profits. That impact, he discovered, is huge.
According to his research, embodied last month in one of his firm's detailed and carefully prepared reports, if corporations had accounted properly and fully for the costs of options, published profits would have been reduced by a whopping 56% in 1997 and 50% in 1998.
This monster overstatement of earnings means, of course, that price-earnings ratios are really vastly higher than even the very rich multiples we've grown accustomed to. According to Smithers, adjusted for the true cost of stock options, the S&P had a P/E ratio of nearly 55 at the end of 1997 and 63 at the end of '98.
Does put the market in a slightly different light, doesn't it?
At the end of December, we ran a little squib on a software outfit called LHS Group. What gave the piece some piquancy was not so much the company as David Rocker's thoughts on the company. An old friend, David runs a hedge fund fittingly named Rocker Partners, and he was anything but enamored of LHS Group.
As we recall, the shares were selling around 50 at the time, down from a high of 76 or so. In the months since, they've run into some rough weather and last Friday closed at 27 and change. Even at that considerably more subdued level, the stock commands a rather generous P/E -- comfortably above 80.
Adding injury to insult for LHS Group's stock (and the company itself probably isn't too happy about it, either) is a downgrade by Lehman Brothers. The firm, just this past week, reduced its rating from 1 to 3, or from "buy" to "neutral."
Unfortunately, our experienced translator of brokerage arcania has repaired to some Caribbean beach, so we can't give you an exact rendering of what "neutral" means. We know it doesn't mean "buy" or "accumulate" or even "hold." It may or may not be a seven-letter word for "sell."
Lehman ascribed its change of heart toward LHS Group to a variety of concerns. These included stiffer competition, for one. And for another, negative sentiment among certain investors because of aggressive selling by insiders, sentiment that wasn't made any the less negative by plans for a secondary last month (the proposed offering was scrapped when the stock began to seriously take gas).
We might also mention that there has been such an exodus from the executive suite that serious consideration is being given to renaming it the executive sour.
Lehman, not so incidentally, serves as investment banker for LHS Group. |
