Vengence be your witness, and redemption be your reward ...
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A NOT-SO-FINE ROMANCE
by Frederick J. Sheehan Jr. 06:00 PM 05|04|2001
Like wounded lovers, buyers of Cisco stock just can't believe the affair is over. But until these hopeless romantics accept reality, the market won't hit bottom.
Today we will talk about sex. Well, not just sex, but sex and money, money and sex. The combination is as old as the hills. It is when the two are spliced together that we achieve the linguistic conjunction of sexy. As in: "Let's not forget why Cisco, Intel, Microsoft, Sun Microsystems, EMC and Oracle have captured the imagination of the American public," as the Wall Street Journal's Neil Barsky wrote recently. "It's that those companies have made so many so rich." Thus, the romance of owning these shares. The financial transaction itself -- building a house, making a loan, buying shares of Cisco -- involves a conjunction and the consent of both parties. The emotional impulses of both acts are similar: hope, attraction, passion, recklessness, insecurity, skepticism, fear, disgust and loss.
The preceding sequence roughly matches that of a market cycle. Roughly, because emotions never come one at a time nor do they proceed in so orderly a pattern. Even so, there are points of no return (in money and romance) after which we can never go back. The condition today of the U.S. stock market is that of a love affair gone sour, but not everyone has abandoned hope. It is the bouillabaisse of these emotions -- regret, wistfulness, the seductive interlude before defeat and despair -- that creates such enormous volatility in the stock market today.
One reason for this Cisco case study is to take advantage of a variable that most investors don't appreciate -- time. Not time as it is usually discussed (e.g., the requirement to stay fully invested so as to maximize compound returns), but instead, time to consider the contrary. There is plenty of time to watch from the sidelines, and there is no hurry to do anything now. Doing nothing has often been the road to riches. Finally, we will hold a moment of silence, a requiem, for doomed lovers, wherever they may rest.
Anatomy of the Cisco Empire
A year ago, consenting adults bought and sold shares of Cisco common stock in such a state of fevered passion that the company's market valuation briefly exceeded $600 billion. It was bigger than the gross domestic product of Spain. To repeat: it was bigger than Spain. A company of 15 years was more valuable than a nation of five centuries. True, the Spanish empire had declined from its greater glory (during which the very land on which sits Cisco's headquarters was a possession), but it is also true that the Spanish economy is growing at a faster rate than is Cisco. At the time, reverent articles predicted that Cisco would soon enough achieve what no company had ever achieved or dared hope: it would be the first one trillion dollar company.
Today, Cisco is a $142.5-billion-dollar company, but Cisco shares are by no means cheap. The price-to-earnings ration of 30:1 is still very expensive in any market, with the possible exception of the late bull market, which was probably the greatest speculation in the long, fascinating history of reckless financial manias.
As key distinction between buyers and sellers of Cisco stock today is their point of reference. To the buyers, Cisco looks cheap. It traded at 140 times earnings in the spring of 2000, so is a screaming buy today. For sellers it is more a question of what the business is worth.
But the buyers are like wounded lovers, who make note of the abating vigor of their one and only, but recall those tender, affectionate days of yore. They cannot bring themselves to believe the affair is finished. So, Cisco lovers would not have cared that the return on equity has slowed from 33% in 1996 to 10% by last summer.
Cisco's earnings growth rate had increasingly depended upon "other income," which includes investments in start-up companies and vendor financing. The trouble with including other income when evaluating a company is that it comes and goes and is an addendum to Cisco's router business. Less than 5% of net income in 1996, "other" grew to 10% by 1999, and rose above 25% in 2000.
Cisco has also taken to announcing "pro forma" quarterly earnings that far exceed GAAP earnings. GAAP financial statements are those of the annual report, which are regulated by the Securities and Exchange Commission. Pro forma financial statements are whatever Cisco wants them to be. For 2000, pro forma earnings growth was 47.2%, while GAAP earnings growth was 24.1%. It is the pro-forma statements with which Cisco entices the analysts, who, by and large, take them as given.
Or took them as given. By early March, Cisco warned that sales growth would be zero over the next six months. In mid-March, Cisco laid off 8,000 workers. In late March, Cisco CEO John Chambers said that this may have been "the fastest deceleration that any company had ever experienced."
So how much is Cisco worth? Probably a lot less that the Cisco lovers hope, and hope is still a powerful stimulant in the market. When hope is gone then we will have hit bottom.
Frederick J. Sheehan Jr. is the director of Equity and Fixed-Income Investments at John Hancock Asset Management Services. This article is excerpted from his April 2 "Quarterly Market Review and Outlook." |
