John Mauldin's Weekly. Long suckers but some decent stuff in there, like on Cisco and the pension fund lies. Plus a little on the inflation/deflation topics.
2000wave.com
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The Meaning of "Excess"
Cisco Cooks the Books Again
Your Basic $90.2 Billion Lie
8.65% Dividends and Growing
Inflation, What Inflation?
Saving Money on Health Care
By John Mauldin
Over the past few months, I have commented about how large
corporations are using their company pension funds to bolster their
corporate earnings. Under accounting rules, if a pension fund has
"excess" funding, the excess can go to the bottom line of the
corporation. Nothing particularly wrong with that, except the
meaning of the word "excess" is as loose as Bill Clinton's
definition of "is." Today we will visit an amazing statistic that
clearly shows just how deceitful, large and widespread this practice
is.
It seems corporations can project what they are going to earn in the
future, and if their projections show that in the future they will
have excess, then that helps their earnings today. The problem is
that corporations are making very aggressive assumptions. Warren
Buffet notes that GE assumes they are going to make 9.5% on their
pension fund investments. The "profits" from these assumptions
allowed them to post $1.7 billion to earnings in 2000, which was 2.5
times what their appliance division made. That was 10% of GE's
profits that year.
IBM assumed they would make 10%. General Motors likewise assumes
10%. You can bet most corporations assume something similar, as they
all use the same consultants to back up their assumptions and give
them an outside, supposedly independent group, to support the
reasonableness of their assumptions. The pressure upon a consultant
to give the Chief Financial Officer a number that works with their
earnings forecast is huge. If you don't give them a number that
helps their bottom line, and is consistent with what your
competitors are saying, what chance do you think you will have to
get hired for next year's work?
The research we looked at last week showed that such assumptions,
except during major bull markets, are very unrealistic. If you have
a third of your portfolio in bonds, averaging 5-6% across the
spectrum, to get to 9.5-10% on the total portfolio, you have to make
11-12% on the rest of your portfolio.
Yet I have shown you study after study over the past year that shows
that if you are a large institution with a broad portfolio, 6-7% on
your stock portfolio is about the best you can hope for, and that is
if you are good. That is especially true for pension funds that are
laboring under the burden of Modern Portfolio Theory.
The vast majority of historical real returns on stocks have come
from re-invested dividends, and not from the growth of the
underlying stock. The past 20 years has been a major exception to
that rule. Because we have been participants in this bull market, we
expect the party to continue.
Historically dividends have been in the 4-5% range. Today dividends
are less than 2%. That means future projected growth based upon
historical patterns can be very misleading. One can argue that
companies which do not pay dividends, but buy back shares or invest
for more growth are in effect paying a dividend which does not have
to be taxed. But the data does not support that conclusion.
Dividends don't lie. They are not pro forma earnings, or accounting
magic. They are real dollars in your pockets.
Cisco Cooks the Books Again
Cisco told us this week that they will make $.20 per share pro forma
earnings, if you ignore all those inconvenient losses. If you choose
to look at the real number, it is closer to $.10, and that is before
the end of the year write-offs from over-priced purchases of other
companies.
Want an interesting exercise? Go to www.bloomberg.com. Get a quote
on Cisco. At this moment the consensus estimated forward earnings
are projected to be $.35 with a Price to Earnings (P/E) ratio of 59.
But if you go to Bigcharts.com and retrieve the same information,
you find they suggest earnings at $.15 with a P/E of 102. If you
look at the 2001 year fiscal year-end for Cisco, you find losses of
over $1 billion dollars.
Who is right? Looking at the actual quarterly tax filings,
Bigchart.com apparently uses past or trailing actual earnings.
Bloomberg uses projected pro forma earnings, and of course don't
refer to those inconvenient write-offs that will happen later this
year, which will possibly once again have the company showing a
loss.
This is the company which said this week, "Sales are flat, we are
not sure when we will see some real growth, but we fired a lot of
people and cut costs so we made more money than you guys projected."
Well, maybe Chief Cheerleader John Chambers actually put a little
better spin on it than I did. This sparked a 300 point Dow rally,
two-thirds of which has been lost as I write.
Let's get some perspective. At the end of the last recession, Intel
was selling for 1.5 times sales with solid growth potential. Today
it is selling for 7 times sales with no growth in sales since 1998!
Microsoft, with powerhouse growth, was selling for a P/E of 24 in
1991. Today it is at 31 with flat sales. These are great companies,
well-managed and with great franchises which will be with us for
decades. I love Microsoft. I am so much more productive because of
that company than I was 20 years ago it is hard to describe. I would
kiss Bill Gates, except that we don't do such things in Texas, at
least in public.
But.
Trees don't grow to the sky. Microsoft and Intel simply cannot grow
at 15% per year, which is what their current prices say the market
believes. 15% a year says they will double in size in less than 5
years. It won't happen. It has taken 25 years for Microsoft to grow
to $25 billion in sales. Where is there another $25 billion they can
find in the next five years? The answer is, there is no such growth
in the wings. Will they grow? Will they be more profitable? Yes.
But they will not double.
Yet investors hope for a continuation of the past. And consultants
look at these companies, and thousands of others, and make
projections which have no hope of coming true in a Muddle Through
Decade. These projections are a house of cards built on false
assumptions.
Your Basic $90.2 Billion Lie
Now, I will share with you the amazing stat I found in Bill Staton's
Money Digest that started this line of thinking. I read it nowhere
else, yet it is absolutely staggering in its implications. "Funny
money in the world of pensionland. According to benefits consultants
Milliman USA, the 50 largest U.S. companies last year reported $54.4
billion in profits from their pension-fund investments, which was
interesting because the same 50 actually saw portfolios decline by
$35.8 billion. How does a loss become a gain? Rack it up to
accounting, accounting that is legal. Think a change might be
needed? I certainly do."
So do I, Bill. That is a $90.2 swing.
Over the next few years, corporations are going to have to begin to
lower their estimates of future growth for their pension funds. This
means they are going to have to take a loss to earnings because of
currently aggressive assumptions. For some of these corporations,
the losses could be substantial. And the longer they maintain their
aggressive assumptions, the worse the day of reckoning will be.
I will make you a side bet right now. When these companies take the
hit, it will not be to current or future earnings. They will go
back and re-state prior year earnings. They will blame the economy,
the stock market and sun spots. They will fire their consultants,
and hire new ones with more conservative projections. But future
earnings will still be pro forma positive. All the loss will be
relegated to the past, because of past mistaken assumptions, so
pulleeze do not even think about selling our stock.
Call me cynical, but if the bulk of your income is based upon stock
options, as is the case with most large company CEO's, what else
would you do? This is going to cause a lot of musical chairs in the
corporate boardrooms.
Baby Berkshire Hathaway Inside the Washington D.C. Beltway
It is time once again for income manager Tom Donaldson to give us
yet another investment idea for your income portfolios. This time he
gives us a firm which has a long history of making money for its
investors. It can be a little volatile, but the dividend and long
term growth is steady. Let's take a look at what Tom says about
Allied Capital:
"After 40 years Allied Capital Corporation (ALD on the NYSE) of
Washington D.C. sports a record to be envied by any long term
investor. Selling at $25.42 with a recently increased annual
dividend of $2.20 for a current yield of 8.65%, Allied had produced
an average annual total return to its shareholders of 18% for the
last forty years with dividends reinvested. Allied Capital is the
nations largest business development company engaged in private
equity investing, an area not accessible to most investors. With 82%
debt securities and 18% equity securities and a portfolio totaling
over $2.2 billion in assets, Allied has a unique niche in the
investment world. The company targets industries for investment in
business services, broadcasting, education, consumer products and
light industrial products. In addition the company has over $649
million in commercial real estate financing as part of its
portfolio. With a Standard and Poor's beta of .71 and an A- rating,
ALD should have a place in every total return portfolio. Hint - if
you buy before June 11th you will catch the next .55 cents dividend.
The regular dividend has never been cut and total annual dividends
have been steady or increasing every year since 1973." (Full
disclosure: My money management firm, Millennium Wave Advisors, LLC
represents Tom.)
Inflation, What Inflation?
The Producer Price Index came out today, and showed a drop last
month of 0.02%. This is probably a good indication that next week's
CPI numbers will be small as well. We are well on our way to a
yearly inflation number of less than 1%, as I predicted years ago.
Commodity prices have stopped their recent rise, and started to come
back down, and are roughly where they were in 1987. Unemployment is
up to 6% and rising, and the growth in consumer credit card spending
is dropping, partially as a result of job worries.
Business sales are slumping dramatically. "The recession was mild
indeed by most measures, but business sales were hit harder than in
1990-91, says John Lonski, of Moody's. For the 12 months ended March
2002, the 2% year-over-year decline in business sales -- defined as
the sum of retail sales and manufacturing shipments plus wholesale
sales -- was the steepest since 1982." (Apogee Research)
Slowing sales are not an atmosphere in which inflation raises its
head. Capital expenditures are not developing, as companies are
being very cautious.
Greg Weldon notes that productivity is soaring and that labor costs
have shown their steepest deflation since 1983, and manufacturing
labor costs are in their steepest deflationary period since 1961.
Yes, the dollar is going to get weaker, as I predicted for this
year, but it is not going to fall out of bed. While that can be
inflationary, there are so many deflationary forces in the economy
(such as massive over-capacity) that inflation is not the problem
the Fed is concerned about.
In fact, a few Fed governors have openly speculated about deflation
in recent weeks. That is a major shift in Fed thinking. Greenspan is
clearly signaling that while he thinks we are in a recovery, that it
is not robust. He is also clearly telling us that inflation is not
something to worry about.
I did something I rarely do this morning. I turned on CNBC to watch
the announcement of the PPI numbers. As I was getting ready, they
had an economist from Prudential that astounded me with her
analysis. "We need to be worried about inflation. The Fed is not
tightening and this is a concern." The other economists gently took
her to task, pointing out that inflation was not in the immediate
future, and that getting the economic recovery on solid ground took
precedent.
Like generals fighting the last war, there is a huge element of the
bond market simply refusing to acknowledge or believe that low
inflation is anything more than a temporary blip. They have
experienced inflation all their lives, and are rooted in their
belief it will come roaring back unless the Fed raises rates.
We can criticize Greenspan and the Fed (and I do from time to time),
but they understand that if they pull the trigger on rates too soon,
they will tank the stock market. Such a move will hurt corporate
earnings, which are already remarkably weak for a quarter in which
there is supposed to be a recovery.
I do not think Greenspan raises rates before the November meeting.
September would be the first time they would consider it, and the
Fed is normally reluctant to do anything which might be considered
political prior to an election. Unless something happens which shows
inflation coming back strongly, or employment picking up rapidly, I
think they hold off till after the election, at the earliest.
Saving Money on Health Care
I am simply appalled at the rise in the cost of health insurance.
There, I agree, we are seeing rampant, take no prisoners, inflation.
I have a small firm with four families who are eligible for and use
health care insurance. I have heard about Medical Savings Accounts
but have not investigated them. The last round of cost increases
brought a directive from the boss to find something cheaper. Going
to a Medical Saving Account saves my firm over $1,000 per month, and
we are getting better coverage. My employees are happy. If they do
not get sick, they get to keep the savings as a form of tax free
retirement money.
My brilliant son-in-law, the insurance salesman, did the research,
got us the best quote and company for us and, of course, the
savings. (He is primarily brilliant for being wise enough to marry
my oldest daughter, who works with me and is one of the happy
employees.) You should have your insurance agent check out Medical
Savings Accounts, or you can email me and I will forward it to #1
son-in-law to get you a quote.
Dallas and New York
This is the week of the Byron Nelson golf tournament in Dallas, so
by tradition it should be raining in North Texas this weekend. I
will take an umbrella, even if the sun is shining. But I will be
with my Saint of a Mother this Sunday, though I may sneak a peek at
the last round. It is always good to have family together. Family
relationships pay the highest dividends of all.
I will be in New York City (Mid-town) June 2-5 speaking at the
annual Hedge Fund Forum. My topic will be the future issues facing
the hedge fund world, and my views should spark a few lively
debates. I believe there are a lot of changes coming to the entire
world of investments, and not just hedge funds. In five years, we
will be amazed at the new investment choices we will have, and at
how we all view investing. I will also be available to meet with
clients or potential clients.
Have a great weekend,
Your ready for a Mother's Day weekend analyst,
John Mauldin
John@2000wave.com |
