... a couple of interesting articles ...
Monday, May 20, 2002, Barron's
Dollars to Doughnuts
As with so many things, a little drop, but not a big one, would be good for the greenback
By Jacqueline Doherty
After appreciating by nearly a third in the past seven years, the dollar is starting to look a little tired. In just over two months, the greenback has fallen 5% against the euro and 6.7% against the yen. Some economists believe this could be the start of a gradual weakening that may continue over the next year or more. If so, investors may want to rethink their approach to the markets. A falling dollar would help U.S. companies that derive a large portion of their revenues from abroad. And for dollar-based investors, overseas investments may look more attractive.
The key question, however, is whether the currency's decline will be gradual or abrupt. "A little bit of dollar weakness would be a good thing for the world economy. But there's a very fine line, and too much of good thing can be a bad thing," warns Knut Langholm, an emerging-market-debt portfolio manager at State Street Research & Management. A 10%-15% fall over the next year or so would be beneficial, but a drop of, say, 30% could raise the specter of rising U.S. inflation and interest rates, which would be bad news for stocks and the economy.
The dollar has shifted direction for a number of reasons, notably a marked cutback in foreign buying of U.S. stocks and bonds. In January and February, overseas investors bought $26.7 billion of U.S. equity and fixed-income securities, down sharply from nearly $100 billion in the year-earlier period. Their reduced enthusiasm for U.S. assets apparently reflects the punk returns U.S. markets have provided global investors in recent years.
They also may be turned off by a perceived change in U.S. policies. While former Treasury Secretary Robert Rubin would endlessly repeat his mantra in favor a strong buck, his successor, Paul O'Neill, insists the markets set exchange rates and has cast doubt on the worth of intervention. U.S. manufacturers also have been clamoring for a lower greenback to make them more competitive, and have been able to gain tariff protection for steel.
U.S. assets also are looking pricey. Based on what it will buy in goods, the dollar itself is expensive. In addition, European and Asian stocks sell at lower price/earnings multiples than do their U.S. counterparts, making some investors view non-U.S. stocks as less risky. Moreover, the gap between American and European economic growth has narrowed, further reducing the relative allure of U.S. investments. Morgan Stanley forecasts 2.8% real growth in U.S. gross domestic product this year and 1.4% in the Eurozone. Next year the growth gap shrinks substantially, with 3.7% forecast for the U.S. and 3.1% for Europe.
The slowdown in global merger and acquisition activity has been equally marked, with far fewer foreign takeovers of U.S. corporations. Overall, global M&A announcements dropped to $14 billion in April, making it one of the slowest months in the past five years, according to Joseph Quinlan, a senior global economist at Morgan Stanley. In addition, there are also fewer deals involving the purchase of U.S. companies. In the first four months of 2002, the U.S. accounted for only 14% of announced global M&A inflows, versus about 30% last year.
Considering that foreign companies probably have had to write down the value of U.S. acquisitions made before the bubble burst, their lack of appetite for new American deals is understandable. "You used to be a hero for doing mergers. Now, you're a scapegoat," observes Quinlan. Add to that the various accounting scandals that have made headlines, and it might take a while for foreign CEOs to risk making deals in the U.S.
Reduced demand for U.S. assets has become a concern because of the need to fund the massive deficit in the current account, the broadest measure of international transactions. The U.S. current-account gap is running close to 5% of GDP, a level that a Federal Reserve study found typically leads to a depreciation of a nation's currency by 10%-20%, notes Gail Dudack, chief investment strategist at Sungard Institutional Brokerage. The currency adjustment also involves typically three years of sluggish economic growth -- not a pretty portent.
Like most analysts, Morgan Stanley's Quinlan expects a gradual decline in the dollar. He sees the euro rising to 95 cents from about 92 cents currently and a low of 86 cents in late January. He also looks for the yen to trade at 130-125 to the dollar, compared with 126 yen currently, but stronger than the 135 level three months ago, despite Japan's continued economic woes. "If we're right about an orderly decline in the dollar and stronger global growth, that's a good environment for large-cap, multinational companies," he says.
Companies that may benefit the most from a weaker dollar are those that generate most of their revenues overseas. As the dollar weakens, a multinational converts stronger euros, pounds or whatever into more dollars. Above is a list of the 25 companies in the Standard & Poor's 500 that derive the greatest percentage of their total revenue from foreign sales. The list, provided by ISI Group, includes mostly mega-cap names. The biggest companies typically have bigger global presences than mid-to-small-cap stocks, which have outpaced their larger brethren in recent years. But if the buck keeps faltering, big-cap names could be back in favor.
The industry sectors with the most to gain from a weaker dollar are technology, with 45% foreign-sales exposure, and energy companies, which reap 33% of sales abroad. Hence, names such as Motorola and Texas Instruments top our list. ISI's survey of tech companies also has recently shown a pickup in spending, notes Jason Trennert, an ISI investment strategist. The improved survey results, the weaker dollar and the decline in stock prices has Trennert considering shifting to a neutral stance on tech shares from his current underweight position. Not exactly the makings of the next raging bull market, but a favorable change in direction.
U.S. industrial companies that have had a tough time competing with foreign outfits could also benefit from a weaker dollar. Steel and car companies are among the first to come to mind; hence their lobbying for a drop. The areas with the least to gain from a weaker dollar include the financial, utility and telecommunication-service sectors, which each generate under 10% of their revenues abroad.
To be sure, investors need to go beyond looking at foreign-sales exposure before judging whether a stock will reap rewards from a falling dollar. Some analysts note, for instance, that foreigners have been big buyers of U.S. large-cap stocks as the dollar was rising. If they begin selling U.S. assets, large caps, with their higher P/E multiples, could suffer.
Foreign markets also may grow more attractive to American investors in a weaker-dollar environment. As with U.S. multinationals, an investor buying foreign securities will benefit from an appreciation in the foreign currency as well as any gain in the security's price. "I think a lot of U.S. investors have about 5% or less of their portfolio in international equities," says Nicholas Sargen, global markets strategist at the J.P. Morgan Private Bank. A more normal level of international diversification would be about 10%-15%.
When looking overseas, investors should consider emerging markets, says State Street's Langholm, the emerging- market investor. He believes a weaker dollar is consistent with increasing commodity prices, which would benefit those emerging markets where commodities are produced. As a result, he believes that high-quality emerging-market bonds will return their coupons of 10% or so to investors. A weaker greenback and stronger euro would lessen inflation fears in Europe, just as the stronger dollar has helped reduce U.S. inflation. If that comes to pass, the European Central Bank might be less likely to raise rates. European government bonds, which yield about the same as Treasuries, would stand to benefit.
As noted, the consensus sees the dollar falling only moderately, perhaps just 10% or so. But the fear is that the decline could be more precipitous and disruptive. If so, inflation could rise as imports become dearer and domestic producers have more leeway to hike their prices. Interest rates also could increase. The U.S. bond market, a major magnet for foreign capital, could push yields higher if that source of funds departs. And the Fed also might be forced to tighten to offset imported inflation. Either way, it could be bad for the economy and stocks.
"There's generally a belief that the U.S. is the leader in the global economy. So there is an unwillingness to sell the dollar short," explains Trennert. That view has generally benefited the U.S. economy and financial markets, albeit at a cost to certain sectors. A gradual reversal could mitigate those negatives, but a swift one could eliminate the positives.
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Monday, May 20, 2002, Barron's
Strength in Numbers
By Alan Abelson
Listen to the coyotes howl!
No, they're not upset by the disclosure the White House had a tip more than a month before Sept. 11 that bin Laden & gang might try hijacking some U.S. planes and, on the advice of "intelligence" (?), chose not to share the warning with us humble folk. After all, as both the CIA and FBI in rare agreement noted, the tipster didn't supply the flight times or even the names of the airlines.
And, no, they're not howling about Jimmy Carter's junket to Castroland where he lectured the natives (boy, we do remember those homilies about moral malaise Jimmy used to regale us with). After all, the Cubans have survived listening to Fidel rant on for 40 years, so they're impervious to a gust of hot-air hectoring from old Jimmy.
Nor was the wailing provoked by the latest revelations that energy traders swapped mythical orders with each other. After all, nobody else wanted to trade with them and they were bored out of their minds (in the case of energy traders that doesn't take too much boring).
Not to keep you in suspense: The thing that got the coyotes' hackles up is the idea that earnings are what a company actually earned, not what a company could have, should have, would have earned if it weren't for a few odds and ends, like having to pay people a salary or send along a bundle every month to Ming the Merciless, a.k.a your banker, for interest and paydown on the dough he lent you.
More specifically, what has them in such a state of agitation is the decision, announced last week, by venerable Standard & Poor's to introduce a new system for gauging corporate earnings. We don't blame the captains of industry and the revered analysts of Wall Street who rushed to take up the cudgels against the outrageous notion of trying to present earnings as they truly are.
What could be more subversive of a noble tradition of gussying up profits so that your stock takes off and everyone is happy -- your shareholders, your faithful analytical followers and, not least, your loved ones, who can count on the skyrocketing value of your options to provide sustenance (caviar and foie gras), shelter (manses in Greenwich and monster bungalows in the Hamptons) and educational expeditions to exotic places (Saks, Bloomingdale's, Neiman-Marcus)?
A sly lot, alert to which way the wind is blowing, the critics aren't coming right out and damning S&P for sticking its nose in their business. Instead, they gently bemoan the possible harm to investors. S&P's new way of describing what earnings are, they murmur sorrowfully, will only "confuse" the poor souls.
And the critics are right. Investors are going to be terribly confused when they look back at the dehydrated versions of past years' reported results and wonder where all the earnings went.
We sympathize with the aggrieved corporate brass who spent years getting advanced degrees in financial engineering and see it all going to waste. And we sympathize as well with their camp followers on the Street who swallowed whole those sugarplum earnings confected by their corporate clients and now are faced with the formidable task of finding nice things to say about uncooked fare.
Amid the grumblings, lamentations and cries of "confusion," David Blitzer, S&P's chief investment strategist and the main man in the noble truth-in-earnings undertaking, seemed remarkably serene when we chatted with him briefly last week. A thoughtful type, he evinced neither a trace of surprise at, nor so much as a hint he was perturbed by, the instant carping that accompanied release of the new earnings treatment. He and his diligent crew merit three cheers -- heck, make that four -- for striving to restore sense and integrity to a vital investment measure that has been deliberately and maliciously robbed of both.
Does this mean that S&P's new formula for describing profits is perfect? Of course not. But is it a major step forward toward a reasonable, consistent and disinterested definition of earnings? Absolutely.
For good and sufficient reasons, which it sketches out in the preamble to its discussion of the new approach, S&P found each of the alternatives -- reported earnings, operating earnings and pro forma earnings -- wanting. So it came up with "core earnings," which are, in S&P's words, "after-tax earnings generated from a corporation's primary business or businesses."
The guiding principle in the new formulation is to encompass all revenues and costs of ongoing operations and exclude pretty much anything that isn't part and parcel of the basic business. Not included in core earnings, for example, are goodwill "impairment" charges (triggered when market value of the item drops below book value); gains and losses from asset sales; pension gains; unrealized gains and losses from hedging activities; merger and acquisition expenses and litigation or insurance windfalls.
Included in core earnings are not only the usual R&D expenses but the cost of purchasing research and development as well, thus removing a dodge notably popular among tech companies; restructuring charges from ongoing operations (under the old regimen restructuring charges were a neat catch-all routinely used for a variety of purposes, all of them nefarious); write-downs of depreciable or amortizable operating assets; pension costs and, lest we forget, employee stock-option-grant expenses. This last, need we say, is a particularly sore point for Corporate America, especially that chunk of it that occupies Silicon Valley.
And no wonder. By S&P's reckoning, options expense could cut earnings by as much as 10%, and, if anything, that probably errs on the side of conservatism. Of the 500 corporate worthies that make up the S&P index, only two (Boeing and Winn-Dixie) include the cost of stock options in figuring net income. Why do we have a nagging feeling that not all the other 498 companies that neglect to do so are motivated by a concern that their shareholders might suffer information overload?
The logic of S&P's inclusion of option expense in toting up earnings seems irrefutable: stock options are granted to employees as part of their compensation package. Ergo, they should be counted among compensation expenses. Logic, schmogic, just listen to those coyotes howl!
And our heart goes out to the poor creatures. The pain will be palpable. S&P reckons, for example, that counting options expense would render quite palpable damage to our old friend Cisco's bottom line: instead of the 14 cents-a-share loss reported for the fiscal year ended July '01, the loss balloons to 35 cents a share.
David Levy, who with his father, S. Jay Levy, authors The Levy Forecast and Macroeconomic Profits Analysis (try saying that out loud in a hurry), a first-rate monthly diagnosis and prognosis of the economy, is one of the select group S&P tapped to help shape up its core earnings concept. By David's estimate, reported operating earnings in recent years have been exaggerated by at least 20% and possibly a heap more. So ask not why we needed a new way to measure earnings; ask rather, why it was so long in coming.
Under the old definition of earnings, the S&P 500 sports a P/E of 22. Under the new, that rachets up to around 30. As David Blitzer observes, the average price/earnings ratio over the past half-century is roughly 16, so today's market is not only overvalued but extremely overvalued.
It's not exactly a stretch, obviously, to suspect that as S&P puts its core-earnings approach into effect and, in the fullness of time, as it or some near-facsimile gains currency and the overvaluation of the market becomes inescapably evident, stock prices will suffer, perhaps severely. But whatever the short-term pain, over the long haul anything that makes corporate reporting clearer, more consistent and more true has got to be an enormous plus, for the market, for investors, and mostly certainly for corporations, not to mention our collective economic health and well-being.
There's simply no substitute for honest numbers.
Standard & Poor's conclusion that it isn't kosher to include pension gains in corporate earnings could take a whack out of some prominent blue-chip bottom lines. By way of example, S&P cited General Electric. Ex the contribution from its overfunded pension plan, GE's per-share net last year would have been $1.11, rather than the $1.41 the company reported (GE sniffs that S&P overstated how much pension income chipped in to total profits).
The gross numbers, as Barton Biggs pointed out in a recent commentary for Morgan Stanley, are formidable. At the end of 2001, GE's pension plan had $45.8 billion worth of assets and was an astounding 45% overfunded. And, even though, reflecting the bum stock market, the value of the fund declined last year, no less than $2.1 million of the company's $13.7 billion in reported earnings came courtesy of its still-fat pension fund.
While Barton cautions that GE's pension fund contribution to the company's earnings may fade in the years to come, should the market's performance prove relatively subdued, if S&P has its way it'll vanish entirely.
Barton wasn't picking on GE. Rather, his remarks were part of a somewhat mournful discourse on how "bad things happen in a leveraged, equity-soaked financial system as stocks drift down," as stocks have for the past two years and counting. And prominent among the institutions bad things are happening to pension funds.
The percentage of pension fund portfolios in equities is a towering 75%; that's one problem. Another is that they've been counting on returns of 9.25%-9.5%, which, as Barton notes, may well prove at least a couple of notches higher than they're likely to enjoy.
He cites Milliman, a Seattle actuarial firm, as calculating that the 50 biggest U.S. pension funds took a hit to the aggregate value of their portfolios last year of $36 billion. Thanks to their generous assumptions of how much their investments should return, however, the fabulous 50 were able to use a "hypothetical" pension fund gain of $55 billion in reporting to shareholders, and include $9 billion of pension fund earnings (or something) in their net income.
As Barton observes, the spread between reality and accounting was a cool $92 billion and it wasn't tilted in favor of reality. In the bubble years, of course, the tilt was positive; but those years are gone, maybe never to return. Fair to a fault, Barton adds pension funds have no alternative to basing their accounting on long-term assumptions. Still, as indicated, those assumptions may be entirely too cheerful and, in any case, the contrast between the real and the hypothetical strikes us as a great argument in favor of excluding pension-fund "earnings" from corporate net income.
Especially in light of what's happening to those monster surpluses that pension plans enjoyed through the roaring 'Nineties. At the end of '99, a mere 15% of the big pension plans were underfunded; currently, about half of them are and, absent another bull market, that proportion will inexorably grow. As it is, the surplus in the top 50 plans in the two years ended 2001 shrunk an incredible 90%.
While none of those plans are deemed by Milliman in danger of running short of cash, it's not inconceivable, as Barton says, that companies may have to start coughing up dough to meet their obligations to their retirees. By way of illustration, he relates that GM at the end of last year had pension-fund obligations of $93 billion, against assets in its plans of $76 billion.
In the 'Nineties, as stock prices went racing to the moon and assumptions on how much portfolios would return over the long term went along for the ride, pension funds changed, as Barton puts it, "from cost center to important profit center" for any number of companies. The trip back, to cost center from profit center, no surprise, is proving not nearly as much fun.
P.S. Barton reports that public pension funds are also hurting: their assets plummeted $370 billion in the past two years. Liabilities are mounting by about 7% a year and state and local governments have no choice but to make up the shortfalls. That translates into possibly higher taxes and probably reduced services.
As he comments: "There will be a lot of dry municipal swimming pools this summer." And not because of the drought. |
