Hello Joel, An e-mail:
-----Original Message-----
From: Brook
Sent: Friday, July 26, 2002 5:31 PM
To: Jay Chen
Cc: Mac; Pete; Shiau
Subject: This guy writes well
Interesting comments and viewpoint from Robert Loest at Millennium Fund on CEO certification and S&P valuation scheme.
Mac; Your charts on past bear market phases were interesting. Chris Woods targets of 500 for S&P and 1000 for Nasdaq aren't so heroic when we've already almost attained those levels today.
Enjoyed our lunch today Jay. Hang in there; if your amaggaedon theory comes true, we'll all paddle rafts across the Pacific to visit you in your gold and platinum cottage in Boracay.
Best, Brook
Wen; r u in HK?
July 23, 2002: Sign What!? As many of you may know by now, the SEC mandated on June 28th that no later than August 14th, the CEOs and CFOs of the 947 largest companies must personally certify, under oath and subject to criminal penalties, that their financial statements are accurate for 2001 and all subsequent years. While this is good for the markets longer term, it will increase volatility for the largest companies substantially over the next few months. This is the entire S&P 500 and a lot more, and it is going to scare the absolute bejesus out of some CEOs and CFOs.
The stock market is so sensitized to the possibility of dishonest accounting by CEOs and CFOs that the mere mention of any upper level management changes will send a stock's price reeling. We saw that happen with Clear Channel Communications (CCU) today. Imagine for a moment that you are Jeffrey Immelt, the new CEO of General Electric (GE), and you are being asked to certify under oath to the accuracy of results at a very complex, multinational corporation - results for which you are not completely responsible. If you are wrong, you could go to prison, or have your reputation and career wrecked. Would you sign? I wouldn't. Not until I had restated everything, and had the most conservative set of financial statements seen since the Sumerians invented accounting.
We are likely to have a mess on our hands. This could very well be what is behind the sudden plunge in the Dow Jones Industrials. Frankly, I wouldn't be caught dead holding one of these large companies unless I was very certain of their financials. This means there are a lot of institutions dumping shares of the largest, most complex corporations. We can expect to see some CEOs and CFOs resign or request a delay for reviews rather than sign such an oath. This will create even more instability in individual stocks and the markets over the short term until someone signs the statements under oath. And this is only going to happen after he or she is damn certain they have restated results in the most draconian and conservative manner possible. This could take awhile, and delay the recovery in the market.
Don't mistake me. I am quite happy to see this new regulation, but it is going to cause a lot of pain. As I've stated in previous posts over the years, by far the most glaring flaw in modern corporate governance is that corporations took the Army model of power structure 200 years ago when the steam engine created the industrial revolution, and made the modern corporation necessary. The flaw is that they did not also incorporate the Army's model of personal accountability.
When I was an officer in the U.S. Navy, I was appointed Special Weapons Officer at one of my duty stations. As is the case throughout all branches of the military, I was required to sign a form that held me personally responsible for all the weapons in the Weapons Department. All of them, even the ones that cost huge bucks. If anything happened to any of them - anything at all - I could expect a court martial.
One of my first duty assignments after I was commissioned was as Disbursing Officer for a ship. It was in the days when we paid cash, before computers made checks and automatic deposit possible for a ship's crew. We'd go on a deployment with several hundred thousand dollars that I had to sign for personally at the base bank before the ship left port. If any of it turned up missing, it came out of my hide. This kind of personal accountability tends to make you careful. It also tends to make you honest and conservative. Too many of our CEOs and CFOs are totally unfamiliar with this higher standard of personal accountability. If it were up to me, I wouldn't hire a damn one who hadn't served in the military for that reason alone. Most of them simply are unlikely otherwise to have a clue what personal accountability really means.
The SEC, finally, is remedying a flaw in the corporate structure that has existed for two centuries, and they are to be congratulated for it. It's an action that took real guts. Certainly more guts than either the President or Congress has displayed. Now all we need to see is an extension of this rule to all publicly traded companies.
Meanwhile, expect to see some major stock price declines among corporations like money center banks, companies that have grown aggressively through acquisition, and other large, complex corporations that probably have been liberal in their use of GAAP accounting rules. I expect that Microsoft (MSFT) is going to look comparatively good here, because of their conservative accounting, narrow business focus, and largely internal growth. So also are other companies that have done most of their growth internally, are fairly narrowly focused, and have a reputation for conservative management.
One of the things we've done to try and mitigate the effects of this volatility is to own more narrowly focused companies that have robust earnings and are large generators of cash from operations. This makes it less likely that management has manipulated the numbers in any major way, because they don't need to. There are a lot of companies in Millennium and New Frontier Funds that have Cash From Operations (CFO) that is double that of reported EPS. We have emphasized other conservative aspects of corporate financials as well in order to eliminate doubtful companies. We got out of Worldcom, Tyco, Enron and several other problem companies long ago. We don't expect this will protect us completely, but it will certainly help.
The stock market is on an emotional roller coaster today. I expect it will last some months longer. You should understand, though, that the underlying economy is recovering. Railroad carloads are experiencing a steady, if slow, recovery. This means that a broad base of industries are beginning to recover, from coal to automobiles to agriculture. Advertising is recovering, and has been for months, from the deepest slide since the Great Depression year of 1938. It is also a bellwether because a lot of different companies advertise, so the recovery must be fairly broad-based.
The underlying fundamentals are likely to continue on this slow recovery path over the next year or so. Eventually all the hysteria in the stock market will work itself out, people will gain new confidence in a new crop of CEOs and CFOs willing to sign a personal blood oath of responsibility for their company's financials, the market will begin to heal, and stocks will again return to reasonable values.
Right now, we are doing some buying. If you are willing to wait this storm out, and have done all you can to ensure that you have the best companies with a simple corporate structure and focus, and very conservative accounting and financials, I suspect that you are going to make a lot of money in the next few years. With each CEO who signs the oath, expect the market to breathe a huge sigh of relief for that company.
R.L.
July 19, 2002: The Bathwater, The Baby and the Tub. I just re-read what I wrote a week ago, and it sounds like I wrote it a week too early. Mutual fund redemptions have hit the market particularly hard the last month or so. While we are fortunate enough not to have to sell due to redemptions because of our large cash position, most funds are having to sell off a pro-rata share of all their investments, no matter how good a company is, in order to meet redemptions. This hits the largest positions in the best companies like Wal-Mart (WMT) particularly hard.
Furthermore, if institutional investors are reducing their exposure to stocks as an asset class, they are selling the S&P 500, which means the more heavily-market-cap-weighted components like Wal-Mart will also be sold disproportionately heavily. The S&P 500 is a cap-weighted index. This is nice in a bull market because it tends to channel increasingly large percentages of investment dollars into increasingly fewer large cap stocks, pushing prices up to unsustainable levels. This is what was responsible for the outperformance of index funds in the last half of the '90s. It is a mechanistic, arithmetic inevitability of a bull market, not great investment judgment.
Unfortunately, this phenomenon works both ways. In a selling panic like we are seeing now, the largest, most heavily-weighted components of the S&P 500 get sold the most heavily, which is now driving the prices of America's greatest companies to unsustainably low levels. Sure, they can stay there awhile, too. With the increased proportion of wealth invested in stocks on the part of individual households over the last 20 years, such panics can also be deeper and last longer than in the past, because there is more to sell. Nevertheless, this has been going on for nearly 2 1/2 years now, so I would assume that most of the selling that's going to be done has been done, and we are seeing the last of the hardcore holdouts finally giving up.
As a result, we have been doing some cautious buying in very conservative, high dividend stocks with very conservative characteristics. High dividend stocks we have added to are FPL Group (FPL), XL Capital (LX), Newell Rubbermaid (NWL), Hubbell, Inc. (HUB.B), General Growth Properties (GGP) and Commerce Group (CGI). We have also repurchased National City (NCC). All have very high dividend yields, some up to 6% or so, and very conservative financials and dividend payout ratios (except for the REITs, of course, which have to pay out at least 90% of earnings by law).
We've also added to our growth end of the Barbell, although not as heavily. We added this week more ESS Technologies (ESST), Symantec (SYMC), Horizon Organic (HCOW), A.C. Moore Arts & Crafts (ACMR), Concord EFS (CEFT), Electronic Arts (ERTS) and Expeditors Int'l (EXPD). All our growth stock additions are directly dependent on the consumer, not the corporation, as we've discussed before.
S&P 500 Fair Value Calculation
There have been a number of articles recently discussing whether the S&P 500 is undervalued. They all generally take the same approach, which is to capitalize the S&P 500 EPS at some interest rate, generally the 10-year T-Note. One does this buy dividing next year's S&P 500 earnings by the 10-year T-Note yield, currently about 5%. All have concluded that the S&P 500 is, with varying degrees of extremeness, undervalued and due for a rally. I don't doubt this, although stocks can stay undervalued for some time. Just because they are low doesn't mean the have to go up tomorrow. For that matter they could go even lower and stay there for a year, but this is becoming increasingly unlikely Nevertheless, I think most of the authors, including Arthur Laffer in the Wall Street Journal Monday, have taken the wrong interest rates to use in their capitalization calculations, and have thus understated the degree to which the S&P 500 is undervalued.
The proper interest rate to use should be that of the 10-year TIPS, or Treasury Inflation-Protected Security, which is currently about 3.3%. The reason for this is that corporate assets, corporate commodities like oil and timber, and the investments required to maintain their value generally appreciate with inflation. Thus, like TIPS, corporate stocks or assets tend to be roughly indexed to inflation (or deflation). Ordinary Treasuries, unlike corporate assets and TIPS, do not adjust for inflation, and therefore are inappropriate for capitalizing an earnings stream supported by assets that do adjust with inflation. If this line of reasoning is correct, then the TIPS interest rate is the proper rate to use for capitalizing earnings on the S&P 500.
Using the TIPS interest rate of 3.3% to capitalize next year's S&P 500 earnings of roughly $50 produces a value for the S&P 500 of approximately 1,500. The current S&P 500 index value as I write this is 857, so by my calculations the market has about a 77% potential upside appreciation at some point in the not too distant future. It's hard for me to believe that an undervaluation this extreme can last for long. Even if I'm off considerably in my assumptions, there is still a very large gain in the market needed just to return to fair value.
Given the large percentage of in-line and positive earnings reports relative to disappointments, and consistently improving broad economic indicators like ad spending and railroad car load shipments, the current panic selling in the broad stock market is based purely on psychology, not on any underlying economic deterioration or widespread company-specific bad news. Sometimes negative psychology simply overwhelms fundamentals in the short term, and there's nothing to do but live through it. However, longer term the market always returns to fundamentals. Longer term, there is a huge bull market ahead. The trick is living to enjoy the longer term.
R.L. |
