reaper, this guy must be reading your posts (or you reading his) -G-
Sunday June 30, 2002 : Hotline Update
The Market Climate remains on a Warning condition. At present, there is not much likelihood of a near-term shift in this condition. The best chance at such a shift would be the combination of a decline in interest rates coupled with a very lopsided market plunge in which declines significantly outpaced advancers. This is a combination that has historically opened the way for intermediate-term bear market rallies. Both of the intermediate rallies seen so far in this bear market (March-May 2001 and Sep-Dec 2001) had this character. Unfortunately, the market has not generated the kind of washout that might give market risk at least speculative merit, if not investment merit.
Interestingly, other good analysts of price-volume behavior have made similar observations about market action here. Paul Desmond of Lowrys (www.lowrysreports.com) notes "The desire to dump stocks is now at the highest level in eight months. The Selling Pressure Index is just 4 points below its Sept 21st extreme of 773. And yet, prices have repeatedly eased lower, never giving investors the impression that stocks are deeply discounted. One analyst recently described the decline as similar to being eaten by ducks. There has been no real panic selling, thus far not a single 90% Downside Day."
In short, market conditions are presently characterized by unfavorable valuations and unfavorable trend uniformity. We would be willing to take at least a moderate exposure to market risk if the market generated a convincing momentum reversal. Such shifts in the speculative environment can sometimes be captured very close to market lows, and we never try to pre-empt shifts in the Market Climate. So until something in the Market Climate does shift for the better, we will remain fully hedged.
Since I have a difficult time condensing an idea into fewer than 23 paragraphs, it's nearly impossible to answer all of the notes I receive and still manage investments. Still, our outstanding shareholder services representatives do pass on comments and questions to me, and I try to work the most common ones into these updates. Good questions frequently require extensive answers, and these updates strike me as the most suitable forum for that.
Two topics deserve mention this week. The first relates to hedging. Currently, we are fully invested in over 100 favored stocks, with our largest positions representing about 2% of assets. Against this position, we have an offsetting short sale divided across the Russell 2000 and S&P 100 indices. While we can and will take unhedged positions when the Market Climate is sufficiently favorable, we are hedged at present, and this means that our returns are driven by the difference in performance between the stocks that we hold long and the indices that we use to hedge.
While this performance difference is a source of risk, it is also our primary source of returns over time when we are hedged. Understand, however, that it is impossible for our favored stocks to outperform the market on a daily basis. Even though we carefully select which risks to take at any given time, we are fundamentally long-term investors. Even when we're hedged, we fully expect to experience many periods in which our favored stocks pull back, relative to the market, for a day, a week, a month, or for several consecutive days, weeks, or months - independent of market movements which are occurring. Unfavorable action in even a small handful of our stocks can and will produce this sort of behavior. In short, the fact that we are hedged does not mean that we take a risk-free position. We expect to be compensated for those risks that we choose to take, but it is risk nonetheless.
The second issue is the relentless tide of accounting scandals on Wall Street. In general, these are not accounting problems but ethics problems. With the exception of Enron's off-balance sheet debt, most of the scandals are arising not because items are left out of the books, but because they are misclassified to keep them out of "operating earnings" or "cash flow from operations" or other headline numbers that have little to do with the free cash flow that can be claimed by shareholders. Much of this elaborate misdirection can be avoided by holding companies to a higher standard than simply operating earnings that beat expectations by a penny. Operating earnings are the only first number in a tedious set of calculations and corrections that must be made in order to determine what can actually be claimed by shareholders. Usually (though not always), even a misleading set of numbers will cough up a confession if you poke at them a little.
A few of our prior updates will help to elaborate this point.
In our April 14th update, I wrote "When people talk about cash flow being an indicator of earnings quality, they're talking about the first figure on the Statement of Cash Flows: 'Net Cash Provided by Operating Activities.' Most of this cash disappears as unspecified "investments" and other uses of cash flow that make it unclear that the cash flow was ever legitimate in the first place. Often these 'investments' are simply expenses that have been purposely misclassified. The investments are then written off later as 'extraordinary losses', keeping them entirely out of the calculation of operating earnings..."
The April 14th update continued with a brief analysis of Enron. This week, we can illustrate these ideas by analyzing another randomly selected company. Let's see. Oh, here's one. Worldcom.
Last week, Worldcom disclosed that it had overstated cash flow by more than $3.8 billion since 2000. Essentially, Worldcom had purposely misclassified billions of expenses as "investments", keeping them entirely out of the calculation of operating earnings (why does that sound familiar?) Wall Street analysts were shocked, arguing that it was impossible to see this coming.
Evidently, they don't read these updates. As long as investors demand that companies deliver free cash flow (operating earnings minus a host of deductions, including capital investment over-and-above the amount required to replace depreciation), it makes no difference whether or not expenses are misclassified as investments. You deduct them anyway, and you measure the promise of those "investments" in part by the cash flow derived from existing assets. In any case, telecom companies like Worldcom, Qwest, and others simply fail this kind of test.
In our December 23, 2001 update, I noted "If you're going to value the stock as some multiple of operating earnings, the next calculation you make had better be to subtract off the value of the debt. For many companies, even if you appropriately adjust for capital spending and growth, the result is a negative number. In many cases, that is an indication that the stock is fundamentally worthless and the debt itself is not supported by cash flows. By our calculations, which should be considered opinion in this case, the group also includes several telecom companies still holding substantial market value, such as Qwest, Level 3, Adelphia and Nextel, several energy companies including Calpine, and certain large lending institutions and insurance companies that I'm going to pass on identifying."
Since last December, the stocks I listed by name have lost about 70% of their market value (the troubled financials are also weakening substantially, but since I refuse to be responsible for a run, I'll still pass on identifying them). Adelphia is now closest to being fairly valued. Having plunged from about $30 in December to 70 cents a share at Friday's close, Adelphia's stock price is now within less than one dollar of what I believe it to be worth.
On the positive side, I note in passing that Cisco, Oracle, EMC and Sun Microsystems have now finally reached the value targets that we published in January 2001, and which Alan Abelson was kind enough to review in Barron's at the time. These targets got a lovely on-air reception by the guys on CNBC's Squawk Box, since they were a fraction of the prevailing market prices (EMC for example was trading near 80). Aside from Cisco, these stocks are starting to look interesting (though only as part of a fully-hedged portfolio). Being about 80-90% off of their highs, we've also got to allow for the possibility of indiscriminate selling by disillusioned investors. We're never very aggressive about stocks that show apparent value without a certain amount of evidence from market action. But at least the techs aren't the focal point of overvaluation anymore. Suffice it to say that we continue to find little merit in telecom or financials. Media companies, investment banks, and a number of high-profile Japanese companies (traded as ADRs) are also deteriorating rapidly in our valuation work.
In other markets, we're still nibbling gradually on precious metals stocks on declines, and would avoid long-term bonds beyond a maturity of about 10 years, as import price inflation and a falling dollar threaten to have an unfavorable impact on reported inflation even if economic activity remains weak. I consider this a reasonably good second chance to lock in a mortgage refinancing rate if you've been considering it.
In stocks, the Market Climate remains unfavorable, which holds us to a fully-hedged position for now.
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