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Mauldin letter
Irrational Assumptions
(And Other Earnings Problems)
$50 billion in Phantom Earnings
The Chickens Will Come Home to Roost
A Few Quick Comments
A Guy's Night Out and Much More
By John Mauldin
This morning I saw economist Larry Kudlow on CNBC once again telling
us the markets would turn back up at some point because the economy
is getting better. Kudlow is a smart man, and I pay attention to his
thoughtful style.
But in this matter he is dead wrong. Over the past few weeks, I
think I have made the point that the connection between a growing
economy and the stock market is tenuous at best, and sometimes non-
existent. A growing economy and a rising stock market co-exist in a
secular bull market cycle. It is a virtuous circle. But in secular
bear markets, growing economies are not reflected in the stock
market.
Quick repeat history lesson: the economy grew twice as fast from
1966 to 1982 as it did from 1982 to 1999. Stock went nowhere in the
first period and rose ten times in the latter. You simply cannot
make the case that a growing economy will result in a growing stock
market.
Over the long term, value drives the stock market, even as emotions
such as fear and greed move it on the short run. Today, we are
going to look at several reasons why the stock market will have
problems over the next few years even as the economy recovers.
Each of these reasons are ways in which the main measure of stock
market value, the price to earnings ratio (P/E), will be affected in
a negative way. Each of them, in and of themselves, might not mean
that much, but the sum of them will weigh heavily on the way we
value our stocks.
Irrational Assumptions
I have written about the fact that many major corporations assume
they will make 9-10% in their pension portfolios. This has created a
serious distortion in corporate earnings.
First, let me set the stage, telling you why this is important. Many
public corporations operate "Defined Benefit" pension plans. That
means they promise an employee you will get X number of dollars per
year when you retire. This is different from "Defined Contribution"
plans, where employees make the contribution, sometimes matched by
the employer, and the amount they get upon retirement is dependent
upon the results they get in their investment portfolio.
Let's say a corporation has put a lot of money into its defined
benefit plan. The actuaries tell them they will need to pay out a
specific amount of dollars in future years. Each year, they have to
determine how much they have to put into the pension fund so that
they will be able to meet future obligations.
If management assumes the fund will grow by 10% a year, the
actuaries may tell them they are over-funded and do not need to make
a contribution this year. If they assume the fund only grows at 6%,
the actuaries may tell them they will need to make a contribution
this year.
So they can control the amount of money they contribute in any one
year by changing the assumptions on the growth of the investments in
the pension fund. As you might expect, if you make a contribution to
the pension fund that is an expense, and is deducted from your
bottom line profits.
Now, here's the cute part. If you assume you are over-funded, you
get to declare the amount you are over-funded as part of your
corporate profits. There is nothing wrong with this, in a strict
accounting sense. There is nothing wrong with the concept. If you
can deftly manage your pension obligations so as to make the fund
grow, that should accrue to the bottom line.
But the devil is in the assumptions. By manipulating your
assumptions, you can manipulate your corporate earnings. In more
easy going times, this was called earnings management, and those
firms who used such techniques to make sure they met analysts'
assumptions were admired. But times have changed, and what was once
called management will now be called manipulation.
The difference is that management gets good press and bonus options
and manipulation gets jail time.
Now Rob Arnott of First Quadrant comes along and tells us what this
means to the corporate bottom line. Arnott is one of my favorite
thinkers. His firm manages $15 billion on corporate pension money in
a variety of styles and programs, as well as hedge funds and other
investments. Arnott's research is first rank.
$50 billion in Phantom Earnings
The average defined benefit plan assumes that its investments will
return more than 9% per year in the future. If they actually get 6%,
then the S&P 1500 (not 500) will have over-stated earnings by $50
billion per year for the last two years.
"How does a $50 billion earnings impact compare with corporate
earnings? Well, in 2000 and 2001, earnings for the S&P 1500 (the
S&P "Supercomposite") totaled $524 billion and $252 billion,
respectively, with P/E ratios of 25 and 46 times earnings. If
return assumptions had been dropped by 3%, then reported earnings
would have been $474 billion and $202 billion, respectively, and the
yearend P/E ratios would have been 28 and 58 times earnings.
Today's P/E ratio would rise from 60 to 80 times current depressed
earnings. Yes, $50 billion per year is significant." (Arnott)
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.(Staton Digest)
Warren Buffett stated clearly in a Fortune article (in the December
10, 2001 issue) "that anyone choosing not to lower assumptions -
CEOs, auditors and actuaries all - is risking litigation for
misleading investors. And directors who don't question the optimism
thus displayed simply won't be doing their job." Buffett thinks
assumptions over 6.5% are unreasonable.
Again, let's go back to Arnott:
"But, we've earned double digit returns over the last five, ten,
fifteen, twenty and twenty-five years. It's preposterous to expect
7% or less, no? Not really. Assuming an asset allocation mix of
70% equities and 30% bonds (yielding 6%), stocks would have to earn
10.7% to attain a 9% composite return. Stock returns have only four
constituent parts:
* 1.5% dividend yield
* +2.5% consensus for future inflation
* +0.0% P/E expansion(dare we assume more??)
* + ?? real growth in dividends and earnings
"This arithmetic suggests that, to get to a 7% return estimate, we
need a mere 3% real growth in dividends and earnings. We can do far
better than that, no? No. Historical real growth in dividends and
earnings has been 1% to 2%. To get to the 3% real growth in the
economy, we have turned to entrepreneurial capitalism, the creation
of new companies. Shareholders in today's companies don't
participate in this part of GDP growth. So, even a 7% return for
equities may be too aggressive. To get 10.7% from stocks, we need
nearly 7% real growth in earnings, far faster than any economist
would dare project for the economy at large, let alone for the
economy net of entrepreneurial capitalism."
What Arnott and others, including myself, have pointed out is that
the double digit returns of the past have come from ever expanding
P/E ratios. Investors have been increasingly willing to overlook
value and assume growth. That is typical of the environment of
secular bull markets.
The exact opposite happens in secular bears. Arnott, in his
calculation above, says we cannot assume that P/E ratios are going
to rise, since they are already at their highest levels in history.
What he does not say is what would happen if investors started to
demand more value? What if the P/E expansion became (dare we say
it?) negative?
If investors simply lowered their P/E expectations by 1 or 2 points
a year, that could wipe out much of any growth potential for the
broad market.
The Chickens Will Come Home to Roost
Many corporations are in a bind. They have over-stated earnings
because they assume that the stock market will grow faster than is
realistic in the current environment. That means instead of earnings
from their pension funds, they have pension liabilities for which
they have not yet accounted.
It was as much as 20% in 2001. I should point out that this was just
for defined benefit plans, which are about one-third of the total,
so that means many companies are far more than 20% off in their
earnings.
If you re-state earnings of this magnitude today, you will get
hammered in the stock market. You will get sued. Of course,
management will trot out the "independent" earnings estimates which
they use to support their assumptions. These "rent-an-assumption"
estimates are going to be seen as a very flimsy excuse in the Enron
Era.
But these assumptions are going to be changed, even if management is
forced to do it kicking and screaming.
And that brings us to the second reason P/E ratios are going to get
worse even as the economy improves. It's what I sadly call the Wendy
Gramm Factor.
Wendy Gramm had the unfortunate position of being head of the
auditing committee for Enron. She was head of the Commodities and
Futures Trading Commission and Senator Phil Gramm's wife. Those of
us who know her know she is smart, honest and as genuinely committed
to integrity as anyone with whom you could hope to be associated.
There are many in Texas who think the wrong Gramm was running for
President a few years ago.
How could she have let Enron get away with such outrageous
accounting practices? Shouldn't she be held responsible for the
problems at Enron? It happened on her watch, after all.
And that illustrates the problem. When a Wendy Gramm can be misled
and fooled by management, accountants and lawyers, what hope does
the average audit committee head have? I can tell you that corporate
audit committees all over America, especially if Arthur Andersen was
the auditor, are doing some serious soul searching.
Corporate boards of directors are like mushrooms: they are kept in
the dark and fed horse manure. (My less-than-sainted-Dad had more
colorful terms, but you get the picture.)
The purpose of most corporate boards is not so much to oversee
management, but to provide access assistance to management. Do you
need to talk with the head of another corporation? You call your
director who sits on another board with someone who sits on the
board of the firm with which you need to talk. That is why so many
corporate directors are on multiple boards. It is not their wisdom
so much as their rolodexes which they bring to the table. The boards
become a sounding board for management, but only rarely become a
true check in a major way. Management usually gets its way, unless
they screw up, and then they get replaced.
But now that will change. The men and women who sit on these boards
are not dummies. Many are and were serious business people in their
own right. Being on a major corporate board will no longer be seen
as a perk. It now can easily become a liability. Why risk your
reputation and fortune to lawsuits for relatively poor pay (when
compared to your net worth)? I can guarantee you there is no amount
of money worth being on the board auditing committee of Enron,
WorldCom, or Global Crossing. The Wendy Gramm Factor is now a
reality, and every board member in America wants to make sure he/she
avoids it.
In the future, you are going to see board of directors start to
require true independence from their accountants. Many will require
the accountants to actually report to the board prior to reporting
to management. I think many will start to seek second opinions from
outside legal counsel on what could be a controversial position. You
will see boards hire outside accountants to ferret out potential
problems in accounting. They will start to err on the side of
caution and conservatism.
Each new shareholder lawsuit is going to reinforce the drive to be
conservative.
Having a board of directors breathing down your neck is going to
make earnings management much more difficult. Boards will instruct
management to paint earnings in the most realistic manner possible.
But it is not just board of directors. It is also going to be the
accounting and legal profession. There is an SEC rule called 102.e.
Basically, if you give an opinion or audit which is found to be
misleading or wrong, you can be barred from practicing before the
SEC or auditing public companies.
I will make you a bet that the Arthur Andersen accountants who
worked on Waste Management and Sunbeam are still plying their trade
somewhere. Ditto for the attorneys. This is wrong. There are
standards, and they broke them.
I work in a regulated industry, the financial services industry. In
essence, the SEC or the CFTC serve as lifeguards. If I don't
behave, they can blow the whistle and order me out of the pool. I
will have to find another field to work in. I sign financial
statements every month that if they are not accurate, my career is
on the line. If it is serious enough, I can go to jail.
I take this damn seriously. I know that every few years, I am going
to be audited by 2-3 government regulators, in my office, going over
everything foe at least 2-3 days. Not just for my accounting, by the
way. Any advertising I do is also subject to scrutiny, as well as
company policies, record keeping and hundreds of compliance issues
which are all subject to review. Staying "in compliance" is a big
part of my world.
My world is full of accountant and lawyers who work to make sure
everything I do is correct. I depend upon them to help guide me
through a maze of regulations. In the past, if they made a mistake,
however, it was only my derriere on the line. I am the one who gets
thrown out of the pool. They can go back to their practice.
You can already see this climate changing. We will see laws enforced
which will make lawyers and accountants more responsible for their
opinions. Frankly, I will enjoy the company.
This is a good thing, and not just because it will make the numbers
we see more believable. I use conservative attorneys and lawyers. (I
should point out, that everyone else says the same thing. I bet Jeff
Skilling of Enron says the same thing in his defense.) They have
explicit instructions to keep me three feet from the edge. I don't
want to get close enough to look over.
But I see other competitive firms doing things my attorneys wouldn't
let me get close to. In a more conservative world, this will level
the playing field for the vast majority of firms which do their best
to be honest and fair.
While this will be a good development, it will be negative for
earnings. Conservative accounting will mean less room to cook the
books
(This is the end of Part One. I will do the conclusion in Part Two
next week.)
A Few Quick Comments
I am relieved to see the dollar showing some strength. It is not
that I think the dollar won't go lower, but I want it to happen
slowly so that the markets can adjust. Rapid devaluations cause all
sorts of problems.
The Bank Credit Analyst thinks that the dollar is headed to $1.10 to
the euro. BCA forecasts are usually on target. Those of you who
want to get into euro denominated assets still have some time with
this recent pull back.
The stock market jumped 3-5% today, depending upon which index you
looked at. I think much of the latest sell-off was traders not
wanting to be long going into July 4, and scared of terrorist
attacks. These did not materialize (thank God), and so the
extremely "over-sold" condition served as a springboard for a major
rally. This could be the beginning of the usual summer rally.
If it is, we will see one cheerleader after another telling us that
we have seen the bottom and the bull is underway. They will be
wrong. This will prove to be another bear market rally. But I have
nothing against those who want to enjoy it.
While still growing, the economy is slowing down, as consumer
spending is slowing down, unemployment is not falling and confidence
is not rising. The key is to watch consumer spending. I think it
gradually slows over the next 12 months, which will gradually slow
the economy and eventually precipitate the next recession. But it
doesn't appear to be slowing dramatically, and so the economy is
still on track to Muddle Through this year and for as long as
consumer spending remains in even a slight growth mode.
Guy's Night Out
My wife has taken the twins on a girl's night out to a Bed and
Breakfast in the country, so the guys are Home Alone. I predict an
overdose of beef (my wife is vegetarian so we take these moments
when we get them) and action movies. You can just about put that one
in the bank.
Contrary to corporate profits, you can never over-estimate the value
of family time, not to mention the calories. Have a great week.
Your getting ready to enjoy the testosterone analyst,
John Mauldin
John@2000wave.com |
