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Posted 12/23/2002
Contrarian Chronicles
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| | Contrarian Chronicles
2003 will be as big a struggle as 2002
I cant get too enthused about prospects for the coming year. There's too much overhang from the market bubble and too many corporations trying to make things look better than they are.
By Bill Fleckenstein
Like so many companies struggling to grow, Bristol-Myers Squibb (BMY, news, msgs) went looking for a magic potion a while back. The drug maker developed a "growth hormone," via accounting gimmickry, to artificially boost its profits. Well, corporate America may continue to play the game, but that doesn't mean investors can't learn how to spot it. In fact, given the big risks still facing the economy, it's the wise investor who appreciates that not losing money means winning.
Recently, The Wall Street Journal ran one of the finest articles I have ever read in a mainstream publication: "At Bristol-Myers, Ex-Executives Tell of Numbers Game," by Gardiner Harris. Everybody on the planet who owns even one share of stock, or who owns shares in any mutual fund, needs to get a hold of this article (published Dec. 12). It will open their eyes to how companies play the game of phony earnings, and thus help readers become much better investors.
What Gardiner basically did, by speaking to 27 current and former executives (whose names were obviously withheld), was to construct a primer on Earnings Management 101. Before talking about some of these games, let me just say that Bristol-Myers is not an isolated case. I have found these tactics to be rampant in corporate America, both past and present.
Low red-blood sale count
In essence, the story began by outlining the first telltale problem: "Bristol-Myers sales rose just 6% in total from 1998 through 2001, and much of that was due to the purchase of another drug business. Yet the company managed to report total earnings growth of 67%, or 37% after a charge for breast-implant litigation." This is the tip-off that something is wrong: soaring earnings per share in the face of anemic top-line growth.
A handful of high-fixed-cost businesses in the world can score dramatic earnings gains once they get past the break-even point, i.e., they have few variable costs. But those businesses are very rare, and it's pretty easy to spot them. Generally, when you see a sizable disconnect between sales and earnings growth, it's a warning sign. This is a case I have made over and over about IBM (IBM, news, msgs).
Another frequent IBM tactic, using one-time asset sales to reduce SG&A (selling, general and administrative expenses), helped perpetuate the Bristol-Myers' earnings magic. As Gardiner noted: "Some former executives say the company used such proceeds to reduce selling, general and administrative expenses, a practice that accounting critics say can give a misleading impression of a company's overhead. The SEC has said proceeds from asset sales should be listed as other income and expenses." What the companies would do is to sell off a division and lower the SG&A, thus boosting profits in that particular quarter.
Take two write-offs and a conference-call in the morning
In any case, as the story proceeded to show, Bristol-Myers branched into other areas of creative accounting as well. It took write-offs and one-time charges that allowed it to improve later results by selling off pieces of the business. Of course, as if to take a page from the "all industries do it" playbook, the company took to channel-stuffing, to try to make quarterly earnings projections, a maneuver that ultimately came back to haunt it.
This is the problem: By focusing on its short-term goal of "beating the number," the venerable Bristol-Myers engineered itself into a position of compromising its long-term health. Many, many companies in America are guilty of this, my favorite example, of course, being Intel (INTC, news, msgs), for reasons I have delineated in the past, and may have time to reprise in the future. In any case, I strongly encourage everyone to read this very well-laid-out story about how corporate America misrepresents its financial results.
Hocus-pocus police, now recruiting
And as you read, keep in mind the companies that you own. Ask yourself if they could be guilty of playing these games. When companies do, problems don't necessarily turn up immediately. But they do tend to arise eventually, and afterward, the result is often a debacle. If you have overpaid for a company whose growth is not what it seems, that obviously just makes matters worse. Anyway, making money in the stock market is not easy. You have to do work, and you have to know what you're doing. Understanding the games that managements play to try to fool you is an integral part of being prepared.
Of course, for the many companies determined to distort their profits, the game has become all the more urgent as the post-bubble aftermath continues to hurt our economy. I believe that the best economic news was seen early this year. The good news was a function of many one-time events which coalesced early on. I think that the economy is liable to be weak in 2003 and could, in fact, become very ugly. On this, Im with Leon Levy, the creator of the Oppenheimer group of mutual funds, who is one hell of a lot smarter than I am, and whose experience and net worth far exceed mine. Levy (whos written a wonderful book, The Mind of Wall Street) told Forbes recently, "Nothing is in short supply. I keep asking that question of everyone. And they have no answers. . . . Autos, fiber-optic cable, computers, cell phones, trucks, airplanes, steel, even food (are in oversupply). . . . It won't get back to the way it was. . . . If nothing is in short supply, how can profits rise?" And when profits ultimately do bring about another bull market, he specifically noted that it won't be in technology. In fact, it might be in Asia, where all the factories and cheap labor are located. (You can read Levys thoughts on MSN Money. See Sell on strength, legendary investor says.)
Of aught three and the economy
I hope readers find Levys forceful words useful. I think that people would be wise to batten down the hatches when they think about next year. I believe it will be the most difficult year since the bubble burst in early 2000, as well as one of the most troublesome years for the major indices.
Obviously, even the geniuses at the Fed feel that way too, judging from the recently released minutes of their last meeting. The testimony shows that they claimed to have acted "because of a faltering economic performance," something I don't remember them anticipating prior to its occurrence. It is my expectation that the market will be down for an incredible four years in a row.
'Miss-the-boat' bucks
As we face the prospect of a market headed lower, let me just reiterate that the main focus of my column has always been to try to help everyone avoid losing money. People sometimes under-appreciate the value of not losing money. Along those lines, I'd like to share a couple of recent statistics from Jim Stack, in his ever-insightful InvesTech monthly letter (see the link at left under Related Sites.). It turns out that, measuring from 1928 to 2002, if you started with $10 and you followed the famous buy-and-hold strategy, that $10 would become $10,957. If you missed the 30 best months, your $10 would only be $154. However, if you missed the 30 worst months, your $10 would be $1,317,803. One can see from these numbers that missing the worst periods is very important to long-run compounding.
Interestingly enough, if you missed the 30 best months and the 30 worst months, your $10 would still be worth $18,558, which is 80% higher than the buy-and-hold strategy. This all comes about because stock prices tend to go down faster than they tend to go up, and tend to do so in compressed periods. Wall Street and most people tend to overlook the value of not losing money, which is why this has been such a keen focus of mine. Some day, when values return, and when the risk/reward equation is skewed to the long side, I hope to be able to turn my attention more to making money, rather than the avoidance of the loss of it.
A Christmas coda
Now, as the Contrarian Chronicles enters hibernation mode until its next edition on Jan. 13, I'd like to spread the holiday spirit by offering a poem by my editor, Mary Levai, titled "'Twas the Night Before Earnings." It is not knowable if Santa is a short-seller, a holder of overvalued tech stocks, or too snowed under in his workshop to have an opinion in these matters. In any case, hed probably get a chuckle or two over this ditty. Meantime, I wish you all a Merry Christmas and a Happy New Year.
'Twas the night before earnings, when all through the house,
Not a profit was stirring, from cell, DRAM, or mouse.
The stock certificates hung by the chimney with care,
In hopes that a bull market soon would be there.
The wide-eyed were up to their gullets in tech,
Fretting from troubles induced by the dreck.
While bear cubs were nestled all snug in their beds,
As visions of vindication danced in their heads.
When out on the Street there arose -- not Saint Nick,
But the thud of a Nasdaq Composite downtick.
From winless PCs, folks flew like a flash,
Saying, "Nah, here's not where to go long the cash."
The moon on the breast of the new-fallen Sox
Brought sheen to some short positions in stocks.
When, what from the post-bubble years should appear
But twelve rate snip-snips and, say, eight reindeer.
With a driver so clueless, ensconced at the head,
It was patently clear, he hailed from the Fed.
To "new-era" cries, the antlered ones came,
And lustily he cheered them on by name:
Now Maxim, Dell, Intel, Big Blue and Sanmina
On Cisco, on Hynix (you laughing hyena).
Oops, one mammal short -- please accept this apology --
And sound the Bronx cheer for ... Micron Technology.
These eight stomping steeds pulled a payload nefarious
Of stock market games in guises quite various.
There's still days till Christmas, so if you've the time,
Sit back and read them in rollicking rhyme:
Write-offs and jam jobs and false-bottom calling,
Quarter-end mark-ups, it's ever so galling.
Preannounce now and guide downward hence,
To hell with the assets of ladies and gents.
Managements yearn to earnings-embellish
They go gun the shares, then cash out with relish,
While hapless investors and suckers-to-be
Watch hoodwinked and hooked to CNBC.
But enough of this brew-ha-ha, confound the mess,
We've a tale to Rap up, from which we digress.
To quote Clement Moore (on whose ditty we call),
"Now dash away, dash away, dash away all."
The Fed's sled touched down with a clickety-clack
On the snow-covered roof of the market Nasdaq.
Its driver made tracks for the soot-lined chimney
(His monogrammed bath sheets read ALAN, not JIMINY.)
When he looked and saw darkness all over the place,
He forthwith proceeded to make about-face.
Then sprang to his sleigh, to his team gave a whistle,
Which is subtext for "nearing the end of epistle."
Don't worry, he cooed, amidst economic blight,
Technological changes will make it all right.
And at liftoff ho-ho'd whilst he jingled his reins,
"Don we all now productivity gains."
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At the time of publication, William Fleckenstein held short positions in Intel. Positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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