Tough Issues Challenging Stock Investors

by | Sep 14, 2003

I get lots of terrific letters from readers (both roses and thorns, I assure you). But one I got last week takes the prize. It’s a list of penetrating questions about all of the toughest issues challenging stock investors. The minute I saw it I knew what today’s column was going to be about. “Expensing […]

I get lots of terrific letters from readers (both roses and thorns, I assure you). But one I got last week takes the prize. It’s a list of penetrating questions about all of the toughest issues challenging stock investors. The minute I saw it I knew what today’s column was going to be about.

“Expensing options will have an impact on earnings for companies such as Cisco, Intel, Dell, etc. Whenever these companies report earnings, analysts jump on the bandwagon and say ‘buy,’ and no one mentions this potential hit to earnings. What are your thoughts on how expensing options will impact the market?”

More and more major companies — technology companies like Microsoft, and nontechnology companies like General Electric — are volunteering now to disclose their options expense in their income statements. It’s getting to be something that no one dares ignore. While you might not hear it in the sound bites you get on financial television, analysts are indeed taking options expenses into account in the detailed work their clients see.

But don’t forget, since 1997 options expenses have been fully disclosed in the footnotes to financial statements of all public companies — even if they haven’t made it into the actual income statement until recently. So it’s not as though an entirely new expense has been imposed on companies — it’s just that this expense is now being reported in a more conspicuous way. So in the end, it probably won’t make much of a difference. Don’t forget, jumping on the bandwagon and saying “buy” is what these guys do for a living.

“Many large corporations are going to have to pour billions into their pension funds. I’m guessing you think this is bullish since they will have to then invest that money into the stock market. But that is still a hit to earnings, and companies have been using unrealistic 9.5% annual returns on their pension funds even now.”

Pension accounting is a funny thing. A company that pours money into its pension plan doesn’t actually report any greater expense than one that doesn’t. What affects reported earnings is the “expected return” assumed for the plan — and indeed, that’s coming down. But accounting mechanics aside, the expense is real, and it comes out of cash flow that could be used for other things.

The good news is that this year’s simultaneous rally in the stock market and rise in long-term bond yields has been a double relief for pension funds. Rising stock prices flatter the asset side, and rising bond yields diminish a pension fund’s expected liabilities. My guess is that over just the last six months a third or more of the pension crisis has solved itself, as if by magic.

The bad news is that companies with pension plans have been scarred by the losses they have taken, and many will be investing less in stocks in the future as a result. It’s debatable whether this change in demand will have any influence on stock prices. But it’s a cinch that it’s a lousy market-timing decision.

“How can I trust earnings reports anyway? Example — Applied Materials had a GAAP loss of two cents a share this past quarter, but on a pro-forma basis it beat analyst estimates by a penny. Why is pro-forma earnings the basis for earnings reports now — and is that giving small investors a true idea of what is going on in these companies?”

Generally accepted accounting principles, or GAAP, don’t result in perfect or objective accounting, because there’s no such thing. But at least GAAP is standardized, so you know what you’re dealing with. While pro-forma accounting isn’t necessarily less honest or accurate, investors have to go to the trouble of figuring what each company’s unique pro-forma approach is based on. That’s a lot of work.

The benefit is that pro-forma accounting gives management an opportunity to offer a customized view of a company’s performance — but yes, often enough management uses it to manufacture a more flattering view. Be that as it may, all companies are required to provide GAAP financials with their SEC filings, so if that’s what you prefer it’s always available.

“Price/earnings ratios are still historically high, and dividends are historically low. Yeah, Microsoft is paying an 0.3% dividend now — but still….”

I’ve written often here that P/Es aren’t as high as many people say — so I won’t repeat those arguments now. But what about dividends? Here, too, appearances are deceiving — and simplistic historical comparisons aren’t appropriate. The absolute level of dividend yields may be low, but companies nowadays pay investors in other ways — notably, stock buybacks.

Moreover, dividend yields today are well above short-term interest rates. And thanks to President Bush’s tax cut, dividend income now receives favorable tax treatment, so on an after-tax basis yields are higher than they appear.

“We are running a huge budget deficit. Last quarter we had surprisingly strong GDP of 2.4%, but wasn’t a large part of that simply spending by the government on war stuff? If that’s the case, why doesn’t the government increase its spending so we can get the GDP up to 5% or more?”

I’d prefer we didn’t have deficits, and I don’t like increases in government spending — and we’ve got both. It’s bad, but how bad is it, really?

The deficit is mostly a simple product of lower tax revenues resulting from the recession — tax cuts have little to do with it. So when the economy recovers, the deficits will recede as quickly as they arose.

On government spending, the question you have to ask is this: Will it create value? Is it money well spent? In the end it doesn’t matter who spends it — what matters is what it’s spent on. If you believe as I do that some military spending is a smart long-term investment in global security, then you should be glad to see that spending taking place.

“Don, I’m a very, very, very cynical and weary small investor. I was a big bull in the ’90s, and God knows my bearish attitude didn’t come easy, but it came from a progression of events and findings that are hard to ignore. How do you address my concerns? I’m sure they are the same concerns other small investors have.”

These are all valid concerns. There’s plenty of risk out there. But look how far the markets have fallen from where they were just a few short years ago when no one was thinking about these things. Those lower prices mean that today investors are being compensated to take these risks.

At the top of the bull market, there were lots of risks too. But you weren’t being paid to take them. So when things went wrong, there was no pricing cushion to absorb the bad news.

Now you’re being paid to take risk. If things get worse, a lot of that is already discounted in prices. So if, despite all of these risks, you see that things are starting to get better in the economy — even a little bit — then this is a great time to take some of that risk — and get well paid for it.

That’s the hardest thing in the world for small investors to do. It’s so much easier to invest at the worst time than it is to invest at the best time. That’s because it’s hard to hear anything when your heart is pounding with fear. But that’s just when you need to listen for the sound of opportunity knocking. I can hear it now. Can you?

The above was an “Ahead of the Curve” column published on SmartMoney.com

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Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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