It's Unstoppable!
Year after year the market has risen relentlessly, confounding even the experts. Each and every year since 1982 the Dow Industrials has ended the year at a higher level than where it began in January. During the 1990's and especially since 1995, that rise has been at double-digit levels. The experts make predictions at the beginning of the year only to become bewildered as the market smashes through their targets to much higher levels. Politicians point to the stock market's rise as confirmation of the wisdom of their policies. On Wall Street, economists and analysts are left with the task of explaining the gold rush in the financial markets.
Officials in Washington site raising taxes and balancing the budget as the main reason for the market's precipitous rise. These actions by government have caused interest rates to drop to the lowest levels in decades. Lower interest rates have allowed the economy to expand, corporations to grow their profits, and investors to reap the rewards of astute political leadership.
On Wall Street a different explanation is given. American corporations, through downsizing and restructuring, are lean and more competitive. The economy is moving through technology into the Information Age. But above all else, it is simply corporate profits. The restructuring of corporate America and the advancement of technology has produced a new paradigm whose chief product is a higher level of profit growth. This higher level of profits is the main pillar that is supporting higher stock prices.
The Golden Egg: Higher Profits
Wall Street follows earnings reports with a microscopic view. Quarterly earnings can make or break a company. This obsession with profits has become a quarterly ritual. Wall Street doesn't like earnings disappointments—so chief executives pursue profits at all costs. Heretofore, profit growth at corporations has averaged between 5 to 6 percent throughout this century. Yet, in the financial press all you hear about is predictions of 20 percent earnings growth. Indeed we are in a new era. "It is different this time," the pundits proclaim. A bit of skepticism is in order.
According to a recent article in Fortune Magazine written by Warren Buffet, corporate profits as a percentage of the economy peaked in 1929. They fell for obvious reasons during The Great Depression; while they rose abnormally through the war years. Since that time the average level of profits has remained within a range of 4% to 6.5%. Beginning in 1982, one obvious trend throughout this bull market is that profit growth has been sub-par. While the average has been between 4 to 6% since 1951, throughout the 80's and early 90's profits remained at the lower end of 4%. Beginning in 1993, earnings growth accelerated to the upper range of 6%.
Two Factors Contributed to Higher Profits
This level of earnings growth, as a percentage of the economy, was triggered by several factors—none of which are supported by the new paradigm theory. Upon closer inspection, the rise in profits has more to do with events in Washington than it does with Wall Street. The advancement in profits during the early part of this decade can be attributed to two factors: 1) a lowering of interest rates by the Federal Reserve and 2) a favorable change in the tax laws.
#1 Lower Interest Rates
The greatest impact upon corporate earnings in this decade came when the Fed lowered interest rates between 1990 and 1992 to help turn around an economy suffering through a recession. By cutting interest rates continuously during those years, interest rates at all levels dropped from 10-12% to as low as 3%. Interest rates fell across the board. The prime lending rate by banks fell to the 6% level. The yield on CDs and T-bills fell to around 3%. In the government and corporate bond market, yields fell to within the 7% range. The country as a whole had experienced double-digit interest rates for more than a decade. Now they were dropping dramatically. Homeowners refinanced their homes, lowered their monthly payments, and put extra cash in their hands. Corporations followed suit. On Wall Street a wave of refinancing corporate debt had begun. Companies were trading in their 10-12% bonds and refinancing their debt at interest rates in the 7-8% range.
#2 Washington Contributes its Share... Favorable Tax Law Changes
Another boost to profits came from a change in the tax laws. Washington lowered corporate tax rates and changed the depreciation rates. By lowering the corporate tax rate, companies were allowed to keep more of their earnings. A change in depreciation on buildings and equipment meant that companies had less to write-off from buying equipment or owning an office building or factory.
The combination of lower interest rates and changing the tax code helped to accelerate profit levels back toward the upper range of 6% experienced most of this century. However, these events were "one time events" and were unlikely to be sustainable. To keep profits growing at rates Wall Street was clamoring for took creativity. Over the last three to four years, profit growth has had more to do with "creative accounting" than it did to real, sustainable earnings. Corporate earnings have had more to due with an accountant's pen, than it did with the fundamental success of the business.
Corporate CEOs and their accountants began to manage earnings in such a way that pleased both Wall Street and shareholders. The creative ways in which earnings were manipulated are too numerous to cover in this article. Suffice it to say they could fill volumes of books, from textbooks to investment best sellers. I'm going to cover just a few.
The Buy-Back Strategy
One way chief executives have been increasing their earnings is through share buy-backs. By purchasing their shares in the open market, companies have been retiring stock at unprecedented levels. The idea behind this concept is to enhance shareholder value. By retiring stock, the company divides its profits between fewer shares of stock.
For example, if a company earned $1,000,000 and had 1,000,000 shares of stock, the profit per share would be $1 per share. Let's suppose that the shares were trading in the market at $10 a share and that the company used all of its profit of $1,000,000 to buy back its shares. At $10 a share, the company could use that money to buy back 100,000 shares of stock leaving only 900,000 shares outstanding.
The following year, if the company made the same $1,000,000 profit, it would be divided over 900,000 shares of stock instead of 1,000,000 shares. The result would be that earnings per share would have risen from $1 per share to $1.11. Even though total profits were the same, earnings per share would have risen by 11%. Thus, through The Buy-Back Strategy, the company's earnings per share increase through the prior year's creative accounting.
Imagine what a company could do if it used debt, along with profits, to buy back shares. The number of shares could be retired at a faster pace, leaving fewer shares to divide the profits. This strategy could then in turn accelerate earnings per share at an even faster pace. Rising, per-share earnings are rewarded by Wall Street by higher stock prices. Rising earnings get analysts' attention. Why? Because analysts tend to issue strong "buy" recommendations on companies whose earnings per share are rising at above-average levels.
The Corporate Restructuring Strategy
Another way in which earnings have been enhanced is through corporate restructuring. This technique has become commonplace and a permanent fixture in financial headlines. This practice involves writing off a large amount of expenses in one year.
Suppose a company is going to downsize its workforce. This could involve closing down plants and result in a large number of employee layoffs. Although this process may take place over a few years, the company books the expense in the first year. The write off is huge and of course, would capture headlines. XYZ Company is shutting down 5 plants and laying off 10% of its workforce! The expenses of doing this should be written off over the time period of completing the plant shutdown, which could take several years. The beauty of this gimmick is that you write off all of your expenses in one year. Wall Street applauds the move because they know that booking all of those expenses in one year makes the next year more profitable.
A Boon To The Bottom Line
The write offs are so big, analysts ignore them. Indeed, stock services such as Value Line, exclude the losses from their earnings per share figures. It becomes a footnote listed at the bottom of the page. In the future, if those losses turn out to be less than originally estimated, they become the source of future profits by adding them back into earnings. In some ways they become a "profit reserve" that can be called upon when a company needs to make its next quarterly profit objective.
The Acquisition Strategy
Another way of bolstering profits is through acquisitions. An acquiring company uses its stock as a currency to buy other companies in an effort to buy another source of sales and profits. The problem here is something accountants call goodwill. Goodwill represents the excess value of a company above its tangible assets such as plants, property, inventory and cash. In the old days, if you bought a company for $110 a share, but its net worth was $10 a share, the excess value was attributable to goodwill. That goodwill reflected the company's brand franchise or the reputation of its product. It was intangible, but it was part of the company's success. An example of goodwill might include the franchise value of Coca-Cola.
Pooling of Interest
In the above example, if a company bought another company for more than its net worth, the excess price paid was attributable to goodwill and would have to be written off over a period of years. The problem is that the writing off goodwill creates an expense that lowers earnings. To get around this, companies use an accounting technique called pooling of interest. This practice allows the acquiring company to buy other companies at inflated prices and keep the goodwill charges off the company's books. This strategy has resulted in merger mania. It enables a corporation to buy another company at an inflated price using its own highly priced stock as currency. In honest times, this process would create huge amounts of goodwill that normally would have to be written off against future earnings. Today, companies avoid this detriment to their bottom line by pooling.
The Merger Wave
These accounting abuses can be credited to what is behind the current merger wave on Wall Street. Companies are using their inflated stock prices to buy other companies. The result of buying more companies brings in more sales and more profits, which Wall Street loves. Using the pooling method of accounting, companies can acquire other companies at high prices without the consequences of depressing future earnings through the amortization of goodwill.
This abuse has caught the attention of the FASB (Financial Accounting Standards Board) which sets the rules governing corporate accounting methods. Even the SEC is looking into the matter. Beginning January 1, 2001 the FASB wants to kill pooling. To make matters worse for companies driving earnings through acquisitions, the FASB wants to start forcing companies to amortize the goodwill acquired from buying another company over a 20-year period. By allowing this abuse to take place in mergers, investors may have little knowledge of a corporation's real assets. This understatement could hide trouble for a merger-oriented company.
A recent issue of Forbes Magazine highlighted this issue with its coverage of an acquisition-oriented insurance company called Conseco. After years of buying other companies, most of the assets on its balance sheet consisted of goodwill. After subtracting debt and goodwill from assets, the company actually has a negative net worth. This problem is making it more difficult for Conseco to borrow money, and at the same time, meet its interest payments on existing debt. The balance sheet has a lot of assets, but most of them aren't real earnings assets. Goodwill is an intangible asset. It doesn't produce interest or cash to make debt payments.
Conseco Per Share Numbers
$16.38 Book value per share
$28.95 Debt per share
$-9.12 Tangible book value per share
As the above examples illustrate, the earnings miracle, which Wall Street claims to justify higher stock prices, is no "miracle" at all. It originated with the Fed lowering interest rates and Washington changing the tax laws. This miracle claim has been perpetuated by the imagination of corporate accountants. I call it "The Earnings Game", and it continues to this day. Nobody wants the game to end. Corporate CEOs, whose major source of compensation comes from stock options, want their stock prices to go higher. Wall Street wants to keep selling investors more stock and mutual funds. Investment bankers want to keep taking more companies public. And the game goes on …
"It Depends on What Your Definition of Is Is."
The game keeps being reinvented. Companies, with the help of analysts, are looking for creative ways to bury the real earnings story. When a myth gets created, such as the new paradigm or the profit miracle, it becomes more difficult to perpetuate it. These days Wall Street keeps diverting investors' attention from the bottom line to earnings-of-a-different-sort. The old earnings used to represent after-tax profits from operating the business. These days, when companies and Wall Street talk about profit, they can mean almost anything. In this new age of miracles almost anything goes. Profits can mean cash profits, profits before taxes, profits before write-offs, pro-forma profits, or in the case of internet companies, "potential" profits.
The New Math in Earnings Profits
Profit calculations have become like the new math taught in schools where 2+2 = 5, 6, 8 or anything you want it to be. The revisionists on Wall Street are hard at work creating new and improved math with which to understand earnings. In the future, instead of just one bottom line, there may be two or three. "Whatever works best" is the new motto.
This revisionists' line distorts the actual value of earnings. Wall Street analysts keep touting 20% earnings gains for the S&P 500 stock index this year. Higher than reported earnings is the reason given for the stock market's advance. Yet, in the most recent issue of Barron's, which listed earnings for the most recent 52-week period ending in June, shows earnings that don't measure up.
$41.02 Current 52-week earnings
$39.33 Year ago 52-week earnings
4.30% Gain in profits from previous year
These are hardly the earnings that would justify a rise of 15% in the S&P this year. For the Dow Industrials, it is more difficult to judge because of the most recent change in the Dow's make-up. Four stocks were deleted; while four new stocks were added, including Microsoft and Intel. However, before the change in the Dow, comparisons can be made for the first two quarters of this year.
Dow Industrials Quarterly Earnings:
1st Qtr 1998 = $20.17 1999 = $21.77 or 7.9% change
2nd Qtr 1998 = $22.33 1999 = $24.75 or 10.8% change
A closer examination of the Dow's six-month earnings indicates that, excluding GM, the Dow's gain in earnings was 0%. GM's profit for the first half of the year rose from $.52 a share to $2.94. In other words, GM accounted for the entire gain in the Dow during the first half of the year. Actual earnings of the Dow's individual companies show that earnings declined for many of the Dow's leaders such as seen in Caterpillar, Chevron, Coca-Cola, Disney, International Paper and Union Carbide. The declines ranged from 12% to 168%.
HP Beats the Street
An example can best be illustrated by the recent earnings report from Dow technology bell-weather stock, Hewlett-Packard. HP recently reported earnings that beat street estimates by two pennies a share. What is curious is the fact that shortly before earnings were reported, the company cautioned Wall Street on its earnings estimates for the company. This caution quickly brought an immediate response of lower estimates from analysts. When the company did report earnings, they handily beat analysts' estimates. This news caused the shares of HP to rise $17 a share, adding $17 billion in increased market value to the stock. The rise of HP on that day accounted for more than half of the Dow's 152-point gain. A closer examination of earnings showed that all of the quarter's profits came from lower taxes. And in comparison to the previous year's report, earnings were actually a tad lower.
I call this game of beating street estimates equivalent to the sport of pole-vaulting. In the case of the market, Wall Street sets the height of the bar the company has to pole-vault over. Of course the height of the pole is guided by the company conferring with the analysts. Several years ago the height of the pole might have been set at 10 feet. Today, through the company's cajoling and with a little help from analysts, the bar's height keeps getting lower and lower. In fact, it may have been lowered so much, the company may no longer need a pole to vault over the bar.
It's Just a Matter of Time
The only problem with this earnings game is it can't continue indefinitely. You can't expect the growth of a component factor to keep a pace that is faster than the aggregate. In this case, the aggregate is sales; while the component is net income or profits. Mathematically, it just doesn't work. To illustrate from the real world, take IBM. Its sales are growing by 5%; while its earnings have been growing by 16%. Closer examination of the financial statement reveals that profits before taxes have been stagnant over the last five years. The real juice to earnings has come from share buy-backs and special tax breaks.
Everyone Seems to Like the Game
Everyone seems to be playing the earnings game. And, why not? It helps to perpetuate the myth of the new era. Corporate CEOs get to see the value of their stock options rise. The rising stock can also be used to buy other companies, and with creative accounting, can drive earnings even higher. Employees of the company don't mind either, because their compensation also includes stock options. Consider what might happen to payroll costs if a company couldn't issue options and instead would have to raise salaries.
Wall Street seems to be happy with the new arrangement as well. Rising stock prices bring more investors into the markets. This increases commissions and investment banking fees. Let's not forget the annual year-end bonuses.
Investors are also content with this arrangement. It allows their net worth to increase, enabling them to divert their savings towards consumption. There is no reason to save when the value of your stock fund is going up 20% a year. In fact, with rising stock prices, investors can spend even more than they earn by borrowing money to spend more or buy stocks. It's easy to borrow when your net worth is rising at a parabolic rate. Many see it as wise to borrow at 8% and invest that money in stocks earning 20%. To many, it really is a new age.
Lastly, let's not forget the value of this game to politicians. The economy continues to grow, tax revenues from social security and earnings are rising, and capital gains taxes are the icing on the cake. This has enabled Washington to spend even more money at the same time; while reducing the deficit. It really is a wonderful life. Isn't it?
Perspectives Part 3 is an on-going series on the American stock market.
