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The Stingy News Quarterly (Q2 2002)
The Best Of Stingy Links Revisiting Graham and Dodd "Originally published in 1934, Security Analysis by Benjamin Graham and David Dodd could have been written yesterday. The players have changed but the conceptual framework is as fresh as ever. The introduction and the first chapter of this opus are especially chilling. Intended as an indictment of the excesses of the roaring Twenties, these first 15 pages of a more than 700-page book are equally applicable to our bubble -- and, by inference, to much that is now unfolding in its aftermath." Third Avenue Funds Q1 Report "There is plenty of blame to go around for the apparent accounting frauds that led to Enron Corporation filing for relief under Chapter 11 of the U.S. Bankruptcy Code. In assessing blame, though, it would be a shame if conventional security analysts, conventional money managers and conventional finance academics were left out of the mix. Whatever their other talents - and these people tend to have many other talents - analysts, money managers and finance professors seem notoriously unqualified to be intelligent, responsible users of GAAP who actually understand the uses and limitations of financial statements." [PDF] Third Avenue's semi-annual report "Those who think of options as an expense have it wrong, at least from the Company and Creditor points of view. Warren Buffett is quoted as saying, 'If options are not a form of compensation what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?' Frankly, the Buffett statement is an overgeneralization, even though most finance academics, and among others, Alan Greenspan, seem to be wholly in concurrence." Dividends do matter "What Modigliani and Miller proved perfectly in the 1960s was the proposition that under perfect market conditions, shareholders should be indifferent as to whether a company pays a dividend or retains the cash, since retaining the cash should just directly translate into future dividends. And of course, we have a perfect market. Everybody translates everything, sees through the way everything's expressed. There isn't any accounting fraud anywhere. There are no problems. The whole thing works beautifully. All is wonderful. Until you meet the real world." Loving the unloved "James generally sticks to the microcap arena - which includes stocks with market caps of $300 million or less - and zeroes in on companies that have been neglected by both analysts and the stock market. He favors firms that were former market favorites but have encountered short-term difficulties." The death of dividends "the demise of dividends over the last 20 years was facilitated by greedy executives who used accounting shenanigans and the bull market to pocket significant stock option gains. Now that the bull market is over and accounting tricks are slowly being purged from financial statements all that remains is the greedy executives" Buy now, profit later "Contrarian shoppers like my wife try to get more for less by going against the crowd. They buy straw hats in winter and toques in summer. Similar thinking has been applied to the stock market for decades by disciples of Benjamin Graham, the father of value investing. Graham ignored fads and loved overlooked companies that were trading at a discount to their book or net asset value. Such stocks provide a measure of safety and, if you're patient, can deliver substantial gains." How to avoid the value trap "A value trap, by contrast, is a stock that looks cheap but ain't. Investors get so focused on one part of the story that they overlook problems with the balance sheet, historical valuations, and, yes, the business model." Farewell to a giant of value investing "Al Frank, who died of cancer April 25 at age 72 in Carmel, Calif., was one of the very best stock pickers in America. He never sought the spotlight and few investors recognize his name, but he deserves a place in the investing pantheon with gods like Warren Buffett, Peter Lynch and John Templeton." The persistence of growth rates "There is no persistence in long-term earnings growth beyond chance, and there is low predictability even with a wide variety of predictor variables." - Forget growth, buy value. Don't count on cash flow "Truth seekers, we have bad news for you. Like everything else in financial statements, even cash flow is corruptible--or at least subject to quality issues of its own. And while cash flow may be harder to manipulate than earnings, Mulford says, there's a "surprising amount of flexibility" in how cash flow can be reported. That's critical if you're considering this measure as a clue to how solid earnings really are." Boom-era valuations are creating fake stock bargains "To the simple price of stocks and (relatively) low price-to-earnings ratios, you can add price-to-book value to the list of metrics that are down from the peak, but shouldn't automatically be assumed to be attractive." Buffett Bonanza Warren's piece "Both Buffett and Munger left no question they find the pickings slim in the stock market. Asked about the relative weight of equities compared to bonds and cash in Berkshire's portfolio, Munger said dryly, 'Our constraint does not come from structure; it comes from our lack of enthusiasm for stocks, generally.'" Buffett: 'I can't recall ever having more fun' "Behind that grin is a track record that put a lid on critics who had questioned his ability to keep pace with the New Economy: Berkshire stock is up nearly 35% for the past two years, while the S&P 500 is down nearly 25% for the same period." Which CEO's greed scared off Buffett? "But it's even more astonishing that an investor who has this kind of power felt powerless to do anything but sell his shares and go quietly into the night. When even Warren Buffett won't name names it tells you how intractable the problem is." Warren Buffett & his CEO's-A team that works "It's a very limited management role that I have, very, very limited. But I enjoy - if you want to call that managing, I enjoy that more than investing. I mean, I like the managers that I work with. I like thinking about business problems and occasionally being able to do something about them. And I would say that it's just amore interesting. There's more human interaction. And I would - if I had to choose one or the other, I would choose the management role over the investing role at Berkshire." Stock Stuff The 2002 Fortune 500 "This year was a record low for the FORTUNE 500. What made this such a terrible year? Sluggish revenue growth and a 53% drop in profits." Siegel and Shiller debate "Just as Siegel's book had seemed to predict - perhaps even to help create - one of the greatest bull markets in U.S. history, the book by Shiller, an economics professor at Yale, was dead-on in forecasting the stock-market plunge that began in the spring of 2000. With two years to test these dueling views against real market data, which holds up best?" Efficient Frontier Spring 2002 Articles include: Only Two Centuries of Data, When Risk and Return Become the Same,Efficiency Rationality and Arbitrage, Of Markets Economies and Populations,Links of the Month. The blue-chip penny stocks "The reality is that a company's share price tells you absolutely nothing about its valuation or market capitalization. That can be a little hard to remember these days, though, with so many well-known companies sporting stock prices that would seem to be screaming "buy me." The problem is, that isn't what they're really saying." McDonald's Fallen Arches "Chances are, if you hear of a "Big Mac Attack" these days, it comes with chest pains. At least at McDonald's headquarters in Oak Brook, Ill., where the bad news tends to be super-sized." Intel proves there's no such thing as a safe tech "The bottom line is that here we are, two years after the peak, and people still don't seem to realize that "it's the price, stupid," to paraphrase a former president. Price is the single biggest determinate of the ultimate rate of return on your investment. Price quantifies how much risk you're taking. Price has some relationship to the underlying business, earnings, dividends, book values, revenues, etc." Yikes! My stock's in single digits! "There is something strange about Focal Communications' stock chart. Very strange. No, it's not just that its shares recently traded at $3. That, as we all know, is hardly a mark of distinction these days. It's that a couple of years ago the chart shows FCOM trading at around $3,000!" McDonald's to begin accepting Nortel shares "'Sure, my grandchildren's inheritance is still pretty much right out the window, but, at least I'll be able to take them down to the local McDonald's for a quarter-pounder every now and then. That'll be a welcome change from my daily routine of cat food,' said McMorgan, a retired mill worker." Management Mayhem Why companies fail "Why do companies fail? Their CEOs offer every excuse in the book: a bad economy, market turbulence, a weak yen, hundred-year floods, perfect storms, competitive subterfuge--forces, that is, very much outside their control. In a few cases, such as the airlines' post-Sept. 11 problems, the excuses even ring true. But a close study of corporate failure suggests that, acts of God aside, most companies founder for one simple reason: managerial error." A record for corporate bankruptcies? "Unemployment is down. New orders are up. And even Federal Reserve Chairman Alan Greenspan thinks an economic upturn is in the cards again. But not everything is coming up roses: Some experts are bracing for a record number of corporate bankruptcies in 2002." Practice audits pay off "The exams aren't cheap, easily costing upwards of $25,000, depending on the extent of the inspection. But for many firms the cost pales in comparison with the consequences of an SEC deficiency letter. "The damage to a firm's reputation if it winds up in the Wall Street Journal or the New York Times for a violation can be huge," says Peter Mafteiu, a director at National Regulatory Services, a Connecticut consulting firm that is owned by Thomson Financial and does mock exams for investment advisors." -- Directors take note! Stock Scandals System failure "Phony earnings, inflated revenues, conflicted Wall Street analysts, directors asleep at the switch--this isn't just a few bad apples we're talking about here. This, my friends, is a systemic breakdown. Nearly every known check on corporate behavior--moral, regulatory, you name it--fell by the wayside, replaced by the stupendous greed that marked the end of the bubble. And that has created a crisis of investor confidence the likes of which hasn't been seen since--well, since the Great Depression." An economy singed "Almost 1,000 American companies have now restated their earnings since 1997, admitting in effect that they had previously published wrong or misleading numbers. As the Securities and Exchange Commission cracks down on creative corporate accounting, more such admissions lie ahead, even among household names. Phoney accounts mean that much of the profit growth of the late 1990s, the ostensible justification for Wall Street's bubbling up to its ephemeral heights, was equally phoney. It is hardly surprising that investors are so anxious." How analysts' pay packets got so fat "Salaries for Wall Street's researchers skyrocketed with the surging stock market. Fueled primarily by the tech and initial-public-offering boom, equity analysts' pay jumped fourfold in a decade--and with it, all pretense that research was being written to benefit the investor." Stock analysts' dirty little secret "It's not that analysts have lost their integrity. It's that they never had it to begin with -- and everyone in the industry knew it. Maybe the brokerages should fire them all." The Enron story is nothing new "Long before Enron and off-balance-sheet accounting became part of the financial lexicon of average American investors, creative accounting was an accepted way of doing business in Silicon Valley. A small, perfectly legal and completely finished piece of financial engineering executed between 1998 and 2000 by Intuit illustrates that technology companies have long been willing to use accounting tactics to tell the stories they want told." Does Tyco play accounting games? "Don't let the recent buoyancy of the stock market fool you. Most investors are still deep-in-their-gut afraid to dive back into the water. And the fears have little to do with the latest Fed report, inventory statistic, or other economic indicator. No, the big concern is the weather. Will another Enron-like storm be sweeping across the country? Are there torrents of financial funny business yet to be uncovered?" Fight and flight at Andersen "When faced with mortal danger, people are biologically primed to respond in one of two ways: fight or flight. The same apparently holds true for accountants. Now that Arthur Andersen has been officially indicted on obstruction-of-justice charges, and big-name clients are defecting on a near-hourly basis, what are Andersen partners to do? Depends where they are on the food chain." Hide and seek "Accounting tricks make it difficult for investors to get a true picture of a company's finances. Here are 10 red flags to watch out for" The revenue games people (like Enron) play "Of all the accounting weirdness around--could anyone ever have dreamed that accounting would vie with pedophilia as front-page news?--the aspect that has most fundamentally affected the FORTUNE 500 is the handling of what are called 'energy trading contracts.'" Companies whose boards need a scare "Don't worry if you lose the actual vote. In the long run, letting management and directors know that shareholders are watching can be just as important as winning the actual count." Is the SEC corrupt or merely incompetent? "One of the features that distinguishes American financial life from American street life is how long it takes the police to turn up after a crime has been committed." Wall Street's den of thieves "The first thing you learn on Wall Street: Earnings don't mean anything. Everyone assumes that earnings are financially engineered (sometimes downward! ) to meet a variety of stakeholder expectations. The key expectation -- the one that stakeholders want companies to meet -- is steady growth. Earnings that spike and swoon set off alarm bells at places like Fidelity. Steady growth makes fund managers feel calm and content." Optimism has no place in accounting "The fiasco at Enron had two causes: (1) perverted "financial engineering" that portrayed failure as progress and (2) generally accepted accounting principles that practically invited delusion and fraud." How much do brokers have to hide? "Given the catastrophes that have slammed the securities industry over the past few months, it's no surprise that investor confidence has hit rock bottom. Enron is just the tip of the iceberg. In early 2002 a rogue Lehman Brothers broker was charged with bilking his clients of some $125 million over a period of years. Retirement accounts have been eviscerated by a series of shocking stock collapses--with analysts often screaming buy to the bitter end. Even with the inquiries by the SEC and several state attorneys general into analysts' conflicts of interest, investors can't help but feel that only part of the sordid story is emerging." Trouble in the boardroom "Scandal. Lawsuits. Tarnished reputations. Oh, how the life of corporate directors has changed! It used to be that a boardroom seat was the plushest of gigs. You got paid lavishly to hobnob with the rich and mighty, swap gossip over a pleasant poached-salmon lunch, and jet home." Options' costs revealed "It has taken an awfully long time - not to mention a crucial assist from the debacle known as Enron Corp. - but finally the investment world is inching toward truth in financial reporting where stock options are concerned." How big is the options bite? "Indeed, the earnings landscape looks a lot different for all of corporate America when options costs are included. Bear Stearns accounting analyst Pat McConnell found that counting options costs reduced S&P 500 earnings per share for 2000 by 9%. Numbers for 2001 look even worse: As of late May, with 389 companies counted, McConnell's tally showed options reducing earnings by 20%." Fund Fun Back to the drawing board "In the ten-year study the low-cost funds demonstrated substantial superiority in all nine of the style boxes." MERs offer best guide to funds' future peformance "Funds that ranked among cheapest in their category by MER generally had a good chance of outperforming over time frames of one, three and five years, the study found." ETFs stray from indexes "In doing so, they are also hoping to 'add value' and thereby boost their fees. 'Index managers want to be better paid for their services,' said one U.S. based panelist." Expenses tarnish index fund results "There's no free lunch for fund investors. And you won't always find a cheap lunch, even if you're shopping for index funds" The end of mutual fund dominance "Combined with the toll taken by fund costs and the toll taken by market timing, this penalty for adverse selection is the third leg of the unfortunate triumvirate of tolls that has left mutual fund investors in the backwater of the returns earned by the financial markets. If financial advisors do no more than keep your client from paying these unnecessary tolls, you've made a great start on serving them well!" Indexing works better elsewhere "In the encyclopedia of index investing, the Canadian stock market should be listed under F for freak. Indexing works very well for exposure to U.S. stocks, and this applies even to the lamentable past 12 months. There's also a convincing argument for using index funds to invest in international markets. In Canada, the case for indexing just isn't nearly as strong." Is Time Running Out For The S&P 500? "The S&P 500 has defined the U.S. stock market for decades. But more and more institutional investors are swearing off the index, saying it distorts the very market it purports to represent. Academics agree. Is it time for a new benchmark?" Real Estate Is housing the next bubble? "In fact, housing didn't just hold its own during the slump. It zoomed. Activity has been so strong that sales of new and existing homes hit all-time records last year. Not exactly what you'd expect when around two million people were losing their jobs, is it? What's more, we've seen record growth in mortgage refinancing, and annual home-price increases between 6% and 8% nationally for three years in a row." Going through the roof "Despite the sharp fall in share prices and a worldwide plunge in industrial production, business investment and profits, consumer spending has held up relatively well in America, Britain and several other economies, supported by low interest rates and the wealth-boosting effects of rising house prices. Over the 12 months to February average house prices in America rose by 9%, and those in Britain by 15%. Adjusting for inflation, this is the biggest real increase on record in America and the biggest in Britain since 1988." Shares do not a shelter make "On one level, popular capitalism has been successful. Socialism has been seen off. Industry has been privatised in the UK and elsewhere in Europe, with a fair proportion of the equity ending up in the hands of the public. Share options and profit-sharing schemes are now widely used to motivate the workforce. But part of this approach has been muddle-headed. Too little consideration has been given to the long-term economic interests of those involved. Investors have been steered in the wrong direction, at great cost to many." Up and atom "No offence, but it's a challenge to get most real estate agents to shut up. At least that's been my experience. After all, it's their job to gush endlessly about the magnificent homes they've got on the market and detail every last one of the fabulous amenities they offer. But strangely, when I began making inquiries about the unique aspects of the Toronto mansion originally built by Canada's once- high-flying developer, Robert Campeau, even the most loquacious realtors clammed up. Sure, they'd happily go on about stuff you'd expect from any half-decent Bridle Path spread: manicured lot, built-in recording studio and chemical-free pool. But something as indispensable as a custom-built bomb shelter seemed to give everyone the heebie-jeebies." Hot property "A fierce debate is raging between economists over whether the authorities should try to let the air out of the market, risking a global property crash and possibly a world recession, or whether they should let the market continue to expand, which risks creating a bubble that would inevitably burst." Tricky Trusts Shakespeare on REITs "Finally, beware of the risk of reaching for yield: purchasing high-yield securities when interest rates are low. At the time of writing (spring 2002), with interest rates at record lows, the number of new trusts appearing is very high. A similar situation occurred in 1997, when again interest rates were low and a large number of new royalty trusts were issued. Unfortunately, as in 1997, many of the new trusts are likely to disappoint investors as Bay Street unloads assets that are unsuitable for income trusts because of variable cash flow or poor quality of the underlying assets." Selling the downside "As you may have guessed from our opening feature, the prices being paid for some assets via income and royalty trusts have exceeded our wildest expectations, but have exhausted neither the imaginations of the corporate financiers of Bay Street, nor the credulity of the Canadian public. It has truly been a situation where, as Buffett says, those who don't know are buying from those who don't care. How have these price levels been reached?" Scary business versus nirvana "After analyzing a typical structured product, Turnbull said, 'in order for the trust to provide the targeted distribution and meet its fee requirements, our model indicates that the managed portfolio must achieve an annual growth rate of 21.71%. We think that 21.71% is a highly aggressive goal than can only be achieved by exposing the managed portfolio to significant risks.'" Trendy trusts? "As ever, the onus is on investors to be vigilant. A few eyebrows were raised on Bay Street recently when managers at PBB Global Logistics Income Fund managers (TSX: PBB.UN), which went public in May, initially marketed their trust to The Street with a planned 11% to 12% payout for unitholders, but had cranked up the yield substantially higher, to 15%, by the time of issue. It earned them a lot more on the markets, but some investors wonder how sustainable the bigger paycheques will be in the long run." Dangerous Derivatives Rogue waves & standard deviations "What we are seeing in the financial system is similar to what we are seeing in the natural world, which is the increasing frequency and magnitude of storms. As seen from the above list and frequency of crises, storms continues to grow and raise the possibility of one too many shocks to the system." Rogue waves & standard deviations - part 2 "The companies, funds, investors, and governments best able to withstand a crisis are those who are unleveraged, liquid and have access to cash. Having no debt enables one to ride out a storm. Leverage becomes a ticking time bomb that offers few avenues for escape. In summary, the best protection against adversity is to have minimal debt and plenty of liquidity." Blowing Up "How Nassim Taleb turned the inevitability of disaster into an investment strategy." New @ StingyInvestor.com Dangerous Diversification Investors are constantly being told to diversify, diversify, diversify. The motivation for the diversification mantra is that it can help to prevent catastrophic losses. It may also allow for increased returns with a lower level of portfolio fluctuation. These benefits sound great but diversification mainly applies to stocks and not to fund selection. Mutual fund diversification can easily get out of hand and wind up costing investors a lot of money. The Coffee Can Portfolio Simply deciding that you'll hold a stock for ten years makes a big difference. The prudent long-term investor will select stocks of profitable companies with little debt. This list can then be pared down by removing companies that produce products that are unlikely to be in demand throughout the next decade. Such an approach automatically steers investors away from risky companies with limited operating histories and unproven businesses. Stingy News Weekly Archive 06/23/02 06/16/02 06/09/02 06/03/02 05/24/02 05/17/02 05/10/02 05/03/02 04/26/02 04/19/02 04/12/02 04/05/02 03/29/02 03/22/02 Bullishly Yours, Norman Rothery ISSN 1499-2787 Refer to legal & conflict of interest disclaimers. | ||||
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