To Our Clients and Friends of Parthenon Capital Management
A moderate dose of optimism returned to the stock market in the second quarter sending the S&P 500 up 5.85%, leaving the index down 6.69% for the first half of the year. Bond prices fell and yields on 10-year treasuries rose to 5.41% from 4.99%. The optimism was fueled by the belief (hope?) that the series of Federal Reserve interest rate cuts, the coming tax rebate and tax cut, and rapid business inventory and production cutbacks have set the stage for a resumption of economic growth and a turnaround in corporate profit growth. It was perhaps a premature leap of faith. Second quarter earnings reports and management outlooks provided after the end of the quarter have dampened the enthusiasm and sent the market back to nearly the levels seen at the end of the first quarter. Consensus aggregate earnings estimates for the S&P 500 companies now call for a drop of over 10% for the year. Earnings are almost certain to remain negative year to year until at least the fourth quarter and possibly for several more quarters. The economic turnaround has been pushed out significantly further than the prevailing consensus at the beginning of this year. While we have been cautious in our outlook for corporate profits, we have been somewhat surprised at the extent of the earnings weakness in some sectors. It is interesting and a bit disturbing to note that this weakness has occurred in an economic slowdown that has yet to reach an actual recession. The structural issues that we have discussed in previous letters, such as the excess capacity across many industries will continue, we believe, to dampen profit growth.
Fortunately, we can contemplate the general while we act on the specific. We are not forced to buy the stock market but have the luxury to concentrate on individual opportunities. The weakness in the overall market is providing a somewhat more fertile, though hardly plentiful, hunting ground. However, our caution on long-term corporate profit growth, along with our desire for a stock price that is compelling by absolute valuation standards, limits our activity.
Our concerns about overall profit growth notwithstanding, near term profit weakness in a business is not necessarily a deterrent to a stock purchase. We often consider the purchase of the stock of a company that we believe has a temporary impairment in its earnings growth. The reasons for the impairment can be company-specific, industry-wide, or the result of a general economic slowdown. Although we may have a general expectation for the timing of an upturn we have no particular date in mind and the timing is never critical to our purchase decision. We are perfectly willing, even eager, to buy a business whose near term prospects are less than stellar if we estimate that the market has priced the stock as if the near term is a permanent state of being. We have learned that the best prices for the patient, long-term investor are obtained before you can clearly see the return of good times. Sometimes it is best to fire the gun before you see “the whites of their eyes.”
Creativity and Illusion.
Telecommunications products company Nortel Networks recently reported what was then the largest loss ($19 billion) in U.S. business history. Management had little time to bask in the glory of that ignominious accomplishment however, because one month later another telecommunications company, JDS Uniphase, reported a staggering loss of $50 billion. The losses are not, for the most part, actual cash losses. Instead they were almost exclusively non-cash write-downs of goodwill. Goodwill is the asset on the balance sheets that represented the excess over asset value the companies had paid for a series of acquisitions. In addition, neither
company actually paid cash for their acquisitions – both companies swapped their stock for ownership of the acquired companies. Investors were not completely surprised by the announcements – both companies had fallen significantly in market value before the announcements although both subsequently fell further.
Do the accounting losses matter, regardless of the staggering size, if the actual cash losses were so much smaller? Is it simply an issue of accounting semantics? Trading ownership in a business with value for ownership in companies that subsequently prove nearly worthless is obviously destructive to shareholder value. Most importantly, the “earnings” and business progress on which the previous high stock prices were ostensibly justified were, at least in large measure, an illusion. The companies had reported pro forma earnings along with (and more prominently than) actual net earnings during their acquisition spree. Pro forma earnings are reported when management wants to show earnings that exclude the cost (or gain) from an extraordinary event, corporate restructuring, divestiture or acquisition. It is designed to show the earning power for a business going forward under the current structure, and when used prudently and conservatively it can be useful for investors as well as management. However, it seems that managers are increasingly using pro forma reporting to obscure any cost that detracts from their stated growth goals.
Generally Accepted Accounting Principles (GAAP) allow more flexibility than is implied by the term “principles.” (Perhaps for more liberal managements, Generally Accepted Accounting Suggestions (GAAS) might be a more appropriate guideline.) Finally, you might think that such gamesmanship would be dying along with the stock prices of so many practitioners. But the second quarter earnings release of one company began with the headline, “(Company) reports second quarter pro forma recurring adjusted earnings before interest, taxes, depreciation, and amortization up 33%….”. Sounds promising, but unfortunately buried in the release was the news that the actual net loss was over $600 million. The stock fell nearly 20% on the day. It may be getting more difficult to hide the bad news. We will continue to search for businesses whose managers use accounting to inform shareholders of actual results as opposed to a tool to obscure weaknesses or create illusions of greater growth and profitability.
While we generally feel that stock market prognostication should be labeled “for amusement only” and we have little faith in our own or other market predictions, a comparison of long-term historic valuations with current valuation levels across nearly all metrics argues for an extended period of moderate overall returns. If it occurs, though perhaps frustrating, it would not be entirely unwelcome and hardly unprecedented. In the five years from 1990 through 1994, before the markets began the extraordinary run in 1995, the S&P 500 had an annual total return of 8.7%. By the end of this period we had accumulated a very strong group of attractively priced securities. We would welcome similar opportunities, which will undoubtedly arise if the market remains subdued.
