October 11, 2004
One of the iron laws of finance is that a security is nothing more than a claim on the future stream of cash that it will deliver to an investor over time. I always use that word “deliver.” For instance, stocks are not a claim on reported earnings or operating earnings (which are, at best, accounting constructions), but on a generally much smaller number that Warren Buffett calls “owner earnings” and others call “free cash flow” – though some of us mean different things by that term than others. What is of interest is the amount that the company can actually deliver to shareholders after all obligations to other stakeholders (bondholders, employees, executives, the Uncle, etc) have been met. That requires a wide range of adjustments and deductions from earnings, the most important generally being investment – over and above depreciation – to provide for future growth. If new investment is profitable, it will positively impact future free cash flow, but it is decidedly a deduction when estimating current free cash flow.
Given that stocks are a claim on a very long-term stream of deliverable cash (not a single quarter or year of operating earnings), it's not surprising that there's a near-zero correlation between annual changes in S&P 500 earnings and annual changes in the S&P 500 index itself. Provided that earnings grow within a fairly well-defined long-term trend (which is true for the S&P 500 as a whole, even if it isn't quite true for each company), temporary shortfalls or spikes in earnings have very little effect on the discounted value of the long-term stream of cash.
Net earnings for the S&P 500 are actually more volatile than stock prices themselves, diving during recessions and soaring early in economic recoveries, but in a way that doesn't correlate at all with short-term changes in stock prices, even if you consider leads and lags. It's true that earnings levels and price levels move together over the very long term – if they didn't, price/earnings ratios would be useless. But even price/earnings ratios are poor valuation tools if one doesn't filter out the uninformative impact of temporary shortfalls (which is the logic behind the “price/peak-earnings” ratio that I use as part of our market analysis – and at 20 times peak earnings, that measure is currently at the same level it saw at the 1929, 1972 and 1987 peaks, eclipsed only by the ultimately unsustainable multiples of the 2000 bubble peak).
Now, if it's true that the discounted value of long-term cash flows has virtually no link to short-term earnings fluctuations for the market as a whole, why do investors pay any attention to earnings announcements?
The reason is that companies vary substantially in the amount of persistence that a given shock to current earnings will have on future earnings. For instance, assuming that there are no credit concerns, a short-term earnings miss for a utility company will have virtually no impact on price, whereas a shortfall of even a few pennies in a technology stock can send the price into freefall. Probably the most important reason is that earnings shortfalls in the tech sector are taken not only as signals about near-term results, but also as signals about long-term growth. A small downward revision in long-term earnings growth expectations is far worse than a large earnings shortfall that leaves the long-term path of earnings intact. Moreover, technology is constantly under threat of obsolescence. A shortfall in even a single quarter may portend new competition or other changes that can permanently affect the future stream of the company's cash flows – not just for one quarter, but forever. As a result, the more persistent the impact of a shock (or in economist-speak “innovation”) to earnings, the greater the impact on price. (Geeks note: this is just the Friedman-Modigliani permanent income hypothesis applied to finance).
There's another reason, however, why technology stocks are so vulnerable to short-term earnings misses. As Jack Ciesielski of the Accounting Analyst's Observer notes, “Soft spots abound in financial reporting, meaning that there are estimates and assumptions sprinkled throughout the construction of financial statements that can either be flat-out wrong, or manipulated to a desired result.” He reports that technology companies lead the way in “critical accounting policies” – areas involving estimates and judgments that have substantial impact on reported results – including income tax issues, revenue recognition, goodwill impairment, depreciation, and so forth. (Not that tech stocks are alone - long-term readers of these updates already knew my views on the implausible smoothness of Fannie Mae and Freddie Mac's earnings years ago).
If you think about the potential latitude that technology companies have to smooth earnings and achieve targets by making small changes in their assumptions, it becomes clear that an earnings shortfall might actually reveal more than just a single quarter's difficulty. Specifically, an earnings shortfall might indicate that a company has already so thoroughly exhausted its ability to use “estimates and assumptions” in prior quarters that it finally has no choice – short of fraud – but to report a shortfall. To that extent, the harsh take-down that tech stocks experience on earnings misses begins to look fairly rational. Given the tendency during the past bear market for companies to bundle their difficulties into huge extraordinary losses, fresh earnings shortfalls in upcoming earnings reports may hint that those once-blank slates have finally been covered with bad news again. Something to watch.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and tenuously favorable market action. That remains a condition in which we are willing to take some amount of exposure to market fluctuations, and though it isn't necessarily apparent in local, day-to-day movements, the Strategic Growth Fund has a full hedge against only about 65% of its portfolio, with (netting various call positions) only put option coverage on the remaining portion. In the event of a market advance of more than a few percent, I would expect the Fund to participate reasonably in any further market strength that might emerge.
That said, our investment position is not based on anticipation of market direction one way or another. At present, rich valuations, an already extended sideways consolidation, a flattening yield curve, and other factors all suggest downside potential, while still tenuously favorable market action suggests a continued willingness of investors to speculate regardless of those negatives. For us, it is sufficient to recognize that on average, the return per unit of risk historically achieved in the current Market Climate has been positive, on average, but that high valuations the tenuous quality of market action create important downside risk.
I don't think in terms of forecasts as much as I think in terms of probability distributions (“bell curves” describing a wide range of market outcomes, placing higher weights on some than others, but ruling out none of them). In my view, the current probability distribution has a good deal of area slightly above current levels, a thin tail (low but positive probability) somewhat more substantially above current levels, and a “fat tail” at lower levels. In non-geek terms, that means that while we're willing to take some exposure to market fluctuations, we want that exposure to have a “safety net” on the downside, hence the full hedge on part of the position and put-only coverage on the remainder.
In bonds, the Market Climate as of last week was characterized by modestly unfavorable valuations and nearly neutral market action. Valuations take greater precedence in bonds than they do in stocks, due to the much lower potential for “bubbles” to emerge in assets with finite maturities. As a result, the duration of the Strategic Total Return Fund remains a relatively short 2 years (meaning that a 100 basis point move in bond yields would be expected to impact the Fund by about 2% on the basis of bond price fluctuations). The Fund also continues to hold just about 15% of assets in precious metals shares.
There were rumors on Friday from some corners of an impending agreement on revaluation of the Chinese yuan – one of the factors cited as responsible for the substantial strength in the yen. The other reason for a relatively strong yen and weak dollar was of course the employment report. Unemployment remained unchanged last month at 5.4%. Of course, the rate would be pushing 7% were it not for the large number of discouraged workers who have exited the labor force in recent years – the steepest drop in civilian labor participation since the early 1960's. In all, a good combination of factors for gold too. In any event, there has been very little in the way of confirmation on the issue of the Chinese yuan, and there is as yet no compelling reason to expect that inevitable revaluation to occur in short order.
New from Bill Hester: The Weighting Game
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