8,5659,590125,679
7,8129,502129,417
13,684
12,735
Source: Bloomberg L.P.
Bear in mind that these are just selected figures, and that we have notqueried General Electric about these items because the company refuses togrant us an interview. Note, however, that on a sales decrease of $3.7 billion,General Electric was able to increase net income by $949 million. This ishighly commendable. However, of this $949 million, $753 million came froman inventory increase, and $88 million came from an accounts receivables increase. Taking this $841 million away, the net increase in earnings was just$108 million.Accountants and analysts use that exact procedure with all asset and liabilityaccounts to compute the difference between cash earnings and accrual earnings.(We emphasize that this is merely a partial picture of General Electric’s financialstatement, and that the company actually generated cash flow of $32.2 billion in2001, up from $22.7 billion the previous year. Other items on the statement ofcash flow account for this difference, such as an increase in insurance liabilitiesand reserves of $9.2 billion). While we hesitate to opine on these matters because of our lack of direct contact with GE, may we speculate that fear that suchitems might be signaling that all was not well was responsible in part for the 47percent decline that GE experienced from top to bottom in 2002?
BuybacksLet’s turn to buybacks and dividends—the two main ways for a company to return cash to shareholders.Nothing is inherently better about companies that pay dividends or buyback stock. A growth company may decide to invest the cash in its business.
318 Practical SpeculationWhen a company perceives that the rate of return in its own business is lessthan shareholders could achieve on their own, it’s prudent for all concerned ifextra cash is distributed. Moreover, in an investment atmosphere that is poisoned by mistrust and fraud, distributions show good intentions in a way thatmere reassurances never could. A company that gives cash to stockholderscan’t waste it on ill-considered mergers, grandiose buildings, outlandish executive perks, and other hubristic activities.As Paul Fels, a reader of our CNBC Money column observed: “You canfake or inflate earnings, but if you pay out cash, you had to have it in thefirst place.”Share buybacks increased rapidly starting in the mid-1980s as the percentage of companies paying dividends dwindled. In 2000, companies spentas much on buybacks as they did on dividends, according to an admirablestudy in the August 2002 Journal of Finance by Gustavo Grullon of Rice University and Roni Michaely of Cornell University.Buybacks have three major virtues:1. Signaling. By authorizing a stock buyback, a board signals to shareholders that it feels the stock is undervalued.2. Better income ratios. Other things being equal, the reduced number ofshares will improve earnings per share and return on equity.3. Flexibility. Investors can interpret the elimination or reduction of a dividend as extremely bad news. Because a stock buyback is a one-timeevent, no embarrassment results from failing to repeat it.The classic study on share repurchases was conducted by David Ikenberry,a professor at Rice University; Theo Vermaelen, professor of finance atINSEAD, a French business school; and Josef Lakonishok, a finance professorat the University of Illinois. The study, published in the Journal of FinancialEconomics in 1995, found that companies buying back their own shares perform some 4 percentage points better than the averages. Studies of companiesin India, England, and Canada confirmed the professors’ findings.At least two funds are putting the study’s findings to profitable use. DavidFried’s Buyback Letter has enjoyed one of the best ratings from Hulbert Digest,the acknowledged arbiter of newsletter performance. Professor Vermaelen’sown buyback fund that he manages for a Belgian bank, KBC, reported a returnof 40 percent from the fund’s inception in July 1998 through April 2002.We verified the academics’ conclusions ourselves in April 2002 by compiling a list of every company in the S&P 500 that had announced a buybacksince the beginning of 2000. We tracked each company’s performance over afull year, using the close on the day after the announcement as the buy date.
Chapter 17 • Earnings Impostors
319
The 224 companies we identified outperformed the S&P 500 by an average of30 percentage points a year, a 1-in-100 million shot by chance alone.By October 2002, we had added 15 additional companies. The advantagedwindled to 6 percentage points—still a very respectable edge.When we reported our findings, many readers wrote in to express concernthat companies would fail to follow through after announcing buybacks. Theworry is misplaced. A company’s buyback announcement signals that management believes the stock to be undervalued. If the stock immediately risesbased on this signal, the job has been done. We found no evidence that companies that do implement buybacks perform better than those that don’t. (Investors can monitor actual repurchases by watching the shares outstandingreported in consecutive quarterly financial statements.)
DividendsWhen mutual funds statements are too depressing to watch and every weekbrings news of a new major accounting fraud, few things seem more reassuring than dividend checks in the mail. Not only do the payouts offer a cushionagainst stock declines; a company that must come up with hard cash to payhigher dividends quarter after quarter has less latitude for accounting shenanigans. A dividend offers tangible proof to shareholders that they exercise atleast some control over the assets they own.Older generations of investors knew this well. “My father-in-law (now deceased) looked only at dividends for his personal support and never concerned himself with the value of his portfolio,” wrote reader Patricia K.Schwabacher. “During market downturns, he worried not at all. He justdidn’t buy a new car or a new boat at those times. He only concerned himselfwith the security of the dividends. He retired at 50 and died at 90, havinglived a very nice lifestyle, with a net worth that increased 10-fold during thatperiod of investment.”Regrettably, the number of companies paying dividends steadily dwindled from 70 percent in the 1970s to about 20 percent in 2000. U.S. tax policy is partly to blame. Dividends are taxed at the corporate level of 20 percent,and when they reach the investor’s pocket they are taxed again at 40 percent,on average. If the company holds onto the money and invests the moneywisely, or buys back its own shares, investors can enjoy capital gains taxed atonly 20 percent. That’s why the retention ratio—earnings retained versustotal dividends paid—has increased from 30 percent in the 1950s to 70 percent today.
320 Practical SpeculationBut the double tax is not the only skewed incentive confronting management. Congress has done further mischief by permitting deductions for interest but not dividends. In effect, companies are encouraged to go into debt. Asratings agencies and investors frown on highly leveraged balance sheets, somecompanies—Enron comes to mind—go to great lengths to hide their debt withdubious or fraudulent accounting.Moreover, executive options decrease in value along with stock priceswhen a company pays dividends. The rise in executive pay over the past 50years has been accompanied by a decline in dividends.We wanted a fresh look at the question of whether dividends actually arepredictive of superior stock returns. As has become our wont, we began by consulting that magnificent analysis of 101 years of stock market data, Triumph ofthe Optimists.Dimson, Marsh, and Staunton, the authors of Triumph, examined the performance of the 30 percent of companies with the highest dividend yields atthe beginning of each year and compared it to the performance of companiesthat were in the lowest 30 percent of dividend yield. From 1900 through 2001,companies with the highest yields returned 12.2 percent a year. Companieswith the lowest yields showed an annual total return of 10.4 percent.A difference of 2.2 percentage points a year may not seem like much.But over time, it becomes a gigantic differential. Over the 101 years of thestudy, $1 invested in the highest-yielding companies could have come to$4,948, while $1 invested in the lowest-yielding companies would havegrown to a mere $1,502.The margin of superiority for high-yielders versus low-yielders, however,has been close to zero since 1990. To determine if the regime shift had set in,we updated the Triumph data by considering the S&P 500 companies thatshowed the highest yields at year-end 2000 and year-end 2001, along withtheir performance in the next year.We found that the 10 high-yield stocks outperformed the market in 2001with a positive return of 8 percent versus a 10 percent loss in the S&P 500 anda 39 percent loss in the Nasdaq. But in 2002, the effect did not hold up. Thetop 10 high-yield stocks were down 34 percent as of mid-October, even worsethan the 24 percent loss in the S&P 500 and exactly even with the 34 percentloss in the Nasdaq.The numbers were similar for the top 30 high-yielders. These stocks werelittle changed in 2001 and were down 25 percent as of mid-October 2002, asTable 17.2 shows.The great danger in buying a stock with a high dividend yield is that dividends can be cut. Ford Motor Company, Dynegy, Goodrich, Transocean, and
321
−34.2423.59
Sabre (TSG)J.C.Penney (JCP)Rockwell Automation (ROK)Dana (DCN)Ford Motor (F)Deluxe (DLX)Winn−Dixie Stores (WIN)Thomas & Betts (TNB)Wachovia (WB)Southern Co. (SO)
−27.1−23.7−46.6−45.5−10.4−70.0−10.8−1.8−39.1−67.4
Average
10.056.776.686.446.346.086.0165.865.66
Plum Creek Timber (PCL)Dana (DCN)Ford Motor (F)J.C.Penney (JCP)Rockwell Automation (ROK)CMS Energy (CMS)Eastman Kodak (EK)Ameren (AEE)RJ Reynolds Tobacco (RJR)CenterPoint Energy (CNP)
Company
January–October 2002Performance (%)
Standarddeviation
Yield atYear-End 2001
Standarddeviation
Average
12.0610.478.488.17.687.337.096.926.96.6
Yield atYear-End 2000
Changing Cycles: Performance of Top 10 Dividend-Yield Stocks (2001 vs. 2002)
Company
Table 17.2
1.77
8.16
−1.8155.79−15.51−3.34−29.27116.65−23.5234.9216.4731.95
2001Performance
322 Practical SpeculationQwest Communications were among the companies that suffered declinesexceeding 40 percent in 2002 after cutting or eliminating their dividends.There is also a risk in buying a company where management is implying thatthey have encountered sufficient barriers in their ability to use your capitalthat they are giving it back to you.
Up with DividendsWe next looked at companies that initiate or increase dividends. The academics have concluded that dividend increases are irrelevant. In the scientific tradition, we vetted their findings. Cycles are always ready to change in markets,racing, and in life—just when they seem “sure as rain.” A preliminary study ofdividend increases in the year 2002 yielded results contrary to the academics’findings.We took the 120 companies in the S&P 500 that increased their dividendsin 2002, and found in mid-October a cumulative performance of −14 percent.Twenty-two companies decreased their dividends, and their performance was−20 percent. The difference is significant at the usual statistical levels. Companies that declared new dividends beat the S&P 500, as Table 17.3 shows.We conclude that there is no magic bullet for stocks. High-yield companies seem to show superior performance over time, but that effect apparently vanished in the difficult year of 2002. Companies that increase dividendshave had relatively woeful performance in the past, but in these times theyaugur good performance.
Dividend Yields and the MarketWe often hear from gurus of the value persuasion that stocks are too high because dividend yields are too low. Bill Gross, the reigning bond king of Pimco,used 100-year statistics on dividend yields and dividend growth in September2002 to argue that the Dow should be at 5000. (It was then at about 8500.)Such an argument is so naïve that we are almost embarrassed to hear itexpressed. It leaves out the fact that companies were spending as much tobuy back shares as they paid out in dividends. It also leaves out the fact thatinterest rates on the 10-year note are at the lowest levels since the 1950s.That means stocks don’t have to yield much to be attractive, as Tables 17.4and 17.5 illustrate.
323
*Returns don’t include reinvested dividends.Source: Bloomberg L.P.
AmerisourceBergenFedExGoldman SachsJohn Hancock Financial ServicesMeadWestvacoMetropolitan LifeMonsantoPepsi BottlingPrincipal FinancialQwestRJ Reynolds Tobacco HoldingsRockwell CollinsUnited Parcel ServiceVisteon
CompanyABCFDXGSJHFMWVMETMONPBGPFGQRJRCOLUPSVC
Ticker
Table 17.3
10/31/20015/31/20026/24/199911/13/20001/13/200210/24/200010/18/20004/29/199910/25/20025/2/20017/28/19997/2/200111/18/19997/14/2000
DividendDeclared12N/A3232−1710497N/A−8756−924
Change afterafter 12 Months (%)
New Dividends and Stock Returns*
28N/A224902972−3N/A−73−229−943
Difference versus S&P 500aftr 12 Months (%)
324 Practical SpeculationTable 17.4
Year-End Yields for U.S. 10-Year Notes (1962–2001)
Year
Yield (%)
Year
Yield (%)
Year
Yield (%)
20012000199919981997199619951994199319921991199019891988
5.0515.1126.4424.6485.7416.4185.5727.8225.7946.6866.6998.0677.9359.137
19871986198519841983198219811980197919781977197619751974
8.8597.2238.98611.51411.80110.38913.98212.43210.3329.1527.7826.8127.7627.402
197319721971197019691968196719661965196419631962
6.9026.4125.8926.5027.8826.1625.7024.6424.6524.2124.1423.852
Source: Bloomberg L.P.
We took out the pencil and paper to see what happens tothe S&P 500 when per-share dividends fall. From 1938through September 2002, S&P 500 dividends have declinedin only six years. Table 17.6 shows what happened to the market in the year of the decline and then in the next year.
Table 17.5 Selected S&P 500 Year-EndDividend YieldsYear
Yield (%)
Year
Yield (%)
200120001999199819971996199519941993
1.41.21.11.31.62.02.22.82.7
19901980197019601950194019351900
3.74.53.43.37.26.33.54.3
Source: Bloomberg L.P., S&P Security Price Index Record, The Triumph of the Optimists (Princeton, NJ: Princeton University Press,2002).
Chapter 17 • Earnings ImpostorsTable 17.6
325
Down Years for Dividends
Year of Decrease
Decline (%)
S&P 500 Return
Next Year’sS&P 500 Return
193819421951195819701971
−37−16−6−3−1−2
25121538011
−5191281116
Source: Niederhoffer Investments.
In the six years that dividends declined, the average capital gain in theS&P 500 was 17 percent. The next year, the gain was 10 percent. Including dividends would add 5 percentage points to those results. The myth that stockscan’t go up unless dividends do is clearly wrong.
Cash IndicatorsIn 2002, when confessions and revelations of accounting frauds filled thenewspaper pages and the air was thick with the dust of crumbling companies, afriend who invests in Indian companies told us that wild exaggerations in financial reporting are the rule there. The only way to tell the genuine companiesfrom the frauds was to find the ones that actually paid taxes.On investigation, we found that many U.S. accounting disasters—WorldCom and Global Crossing being notable examples—had reported splendidearnings right up to the moment they imploded. There was, however, one signof trouble that in retrospect seemed intriguing. Relative to the actual cash taxesthat the companies paid, both companies had reported very high annual earnings before interest, taxes, depreciation, and amortization (EBIDTA) and taxes.We wondered if the amount of taxes actually paid by a company relative toreported earnings might provide a clue as to whether financial chicanery wasoccurring behind the scenes. After all, few companies would go so far as topay taxes on money they never made in the first place.The mobsters of early Las Vegas understood this. Susan Berman, in herbook, Lady Las Vegas, reports that when casino operators divided up the profits,there would be a pile for themselves, a pile for the government, and a pile forthe mob bosses. Bugsy Siegel’s bosses knocked him off when he didn’t have a
326 Practical Speculationpile for them. They figured that if they didn’t get their pile from Bugsy, he waseither mismanaging their assets or stealing from them.Nothing is wrong in principle, or is even suspicious, about a companyreporting one income to the government and another to the public. Companies have two opposing goals: reporting as little net income as possible tothe IRS—thereby limiting tax liability—and reporting as much net incomeas possible to the investing public. The rules that the IRS uses to calculate acompany’s income and tax liability can differ significantly from the Generally Accepted Accounting Principles (GAAP) the SEC requires companies tofollow when calculating the income they report to the public.A company’s taxable income may differ significantly from the income itreports to shareholders for many legitimate reasons: the depreciation methodused, the treatment of amortizing intangibles, the way revenues are booked,and whether and how stock options are expensed.Tax accounting is one of the most technical, controversial, and fuzzy of allaccounting areas. One generalization we can make is that growing companiestend to have increasing deferred tax liabilities. That’s because they are continually making capital expenditures (buying computers or trucks, for example).Estimates of when deferred liabilities (or credits) are likely to be realized canvary substantially under GAAP and IRS guidelines. The difference in timingcan occasionally—though not always—be material.A back-of-the-envelope study seemed in order. Using the 30 Dow JonesIndustrial stocks, we compared the EBITDA from their income statementsto the cash taxes paid figure in their cash-flow statements. We separated thecompanies into high-tax payers and low-tax payers, and compared theirstock performance. The results are shown in Tables 17.7 and 17.8.Counterintuitively—which suggests the finding deserves closer scrutiny—the companies that paid less tax on the same amount of income did worsethan the companies that paid more. You would expect that companies betterable to avoid, or at least put off, paying taxes would be better managed andthus have higher performance. Our studies suggest the reverse at a statistically significant level.To make sure our results were not due to chance, we ran the same test ona sample group of 50 S&P 500 stocks. As Table 17.9 shows, the high-tax payers again significantly outperformed the low-tax payers.Our studies were very preliminary. It is quite possible that during other periods and other regimes, companies paying less tax would outperform, helpedby their greater cash flow.
327
Ticker
HPQXOMHDPGWMTBAJNJKOMOMRKDISMCDMMMAACAT
Name
Hewlett-PackardExxon MobilHome DepotProcter & GambleWal−Mart StoresBoeingJohnson & JohnsonCoca−ColaPhilip MorrisMerckWalt DisneyMcDonald’s3MAlcoaCaterpillar3,20029,0005,7007,00013,4006,5009,5006,20018,00011,5004,6004,0003,3003,5002,500
EBITDA, 2001(in Thousands)
Table 17.7
1,1599,8551,6851,7013,1961,5212,0901,3513,7752,300881774520548379
Cash Paid, 2001(in Thousands)
High-Tax Payers
17.5
−13.9
Average stockperformanceStandarddeviation
−37.6−13.8−45.513.4−17.74.3−11.83.45.8−18.8−32.0−13.43.3−30.1−17.8
(%) Return1/2002–9/2002
2.82.93.44.14.24.34.54.64.85.05.25.26.36.46.6
Ratio, EBITDA/Tax Paid
328
Ticker
IBMINTCSBCUTXDDIPMSFTAXPGMCHONEKGETJPM
Name
IBMIntelSBC Comm.United Tech.DuPontInternational PaperMicrosoftAmerican ExpressGeneral MotorsCitigroupHoneywellEastman KodakGeneral ElectricAT&TJ.P. Morgan16,1008,90020,0003,7003,5003,30013,0006,80023,00031,6001,1001,90027,40015,60011,200
EBITDA, 2001(in Thousands)
Table 17.8
2,2791,2082,6964974563331,3005451,8432,411791201,487803479
Cash Paid, 2001(in Thousands)
Low-Tax Payers
Standarddeviation
7.17.47.47.47.79.910.012.512.513.113.915.818.419.423.4Average stockperformance
Ratio, EBITDA/Tax Paid
−22.3
−43.8−43.8−35.01.4−5.1−5.5−30.4−8.5−12.3−37.7−8.70.9−24.4−49.2−32.3
(%) Return1/2002–9/2002
Chapter 17 • Earnings ImpostorsTable 17.9
329
S&P 500 Sample Results
50 of 500High-Tax PayersAverage performanceStandard DeviationCount
−15.724.925
Low-Tax PayersAverageStandard DeviationCount
−31.024.625
Cash MoneyBalance sheets contain gold, but you have to know where to look. We found itburied in the fourth layer from the top, after cash, marketable securities, andaccounts receivable—the inventory changes.Is the company’s inventory up? Chances are its stock is going to fall.Is inventory down? Likelier than not, that stock will rise.Sounds pretty much like common sense. It’s an accounting twist as newas the twenty-first century and as old as trade: If a company puts a high valueon a heap of inventory, earnings might be pumped up. But those microchips,routers, and subassemblies that are valued at billions on the balance sheetmay have to be unloaded at a steep discount.You can ignore it. But you can bet the market won’t—not when times aretough and trust is low.Anecdotes about companies that found their inventory building up beforeprecipitous declines in price are legion. For example, Nvidia Corp.’s inventory inthe year ending January 2002 increased to $214 million from its January 2001level of $90.4 million. That’s a jump of 137 percent; sales rose only 86 percent.Doubtless Nvidia was building up inventory in anticipation of much highersales in 2002. Its shares declined 89 percent in 2002 (through October 9).Or look at Tellabs, which fell 74 percent in 2001. Its inventory at year-end2000 had increased 131 percent, to $428 million from $186 million, from theyear-earlier level, while sales rose just 46 percent. In 2001, sales fell 35 percent.Motorola provided an especially noteworthy example in 2000. Inventoryincreased some 40 percent, to $5.2 billion from $3.7 billion, but sales only rose14 percent, to $37.6 billion from $33.1 billion. Motorola stock’s 26 percent
330 Practical Speculationdecline in 2001 seems somewhat muted, unless we note that in 2000, whenthe market in its wisdom was perhaps already discounting this, the pricedropped 60 percent.Companies that suffered sharp price declines in 2000 after reporting inventory increases at the end of 1999 are particularly numerous. Start withAmazon.com, where inventory jumped some 650 percent, to $221 millionfrom $30 million. Sales grew almost 170 percent, to $1.6 billion from $610million, and there were probably good explanations for management’s decision to build up inventory. But the market was unforgiving, and Amazon.comfell some 80 percent in 2000.Table 17.10 summarizes the ending inventory versus sales change andnext year’s percentage price appreciation. It seems like plain common sensethat an inventory buildup relative to sales could be a sign of trouble. Most ofus who have been in business have been victimized by rosy estimates of thevalue of inventory that can be sold only at drastically reduced prices, particularly in industries where products are subject to rapid obsolescence.Unfortunately, it’s not that simple. Many companies that report sharp increases in inventory are merely responding to sharp increases in sales. Often,they go on to show great performance in subsequent years. On the other side,many companies that show sharp decreases in inventory in a year are responding to drastic declines in sales. Instead of being star companies with soundearnings, they go on to dismal market performance.As readers of our column and all other sober-minded investors know,anecdotes prove nothing. The diversity of stocks is so great that a story can befound to prove any generalization. To settle the issue, what’s needed is a systematic and scientific study from an investigator knowledgeable in accounting, statistics, and practical investment.Fortunately, such a study has been completed by Jacob Thomas, Ernst &Young professor of accounting and finance at New York’s Columbia University, and one of his former students, Huai Zhang, now a professor at the University of Illinois.Table 17.10 Inventory Buildups, Stock TakedownsCompany
Year
Ending Inventory(in Millions)
InventoryChange (%)
SalesChange (%)
Next Year’sStock Change (%)
NvidiaTellabsMotorolaAmazon.com
2001200020001999
213.9428.35,242.0220.6
13713141650