Semi-Daily Journal

Yes, Virginia, there is a problem....

March 20, 2003

In U.S. Eyes, a Fraud Particularly Bold
By FLOYD NORRIS - NYTimes

It was a fraud that went on for more than 15 years, complete with "family meetings" to create records to fool the auditors, who seem never to have caught on that something was amiss, even as a company that was barely breaking even was reporting more than $1 billion in nonexistent profits.

That, in any case, is what the Justice Department and the Securities and Exchange Commission say went on at HealthSouth, the health care company run by Richard M. Scrushy, who is said to have directed the fraud. HealthSouth's former chief financial officer has agreed to enter a guilty plea and to cooperate with investigators.

In some ways, this case is unusual. While most accounting fraud cases filed by the S.E.C. come months or even years after inaccurate accounting is disclosed, the public had virtually no idea of the scope or magnitude of the case before charges were filed yesterday....

Funny, Warren Buffett is concerned. John Bogle is concerned. Arthur Levitt is concerned. William McDonough is surely right to be concerned. Of course, there are lots of us who worry about corporate governance. Say, investors....

There are a lot of little problems with the market. The war uncertainty and oil price uncertainty and corporate governance contribute to investor unease. However, what about the concerns that stocks are still overvalued with P/E ratios still well above the historic average? A big part of the bubble bursting is investors recalculating the risk and the true worth of the stocks they hold. Does not part of McDonough's statement hint at this? As for information, a lot of it gets filtered through the market cheerleaders on those insipid TV shows. Given their record, investors no longer trust them. Dow 36,000! Har! Har! Past misbehavior makes it more difficult for corporations to deliver their message.

Frankly, I do not understand what you are arguing nor do I know of your context for the Buffett complaints. Oxley-Sarbanes seems a fine framework to be filled in by an accounting board.

Yes, corporate governance problems can be corrected if never absolutely. No matter, go along happily investing knowing the problems that remain, but be careful.

A sufficient knowledge of asymmetrical information problems is enough to evoke concern. When you have two parties bartering over the price of an item asymmetrical information effects the price. The classic textbook example is the used car market (not as good an example as it used to be with Carfax and Consumer Reports). They buyer knows full well that the seller probably knows more about the car than they do. They have either been driving it or, in the case of dealerships, have mechanics that can look for them.

This has the effect of driving down the price of used cars. The same is true in all markets. If buyers as a whole think the sellers can and will conceal information from them than the prices they are willing to pay will be lower than otherwise.

In the stock market buyers always have less information than the companies who have stock options on the market. What does that mean? Buyers price the shares at a percentage of what they would if they knew everything about that company. We have companies that are still restating earnings from years ago. This makes investors unwilling to buy at a high price because they do not know for sure what they are buying. In order for this relationship to work outside controls create an atmosphere where people feel comfortable that the stated price/earning ratio on a stock are probably correct. Or correct most of the time on most stocks.

Is our information imperfect? Yes it is. Just by knowing that we know the price is distorted. Without faith in earnings statements the market will continue to decline regardless of the geopolitical scene.

"However, what about the concerns that stocks are still overvalued with P/E ratios still well above the historic average?"

This is quite puzzling to me. After 36 months of the fiercest bear market in more than 50 years, why are p/e ratios for the S&P still so high? What does this mean? I am convinced this is important, but why?

Remember, WorldCom wrote down its hard assets by 75% a few days ago. What does this mean about the assets of other telecoms?

http://www.nytimes.com/2003/03/16/business/yourmoney/16WATC.html

March 16, 2003

From WorldCom, an Amazing View of a Bloated Industry
By GRETCHEN MORGENSON - NYTimes

EVER since WorldCom toppled into bankruptcy last summer, the company has been teaching stunned investors one lesson after another. Not only have we learned how easy it is to cook up a monumental accounting scandal, but our eyes have also been opened to the special treatment that WorldCom's executives received — in the form of hot stock issues — from Wall Street during the bubble. And who could forget the picture of gullible Wall Street analysts cheering investors into the company even as it was flaming out?

But last week's WorldCom tutorial may beat all the others. Thanks to its announcement on Thursday, we now know in actual, quantifiable, stupefying terms, just how much WorldCom overpaid for the telecommunications network it built.

After reviewing its books, WorldCom said that it would write down the value of its assets by $80 billion. Some of this had been expected; $45 billion in good will at the company — largely a result of overpaying for acquisitions — surely had little value.

But more than a few jaws dropped when WorldCom noted that it would write down the value of its property, plant and equipment and other intangible assets to $10 billion from $44.8 billion. That meant that WorldCom's hard assets, including its network, are now worth almost 75 percent less than what they had cost. And don't forget, these assets were bought with actual cash, not highflying shares....

Again, how do we properly value Cisco or Intel or Yahoo apart from options expenses? And, how much under-funded pension plans have still to be accounted for? What is "fair value" these days?

A pet idea of mine. About Enron, Senator Lieberman said something like "It's important to do something about this, but it's equally important not to do too much." A truism, but not a reassuring thing to hear at that moment.

Joe was wearing two hats. #1, Arthur Anderson's man in the Senate, and #2, the man in charge of the Enron and related investigations. And Arthur Anderson was unquestionably part of the problem.

My feeling is that if there are known to be problems about corporate governance, that that would have to be a drag on the market unless the vast majority of investors were really stupid. Have I missed something?

And are we to believe that there's no drag on the market unless a lot of investors stand up and say that they weren't investing simply because of corporate governance? Non-investors with money to invest don't usually give press conferences about their reasons.

If, whenever a Democrat says anything criticizing a Republican, someone invariably stands up and accuses him of partisanship without any other evidence than that, can't we decide that the accuser is partisan and ignore him or her? (And vice versa of course).

rm,

It is incredible to me that anyone could cite to Warren Buffett as an authortity on matters of corporate governance and have NO IDEA AT ALL that Buffett has within the past few weeks dismissed Oxley-Sarbanes as irrelevant and that he is NOW CONDUCTING a public hunt for "independent" board members from among Berkshire's own stockholders while loudly complaining that the NYSE rules are making him do this where there is no need.

I don't feel like doing web research for someone with an e-mail address like "rm@law.harvard.edu" who responded to my original comment in the condescending and foolish fashion you employ - so I think I'll just leave this one alone. (BTW: "Yes, Virginia ..." is now a derivative, ignorant cliche. You might want to update your witticism list by, say, 50 years.) Try starting your research with google. Goodbye.

"This is quite puzzling to me. After 36 months of the fiercest bear market in more than 50 years, why are p/e ratios for the S&P still so high? What does this mean? I am convinced this is important, but why?"

It isn't over yet. Far from it. There is no sign of capitulation. There is still plenty of room for stock values to fall and no reason to expect them not to. Sure, there will be bull legs in this bear market. But it's a bear market and all signs are it still has years to run.

As for the real economy - for nice depressing reading go read the latest Beige Book.

Is there a remote possibility that higher earnings multiples have anything to do with the level of interest rates?

Anyone worried over an upcoming implosion of the real estate bubble? Would that incite investors to pull their money back into stocks or get them worried that companies will have to write off real estate losses from their balance sheets?

There are some geographical peculiarities in the real estate bubble. In North Dakota my brother's brother-in-law bought a livable house (livable at 40 below zero, whether Fahrenheit or Centigrade) for $2000.

North Dakota: among the best states for low crime, low unemployment, high life expectancy, and good high school education. And for 70 years or more, a state which has been steadily losing population. Why? Because Americans want crime, unemployment, premature death, and failing schools. That's why.

And I suppose 40 below zero with a 30 mile wind has something to do with it too.

Ian, I second your concerns about the high P/E ratios. There is a significant potential downside. We know there was a stock bubble. We know that stocks were way overvalued. How fast can they return to those highs and not create a new bubble? The best analysis I have heard is that the markets are controlled by the hedge funds and the small investor is likely to get trampled.

Dear RM,

I too can only find support for corporate reform measures such as Oxley-Sarbanes accounting oversight and independent directors from Warren Buffett. Odd, there is article after article showing such support.

Thanks!

"Is there a remote possibility that higher earnings multiples have anything to do with the level of interest rates?"

It strikes me that if you buy a company stock at a price that is high relative to the expected income stream of the company you are in for trouble. Interest rates may be low, but there is no reason to pay too much for earnings. There were all sorts of reasons given to buy Cisco at 150 times earnings in 1999-2000, but I hope you did not.

I am still concerned about stock valuations.

Sam: need to look at real interest rates,not nominal ... if we are worrying about deflation, real rates might still be quite high.

Omnes: The stock market did not start going down because of "corporate scandals", and anyone who is in the mood to reconstruct accounts along Sarbanes-Oxley lines can do so. Attracting attention to this side-issue distracts it from genuine problems with respect to the corporate sector.