You Must Remember This
Five axioms for the market watchers to follow in the year ahead
By Wayne Lilley
The performance of this year's Top 1000 reflects a bedraggled economic picture. The aggregate profitability of the Top 20 companies in 2002 was $24 billion. That's up marginally from $23.9 billion in 2001, and way shy of the $30 billion racked up back in 2000. In fact, seven companies made this year's Top 20 despite declines in profits. And there's no shortage of overhangs on the road ahead. Herewith, five rules to follow when weighing who to back.
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Don't expect a miracle
The fact is, the clouds shadowing capital markets aren't going to disperse any time soon. Investors disillusioned by elastic accounting, executive perp walks, felonious investment bankers and lying stock analysts are fleeing the stock market, creating what CIBC World Markets Inc. describes as a $45-billion liquidity bubble. Mutual funds, the investment of choice for the masses a year or so ago, have particularly felt the pinch. Throughout the seven months to the end of March, equity funds suffered net redemptions, and investors have withdrawn $6 billion from money-market funds in favour of even safer alternatives such as GICs or just plain old bank accounts. The numbers: GICs were up 7% for the year ended in March; cash in chequing and savings accounts was up 5%.
So all that cash is poised to jump back into the market at the first salubrious sign, right? Incorrect, says CIBC. "The most likely scenario is that this cash will remain on the sideline for the remainder of the year, with 2004 seeing a gradual and hesitant move from cash into equities," the bank averred in a May report.
Ironically, the Bank of Canada's efforts to control inflation, so far considered a bright spot on the economic horizon, could turn out to have worked too well. Raising interest rates keeps the economy in check by raising prices and discouraging spending. But a little inflation is needed to keep the economy growing. A slowdown in demand for goods and services depresses prices and can become self-perpetuating: Consumers postpone purchases in expectation of still lower prices. Hello, deflation.
Bank of Canada governor David Dodge discounts that scenario, it seems. But last January, the bank forecast that inflation would remain above the bank's 2% target in the first half of 2003, one reason being the upheaval in the Middle East, which it called a "one-off" factor. The bank's forecast, however, was made before the country's biggest airline became insolvent, the situation in Iraq came to a head, and Canada was cursed by SARS and mad cow disease.
One-off, indeed.
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Heed the warning signs
Lousy markets for investors-created in part by reluctant investors themselves-have been just as lousy for pension funds, both institutional and corporate. During the boom, managers got used to generating an annual 7% or so just by slipping their portfolios into cruise control. Now, suddenly, pensions are a crash scene. A Report on Business survey in May found that the aggregate funding deficit of the pension funds sponsored by 104 companies in the S&P/TSX index has ballooned to $18.7 billion-an average of a whopping $180 million per company.
Things won't get better fast. Regulations permit funds to take a number of years to make up a deficit. But in the absence of the frothy markets of the past, that money is not coming from investments. Instead, plan sponsors are having to ante up more cash, diverting dollars that could otherwise be used for growth.
When you're finished contemplating the effect of increased pension contributions, spare a moment for another Zeitgeist worry: options. Companies argue that options are an incentive to management to drive up the share price, benefiting all shareholders. Critics counter that options represent a cost to all shareholders, since to cover option obligations, companies either have to issue more stock, thereby diluting shareholders' equity, or buy shares at the market price and then sell them for less to holders of options. Establishing the true cost to the company has been difficult. But under new financial reporting standards proposed by the Canadian Institute of Chartered Accountants' Accounting Standards Board, companies will at least have to take a stab at it and indicate the amount as an expense.
To be sure, the value of options is usually given in footnotes, which most investors don't read. Bombardier Inc.'s annual report reveals that its option plan would have cost $6.6 million last year had it been treated as an expense. But if it was supposed to spur management performance, it failed dismally: The company's loss for the year was $615.2 million. Meanwhile, on the pension front, Bombardier also intends to contribute an extra $50 million to its pension plan, for a total of $260 million in the year, in an effort to reduce its nearly $2.7-billion deficit. In fact, remove option costs from profits, and some Top 1000 companies wouldn't make the list.
As 2002 is the first year that employee option expenses are being disclosed (in advance of the required expensing of options, which is proposed for 2004), the numbers are bound to draw fire from shareholders as they're released. Nortel Networks' pro forma stock-option expense of $952 million (U.S.) will be difficult to ignore. So will those of some Top 10 companies in this year's ranking, such as Bank of Nova Scotia ($58 million), Manulife Financial ($48 million) and EnCana ($80 million).
As the market becomes more aware of options' drain on earnings, it's conceivable that companies will phase them out. Already, credit rating agencies-the guys who have clout-are regarding the pension deficits of some companies as akin to debt and downgrading their ratings accordingly.
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Insist on real earnings
Though claimed by their users to be a measure of financial health, pro forma earnings (unaudited results that don't include such things as the write-off of goodwill) and EBITDA (earnings before interest, taxes, depreciation and amortization) mainly gussy up earnings, giving the impression that they equate somehow to profit. In truth, they ignore a lot of things, like, for instance, massive restructuring costs that management deigns to consider a one-time occurrence. Or, to give another example, the possibility that taxes or interest will eat all the profit, creating a loss.
Stuff like that actually happens. Conrad Black's Hollinger International Inc. announced in guidance last February that its EBITDA for 2002 would be between $110 million (U.S.) and $120 million (U.S.). In fact, it would probably be toward the low end of the range, the company modestly allowed. True enough: The figure turned out to be $111.4 million. But Hollinger's subsequent annual report, which must comply with generally accepted accounting principles (GAAP), revealed the company wasn't being nearly modest enough. It reported a net loss of $238.8 million (U.S.).
Securities regulators suggest that EBITDA, as well as earnings described as operating, pro forma, cash or adjusted, should be approached warily. Since companies can define them as they please, the Canadian Securities Administrators, the umbrella group for provincial regulators, points out that such earnings "present only part of the picture and may selectively omit certain expenses, resulting in a more positive portrayal of a company's performance."
Even so, EBITDA and pro forma reporting isn't banned. Rather, Canadian companies have to reconcile their pro forma statements with the audited ones. That of late fewer companies are brazenly parading pro forma numbers in public is at least a small step in the right direction.
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Don't count on the cops
Individual and corporate investors are not known for broadcasting their own contributions to the outward rush of an ebbing market. But they don't mind fingering overzealous investment bankers and their lapdog analysts, greedy CEOs and complicit auditors. And, not to be forgotten, weak-kneed regulators.
Three years after the fact, regulators-along with opportunistic lawyers and politicians-are claiming to be cleaning up the scummy residue left over from markets' high-water mark. The biggest headline-grabber was the probe into conflicts of interest at leading investment banks spearheaded by New York State Attorney General Eliot Spitzer. But the results may not be enough to lure investors back into the market. The fines-negotiated, not imposed-totalled $1.4 billion (U.S.), a pittance for Wall Street. Nor was it confidence-building that the probe snagged just two equities analysts (out of thousands) for pumping stocks they privately regarded as "POS" (as in Piece of ...).
Still, the stricter standards that emerged-research is to be kept separate from underwriting, for instance-will at least apply to how Wall Street handles the 174 Canadian companies that are quoted on stock markets in both countries, and probably to others. It's doubtful, though, that these rules will lead to more rigour: The principles being applied are the same as the ones already in place, which regulators haven't proved especially adept with. It was back in 1999 that the Ontario Securities Commission first alleged that former Corel Corp. CEO Michael Cowpland's holding company had made potentially illegal insider trades, saving him millions when Corel's forecast profits turned into actual losses. Four years later, the case still drags on, thanks largely to the OSC's inability to settle on an appropriate penalty.
The U.S. inquiry also led to a rule forbidding underwriters from snaring underwriting business by bribing executives of one company with IPO shares of another. This shouldn't even have to be codified. But the rule is also academic, given that investors have soured on new issues. Unless the new issue happens to be an income trust, that is.
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Trust in income
Income trusts, also known as income funds, have become the instrument of choice for companies seeking to raise capital. Instead of trying to sell common shares to a loss-battered public, a company forms a trust to buy its operating entity. The underlying business can be anything from real estate to seafood. The trust owning the business sells units to investors, who receive all or most of the operating entity's cash after expenses.
Trusts have enraptured investors, especially the retail variety disenchanted by sagging portfolios of common shares and the low interest rates paid by bonds. Income trusts accounted for 88% (by value) of the IPOs on the TSX last year. And unlike equities, they've pretty much met investor expectations; the sometimes oddball businesses involved generally have kicked out their targeted 8% to 12% yield to unitholders.
Clearly, doling out most of the cash flow to unitholders has a downside for the trust management, as it takes careful planning to ensure that enough funds remain to run the business, never mind expand it. Trusts typically don't offer options, either.
But for investors, those restrictions are an upside. Unlike the leaders of companies owned by shareholders, an income trust's management can't take flyers on overpriced acquisitions or fluky forays into new businesses. Few shareholders of broadcaster CanWest Global, for example, are fans of management's spending billions to buy newspapers, saddling the company with debt and halving the stock price in the process.
In the face of speculation that the trust sector of the market is overheated and due to cool, the numbers have been impressive. The compound annual growth rate of the S&P/TSX Total Return Index from March 31, 2000, to March 31, 2003, was -11.1%. Yet the Scotia Capital Income Trust Index was up 23.9% over the same period.
There may be some more good news for trusts on the way. The potential unlimited liability of unitholders for such things as actions against the business behind the trust has spooked some institutional investors. It has also kept trusts off the S&P/TSX index, the principal aggregation that index funds track. But Ontario has promised legislation that will limit unitholders' liability. And while it might be too much for pension funds to expect that trusts will bail them out of their deficit positions, they might come to view them as retail investors do: the only thing around generating a return.
