goes, 'In the end, everything is a toaster'. If this means that the forecast needs to be a very long one, so be it - it will be less inaccurate than running a valuation off an accurate five year forecast, and then extrapolating this to infinity.
4. Don't spend too much time worrying about financial efficiency.
Playing mathematical games with the weighted average cost of capital is tempting and fun, but generally has a disappointingly small effect on valuation. Substituting debt for equity shifts value from the government to the providers of capital because the company pays less tax. That is it. And even then there is an offsetting factor - it is more likely to incur everyone the inconvenience of going bankrupt.
5. Remember the ‘Polly Peck phenomenon’, especially in countries with high inflation.
If a company operates in a weak currency with high inflation, its revenues, costs and profits will probably grow quickly. If it funds itself by borrowing in a strong currency, with low interest rates, it will pay little interest, but will tend to make large unrealised currency losses on its debt. It may still be looking very profitable on the day that it is declared insolvent.
6. Unfunded pension schemes should be treated as debt.
Many companies fund their employees’ pensions by paying into schemes operated by independent fund managers. These schemes are off their balance sheets. Some companies operate a ‘pay-as-you-go’ system. They will show a provision for pension liabilities on their balance sheets, generally offset by a pile of cash among their assets. These companies are effectively borrowing from their employees - the provision should be treated as debt.
7. Remember to ask: ‘Who's cash flow is it anyway?’
Companies consolidate 100% of the accounts of their subsidiaries, even if they only own 51% of the shares in the subsidiary. In the profit and loss account the profit that is not attributable to their shareholders is deducted and shown as being attributable to third parties. Unless it is paid out in dividend, however, the cash remains inside the company. This means that the popular ‘cash flow per share’ measure implies that the shares should be valued by including something that does not belong to them - they should not.
8. Accounting depreciation is a poor measure of impairment of value.
If an asset is bought for £100 and has a five year life then it will be depreciated at a rate of £20 a year. This is not the same as saying that its value falls at a rate of £20 a year. The result is that the profitability of the asset is generally understated early in its life and overstated later in its life. This means that companies’ profitability tends to be understated when they grow, and overstated when they stop growing.
9. You can’t judge an acquisition by whether it adds to earnings.
Acquisitions are just very big, very long term, investments. So they are extreme examples of the rule mentioned above that new investments tend to look unprofitable in the early years. This does not mean that they are bad investments. Company managers have preferred not to explain this awkward fact, but to evade it by using accounting tricks to avoid creating and amortising goodwill. New accounting rules are increasingly making this more difficult. It should not matter, but managers still believe that it does.
10. Operating leases are debt - they just don’t look like it.
Companies often lease assets - aeroplanes, ships or hotels, for example. If the lease effectively transfers the asset, it is a finance lease, and looks like debt in the accounts. If it doesn’t then the lease just appears as rental payments in the operating costs. But it is still debt, and the shares will still reflect that fact, being much more volatile than it looks as if they ‘ought’ to be.
‘The backlash against analysts is in full swing. Don’t be diverted by the spectacle, however enjoyable it might appear. Use the research available dispassionately. As in all human life, you’ll find there’s good and bad there. Just be sure, once you’ve digested, to formulate your own conclusions.’
Edmond Warner
Martin Barnes
Martin Barnes is Managing Editor of The Bank Credit Analyst. He has almost 30 years of experience in analyzing and writing about global economic and financial market developments. In recent years, he has written extensively about new technologies and long-wave cycles, the financial market implications of low inflation and trends in corporate profitability.
General principles and the role of liquidity
1. Know when to be a contrarian.
The crowd is often correct for long periods of time, so it does not always pay to be a contrarian. The time to bet against the crowd is when market prices deviate significantly from underlying fundamentals. For example, gold has been in a bear market for years and it has been correct to stay negative toward the market given the falling trend of inflation. Contrarian strategies have not worked. On the other hand, the surge in technology stocks in 1999/2000 in the face of suspect earnings trends clearly provided an excellent opportunity to take a contrarian stance and this paid huge dividends when the bubble inevitably burst.
2. Don’t use yesterday’s news to forecast tomorrow’s markets.
Many people make the mistake of forecasting the stock market on the basis of current economic data (which usually relate to developments of at least a month ago). This is a mistake because the stock market leads rather than follows the economy. It makes more sense to use the stock market as an indication of what the economy is likely to do in the future. By the time that the economic data has confirmed a trend, the market is often discounting the next phase of the cycle. The market is forward looking while economic data are backward looking.
3. Liquidity is key.
All great bull markets are rooted in easy money. Stimulative monetary conditions mean low interest rates that, in turn, encourage investors to take on more risk. Buoyant liquidity will always find its way into asset markets, pushing prices higher. The corollary is that a bull market cannot persist in the face of tightening liquidity. Thus, investors must pay close attention to the factors that drive monetary policy.
4. Understanding the inflation trend is critical to success.
Following on from the previous rule, inflation is the single most important economic variable when it comes to predicting the trends in financial markets. Rising inflation is toxic for both bonds and stocks because it points to tighter monetary policy and rising interest rates. On the other hand, falling inflation is extremely bullish for the opposite reasons. Most bear markets have occurred in response to rising inflation pressures. Correspondingly, falling inflation was the single most important force behind the powerful bull markets in bonds and stocks during the 1980s and 1990s.
5. Take a long-run view.
An increased focus on the short run has become one of the scourges of modern life. Companies are often more obsessed with propping up near-term earnings than with taking long-term strategic decisions,
