I read nearly one thousand 10-ks (a company’s annual financial statement and related disclosures) each year. Typically a bland legal document filed with the SEC, the 10-k offers facts about the business, risks a company is facing, and what its future may hold.
Most years, the information provided consists of distilled facts with little additional insight. In contrast, the current crop of reports is anything but typical. With the Federal Reserve (Fed) moving the economy toward a bold new approach of money creation, 10ks reflect an uncertain future. As I read each report, I am surprised with some key developments that shape not only business today, but what we should expect in the future.
While the companies I study vary greatly, these five general themes are obvious:
- Credit is liquidity – I have warned in the past that both corporate and individual borrowers often view available credit as cash on hand. As consumers have seen their ability to borrow curtailed, many have changed their view. Unfortunately, corporate borrowers have not. American Express (AXP) highlights a credit facility that allows them to sell $5 billion of credit card receivables as a key component of their liquidity strategy. As we have learned before, and most likely will relearn many times again, credit-reliant borrowers often see needed credit disappear at the worst possible time. Many companies have yet to absorb this lesson.
- Mistimed share buybacks – Companies often tout share buybacks as an effective method of returning capital to shareholders. However, these companies often fail. Many bought back their shares early in the year when prices were high and suspended the buyback when prices fell. For example, SunTrust (STI) repurchased its shares at an average cost of $61.82 over the first five months of the year, but took no action as the stock slid to $29.54 by the end of 2008 and $6.70 in February 2009. While I am in favor of companies returning capital to shareholders, the current process of buying over-inflated shares yet taking no action when prices are declining does not work.
- Little clarity – Companies often offer a range of expected profitability for the year ahead. This time no such guidance appeared. From Intel (INTC) to Hershey (HSY), visibility is low and the future is unknown.
- Poor earnings quality – In boom times, earnings are clean. A company pays cash for a product, receives cash on sale, and sees an increasing income accompanied by an improving balance sheet. 2008 did not offer such clarity. Earnings quality is declining. An example would be Morgan Stanley (MS). For 2008, MS posted income of $1.7 billion on net revenue of $24.7 billion. Given the environment in which they operated this is impressive. However, a little digging shows that $5.6 billion of that revenue (23%) came from the declining value of MS’s own debt. By carrying this liability at fair value, MS’s declining business prospects boosted its bottom line. Only in the crazy world of FASB fair value accounting do a shrinking stock price and widening credit spreads yield more net income.
- Pension time bomb – Another byproduct of GAAP accounting is the mistreatment of pension plans. If we view our 401ks as a personal pension plan, market action has a direct effect. When markets decline, our portfolio value shrinks and we are faced with a funding shortfall. Corporations do not have the same problem. By allowing actuarial calculated gains to be reflected in the pension funding status, companies can ignore the market and publish numbers based on their assumptions. Consider Time Warner (TWX). With an allocation of 56% equities, 24% bonds, and 20% cash, TWX’s pension assets declined 36% in 2008. However, its pension obligation recorded an actuarial gain of 3%. Eventually actual versus modeled results will be brought in line, but until then corporate balance sheets offer an example of the mark-to-model practices that triggered the current recession.
Witnessing these five trends, I remain concerned for the future. While policymakers continue pulling each lever they can find to halt the recession and drive stock prices higher, I question their ability to succeed.
- If printing wealth worked, why do would any of us work?
- If governments can deliver via computer screen all the tangible goods people desire, why is there poverty?
As the current money creation experiment continues, we are well served to remember that creation of wealth comes from corporations serving consumer needs and innovating. Only when we return to this fundamental basis will the economy permanently recover. When that time comes, the five trends I note above will reverse themselves and solid business fundamentals will create a long-lasting recovery.
Sean Hannon, CFA, CFP is a professional fund manager.
Other recent posts by Sean:
- When to Double Down on a Losing Position
- 5 big 2009 Market Predictions
- Understanding Trading Channels on Stock Charts
- 5 Lessons from the Credit Crisis
View all Posts by Sean Hannon.