stocks (Part 2)

Option Compensation - Part One
In the debate over whether or not options are a form of compensation, many use esoteric terms and concepts without providing helpful definitions or a historical perspective. This article will attempt to provide investors with key definitions and a historical perspective on the good, the bad and the ugly characteristics of options.

In part two, we discuss the debate over whether or not options should be expensed.
Definitions
Before we get to the good, the bad and the ugly, we need to understand some key definitions:

Options - An option is defined as the right (ability), but not the obligation, to buy or sell a stock. Companies award (or "grant") options to their employees. These allow the employees the right to buy shares of the company at a set price (also know as the "strike price" or "award price") within a certain span of time (usually several years). The strike price is usually, but not always, set near the market price of the stock on the day the option is granted. For example, Microsoft can award employees the option to buy a set number of shares at $50 per share (assuming that $50 is the market price of the stock on the date the option is granted) within a period of three years. The options are earned (also referred to as "vested") over a period of time.

The Valuation Debate: Intrinsic Value or Fair Value Treatment - How to value options is not a new topic, but a decades-old question. It became a headline issue thanks to the dotcom crash. In its simplest form, the debate centers around whether to value options intrinsically or as fair value:
1. Intrinsic Value - The intrinsic value is the difference between the current market price of the stock and the exercise (or "strike") price. For example, if Microsoft's current market price is $50 and the option's strike price is $40, the intrinsic value is $10. The intrinsic value is then expensed during the vesting period.
2. Fair Value - According to FASB 123, options are valued on the award date by using an option-pricing model. A specific model is not specified, but the most widely used is the Black-Scholes model. The "fair value", as determined by the model, is expensed to the income statement during the vesting period.

The Good
Granting options to employees was viewed as a good thing because it (theoretically) aligned the interests of the employees (normally the key executives) with those of the common shareholders. The theory was that if a material portion of a CEO's salary were in the form of options, she or he would be incited to manage the company well, resulting in a higher stock price over the long term. The higher stock price would benefit both the executives and the common shareholders. This is in contrast to a "traditional" compensation program, which is based upon meeting quarterly performance targets, but these may not be in the best interests of the common shareholders. For example, a CEO who could get a cash bonus based on earnings growth may be incited to delay spending money on marketing or research and development projects. Doing so would meet the short-term performance targets at the expense of a company's long-term growth potential.

Substituting options is supposed to keep executives eyes on the long term since the potential benefit (higher stock prices) would increase over time. Also, options programs require a vesting period (generally several years) before the employee can actually exercise the options.

The Bad
For two main reasons, what was good in theory ended up being bad in practice. First, executives continued to focus primarily on quarterly performance rather than on the long term because they were allowed to sell the stock after exercising the options. Executives focused on quarterly goals in order to meet Wall Street expectations. This would boost the stock price and generate more profit for executives on their subsequent sale of stock.

One solution would be for companies to amend their option plans so that the employees are required to hold the shares for a year or two after exercising options. This would reinforce the longer-term view because management would not be allowed to sell the stock shortly after options are exercised.

The second reason why options are bad is that tax laws allowed managements to manage earnings by increasing the use of options instead of cash wages. For example, if a company thought that it could not maintain its EPS growth rate due to a drop in demand for its products, management could implement a new option award program for employees that would reduce the growth in cash wages. EPS growth could then be maintained (and the share price stabilized) as the reduction in SG&A expense offsets the expected decline in revenues.

The Ugly
Option abuse has three major adverse impacts:
• Oversized rewards given by servile boards to ineffective executives - During the boom times, option awards grew excessively, more so for C-level (CEO, CFO, COO, etc.) executives. After the bubble burst, employees, seduced by the promise of option package riches, found that they had been working for nothing as their companies folded. Members of boards of directors incestuously granted each other huge option packages that did not prevent flipping, and in many cases, they allowed executives to exercise and sell stock with less restrictions than those placed upon lower-level employees. If option awards really aligned the interests of management to those of the common shareholder, why did the common shareholder lose millions while the CEOs pocketed millions?
• Repricing options rewards underperformers at the expense of the common shareholder - There is a growing practice of re-pricing options that are out of the money (also known as "underwater") in order to keep employees (mostly CEOs) from leaving. But should the awards be re-priced? A low stock price indicates the management has failed. Repricing is just another way of saying "bygones", which is rather unfair to the common shareholder, who bought and held their investment. Who will reprice the shareholders' shares?
• Increases in dilution risk as more and more options are issued - The excessive use of options has resulted in increased dilution risk for non-employee shareholders. Option dilution risk takes several forms:

• EPS dilution from an increase in shares outstanding - As options are exercised, the number of outstanding shares increases, which reduces EPS. Some companies attempt to prevent dilution with a stock buyback program that maintains a relatively stable number of publicly traded shares.
• Earnings reduced by increased interest expense - If a company needs to borrow money to fund the stock buyback, interest expense will rise, reducing net income and EPS.
• Management dilution - Management spends more time trying to maximize its option payout and financing stock repurchase programs than running the business.
Conclusion
Options are a way to align the interests of employees with those of the common (non-employee) shareholder, but this happens only if the plans are structured so that flipping is eliminated and that the same rules about vesting and selling option-related stock apply to every employee, whether C-level or janitor.

The debate as to what is the best way to account for options will likely be a long and boring one. But here is a simple alternative: if companies can deduct options for tax purposes, the same amount should be deducted on the income statement. The challenge is to determine what value to use. By believing in the KISS (keep it simple, stupid) principle, value the option at the strike price. The Black-Scholes option-pricing model is a good academic exercise that works better for traded options than stock options. The strike price is a known obligation. The unknown value above/below that fixed price is beyond the control of the company and is therefore a contingent (off-balance-sheet) liability.

Alternatively, this liability could be "capitalized" on the balance sheet as a liability. The balance sheet concept is just now gaining some attention and may prove to be the best alternative because it reflects the nature of the obligation (a liability) while avoiding the EPS impact. This type of disclosure would also allow investors (if they desire) to do a pro forma calculation to see the impact on EPS.

Option Compensation - Part Two

The question of whether or not to expense options has been around for as long as companies have been using options as a form of compensation. But the debate really heated up in the wake of the dotcom bust. This article will look at the debate and propose a solution. Before we discuss the debate, we need to review what options are and why they are used as a form of compensation.

You can read the first part of this series here.
Why Options Are Used As Compensation
Using options instead of cash to pay employees is an attempt to "better align" the interests of the managers with those of the shareholders. Using options is supposed to prevent management from maximizing short-term gains at the expense of the long-term survival of the company. For example, if the executive bonus program consists solely of rewarding management for maximizing near-term profit goals, there is no incentive for management to invest in the research & development (R&D) or capital expenditures required to keep the company competitive over the long term. Managements are tempted to postpone these costs to help them make their quarterly profit targets. Without the necessary investment in R&D and capital maintenance, a corporation can eventually lose its competitive advantages and become a money-loser. As a result, managers still receive their bonus pay even though the company's stock is falling. Clearly, this type of bonus program is not in the best interest of the shareholders who invested in the company for long-term capital appreciation. Using options instead of cash is supposed to incite the executives to work so the company achieves long-term earnings growth, which should, in turn, maximize the value of their own stock options.

How Options Became Headline News
Prior to 1990, the debate over whether or not options should be expensed on the income statement was limited mostly to academic discussions for two main reasons: limited use and the difficulty of understanding how options are valued. Option awards were limited to "C-level" (CEO, CFO, COO, etc.) executives because these were the people who were making the "make-or-break" decisions for the shareholders. The relatively small number of people in such programs minimized the size of the impact on the income statement, which also minimized the perceived importance of the debate. The second reason there was limited debate is that it requires knowing how esoteric mathematical models valued options. Option pricing models require many assumptions, which can all change over time. Because of their complexity and high level of variability, options cannot be explained adequately in a 15-second soundbite (which is mandatory for CNBC). Accounting standards do not specify which option-pricing model should be used, but the most widely used is the Black-Scholes option-pricing model.

Everything changed in the mid-1990s. The use of options exploded as all types of companies began using them as a way to finance growth. The dotcoms were the most blatant users (abusers?) - they used options to pay employees, suppliers and landlords. Dotcom workers sold their souls for options as they worked slave hours with the expectation of making their fortunes when their employer became a publicly-traded company. Option use spread to non-tech companies because they had to use options in order to hire the talent they wanted. Eventually, options became a required part of a worker's compensation package.

By the end of the 1990s, it seemed everyone had options. But the debate remained academic as long as everyone was making money. The complicated valuation models kept the business media at bay. Then everything changed, again.

The dotcom crash witch-hunt made the debate headline news. The fact that millions of workers were suffering from not only unemployment but also worthless options was widely broadcast. The media focus intensified with the discovery of the difference between executive option plans and those offered to the rank and file. C-level plans were often re-priced, which let CEOs off the hook for making bad decisions and apparently allowed them more freedom to sell. The plans granted to other employees did not come with these privileges. This unequal treatment provided good soundbites for the evening news, and the debate took center stage.

The Impact on EPS Drives the Debate
Both tech and non-tech firms have increasingly used options instead of cash to pay employees. Expensing options significantly reduces EPS in two ways. First, it reduces expenses because GAAP does not require stock options to be expensed. Second, it reduces taxes because companies are allowed to deduct this expense for tax purposes. A study done by Bear Stearns (Accounting Issues, July 2002) estimates that, had the fair value of stock options been expensed in 2001, the aggregate diluted EPS for the S&P 500 would have been reduced 20%. Faced with such a sizable hit to EPS when earnings are already under pressure due to a weak economy, companies are, not surprisingly, reluctant to expense options.

The Debate Centers on the "Value" of the Options
The debate over whether or not to expense options centers on their value. Fundamental accounting requires that expenses be matched with the revenues they generate. No one argues with the theory that options, if they are part of compensation, should be expensed when earned by employees (vested). But how to determine the value to be expensed is open to debate.

At the core of the debate are two issues: fair value and timing. The main value argument is that, because options are difficult to value, they should not be expensed. The numerous and constantly changing assumptions in the models do not provide fixed values that can be expensed. It is argued that using constantly changing numbers to represent one expense would result in a "mark-to-market" expense that would wreck havoc with EPS and only further confuse investors. (Note: This article focuses on fair value. The value debate also hinges on whether to use "intrinsic" or "fair" value.)

The other component of the argument against expensing options looks at the difficulty of determining when the value is actually received by the employees: at the time it is given (awarded) or at the time it is used (exercised)? If today you are given the right to pay $10 for a $12 stock but do not actually gain that value (by exercising the option) until a later period, when does the company actually incur the expense? When it gave you the right, or when it had to pay up?

These are difficult questions, and the debate will be ongoing as politicians try to understand the intricacies of the issues while making sure they generate good headlines for their re-election campaigns. But I propose a simpler solution.
Eliminating options and directly awarding stock can resolve everything. This would eliminate the value debate and do a better job of aligning management interests with those of the common shareholders. Because options are not stock and can be re-priced if necessary, they have done more to entice managements to gamble than to think like shareholders.

The Bottom Line
Options have not worked, and the current debate clouds the key issue of how to make executives more accountable for their decisions. Using stock awards instead of options would eliminate the option for executives to gamble (and later re-price the options), and it would provide a solid price to expense (the cost of the shares on the day of the award). It would also make it easier for investors to understand the impact on both net income as well as shares outstanding.

In-Process R&D Charge Offs: The Bad and the Ugly

When we examine a rule from generally accepted accounting principles (GAAP), we normally try to look at the good, the bad and the ugly. However, in the case of in-process R&D we can find no "good". This article will provide investors with a definition of in-process R&D charge offs that can be used to make better investment decisions.
Defined
Under GAAP, when one company acquires another firm, it generally pays more than book value. The excess over book value is called goodwill, and it is allocated to all the assets that are acquired. If an acquired company is developing a new product, but that product is not yet being sold, GAAP requires that the goodwill allocated to that product be immediately charged off, even if the product is expected to hit the market within a relatively short time.

For example, assume International Blowfish acquired Fugu Inc. for $1.5 million. Fugu is developing a software product, which is its major asset. Blowfish determined that $900,000 of the purchase price should be allocated to the software product. This amount is considered "in-process" R&D because the software is not yet ready for sale as of the closing date of the acquisition. The software may be only weeks away from being introduced to the market, but GAAP requires Blowfish to charge off the $900,000. This charge will reduce earnings by $0.02 per share, a fact that management discloses in its discussion of pro forma EPS.

Paying top dollar for another company only to turn around and charge off a large portion of the price tag causes many investors to wonder if it was worth making the acquisition. And in the above example, it really doesn't seem to be logical, especially since the product was almost ready to be introduced to the market. Despite the fact that this is really a timing issue, it is required under GAAP, and FAS 142 does not eliminate this rule (because it applies to patentable assets).

The Bad
The bad thing about this rule is that it really doesn't make sense, and it distorts "real" results. One of the core principles of accounting is to match costs and the revenues they create. That is why an investment in a plant or developing software is generally amortized over its useful life and is matched against the revenues that plant or product generates.

In-process R&D charges are really a front-loading of expenses, which understates current results while overstating future earnings. This amount that is charged off in the current quarter would have normally been amortized over the useful life of the software. Consequently, as the software generates sales in the coming quarters, the expenses related to developing that technology will not be amortized (matched) against that revenue, thus overstating EPS.
The Ugly
Things gets ugly when companies use in-process R&D to manipulate earnings. Allocating goodwill is a guessing game and GAAP gives accountants a lot of leeway (the infamous gaps in GAAP). Management can decide to front-load expenses (overstating the allocation to in process R&D), to the benefit of future earnings.

Investors need to see if the company has hired an outside consultant to examine the facts and allocate goodwill. Hiring an outside consultant/accountant could indicate that management is making an effort to get it right, but this does not necessarily prevent the company from front-loading expenses.

Conclusion
In-process R&D must be recognized for what it is: a bad rule that is based more on timing issues than logic. It distorts operating results, making it harder for investors to analyze companies. It is also another gap in GAAP that companies can use to manipulate EPS.

Using The Cash Conversion Cycle

A timeless piece of advice for investors will always be to stick to the fundamentals. Why do fundamentals matter? Well, in the end, a solid company with strong fundamentals and a management team who is consistent and accountable to investors will likely remain a good long-term company. In other words, your average S&P 500 blue chip firm will likely still be around and their business will, to some degree, grow whether in an up or down market. Additionally, the way the large players of the institutional arena operate attests to the importance of fundamentals. The asset management wings of these heavyweights are not buying tens of millions of shares based on a hunch or whim. They derive model valuations based on fundamentals. In this article, we'll provide an overview of one important fundamental metric: the cash conversion cycle.

What Is the Cash Conversion Cycle?
Speculative trading bubbles will likely come and go, and pure anxiety and sentiment from investors of all sizes will always factor into the market. It is, however, no secret that to pick a solid performer when the market is slow or under attack takes a little more know-how. The cash conversion cycle (a.k.a. net operating cycle), can tell you how cash is moving through a company in terms of duration. This ratio is vital because the cycle represents the number of days a firm's cash remains tied up within the operations of the business

The cash conversion cycle is a derived ratio and is generally not part of ratio comparison sections found in financial portals or websites. You can, however, construct the three ratios that compose the calculation of the cash conversion cycle by taking a little time to look at a firm's inventory, receivables and payables:

Cash Conversion Cycle (or Net Operating Cycle) = Average Inventory Collection Period + Average Receivables Processing Period – Average Payables Period

Most financial websites will present these components in a standard ratio comparison, so you need not worry about deriving the ratio independently.

The cash conversion cycle simply indicates the duration of time it takes the firm to convert its activities requiring cash into cash returns. Therefore, a downward trend in this cycle is a positive signal while an upward trend is a negative signal. Why is this so? When the cash conversion cycle shortens, cash becomes free for other uses such as investing in new capital, spending on equipment and infrastructure, as well as preparing for possible share buybacks down the road. On the flip side, when the cash conversion cycle lengthens, cash remains tied up in the firm's core operations, leaving little leeway for other uses of this cash flow. Below is a numerical example of this calculation:


For demonstration purposes, we have steadily held the payables processing period at 72 days. It is clear from the above example that the firm's financial condition, from the perspective of the cash conversion cycle, has improved. Inventory processing and accounts receivable turnover has improved for firm A from year one to year three, implying that the processing period of each has declined.

Conclusion
In taking the time to find the cash conversion cycle, pay attention to the trend of its three general components, with special emphasis on the payables processing period. Sometimes shorter processing periods for inventory and/or receivables can be largely offset by increases in the processing period for accounts payables. The processing period for accounts payables will increase if the firm is paying its creditors and suppliers at a slower rate. The main point to remember, however, is that an understanding of each of the three factors in the formula can help pinpoint the trend not only in the cash conversion cycle but also in the individual processing periods themselves, insights that can give both a synopsis of operational efficiency and the justification behind it.
In-Process R&D Charge Offs: The Bad and the Ugly

When we examine a rule from generally accepted accounting principles (GAAP), we normally try to look at the good, the bad and the ugly. However, in the case of in-process R&D we can find no "good". This article will provide investors with a definition of in-process R&D charge offs that can be used to make better investment decisions.
Defined
Under GAAP, when one company acquires another firm, it generally pays more than book value. The excess over book value is called goodwill, and it is allocated to all the assets that are acquired. If an acquired company is developing a new product, but that product is not yet being sold, GAAP requires that the goodwill allocated to that product be immediately charged off, even if the product is expected to hit the market within a relatively short time.

For example, assume International Blowfish acquired Fugu Inc. for $1.5 million. Fugu is developing a software product, which is its major asset. Blowfish determined that $900,000 of the purchase price should be allocated to the software product. This amount is considered "in-process" R&D because the software is not yet ready for sale as of the closing date of the acquisition. The software may be only weeks away from being introduced to the market, but GAAP requires Blowfish to charge off the $900,000. This charge will reduce earnings by $0.02 per share, a fact that management discloses in its discussion of pro forma EPS.

Paying top dollar for another company only to turn around and charge off a large portion of the price tag causes many investors to wonder if it was worth making the acquisition. And in the above example, it really doesn't seem to be logical, especially since the product was almost ready to be introduced to the market. Despite the fact that this is really a timing issue, it is required under GAAP, and FAS 142 does not eliminate this rule (because it applies to patentable assets).

The Bad
The bad thing about this rule is that it really doesn't make sense, and it distorts "real" results. One of the core principles of accounting is to match costs and the revenues they create. That is why an investment in a plant or developing software is generally amortized over its useful life and is matched against the revenues that plant or product generates.

In-process R&D charges are really a front-loading of expenses, which understates current results while overstating future earnings. This amount that is charged off in the current quarter would have normally been amortized over the useful life of the software. Consequently, as the software generates sales in the coming quarters, the expenses related to developing that technology will not be amortized (matched) against that revenue, thus overstating EPS.
The Ugly
Things gets ugly when companies use in-process R&D to manipulate earnings. Allocating goodwill is a guessing game and GAAP gives accountants a lot of leeway (the infamous gaps in GAAP). Management can decide to front-load expenses (overstating the allocation to in process R&D), to the benefit of future earnings.

Investors need to see if the company has hired an outside consultant to examine the facts and allocate goodwill. Hiring an outside consultant/accountant could indicate that management is making an effort to get it right, but this does not necessarily prevent the company from front-loading expenses.

Conclusion
In-process R&D must be recognized for what it is: a bad rule that is based more on timing issues than logic. It distorts operating results, making it harder for investors to analyze companies. It is also another gap in GAAP that companies can use to manipulate EPS.
Old Stock Certificates: Lost Treasure Or Wallpaper?

Have you ever found or inherited a stock certificate for a company? What if you've never heard of the company before? Well, here we go over how you can find out whether you were left a fortune waiting to be claimed, or just a piece of paper ready for the recycling bin.
Stocks in Physical Form
The happening upon old stock certificates is actually more common than you might think. In the past, investors received physical certificates (referred to as in bearer form) when they bought stock. The problem over old stock certificates doesn't arise very often anymore because most stocks are kept in electronic form in your broker's computer system (which is known as in street name).

So, if you find an old certificates it's important that you know where to start looking to see if your discovery is merely wallpaper from a bankrupt company or a lost treasure. Rather than throwing away the piece of paper that might be your lottery ticket, take the time and do the research.

The Key Pieces of Information
First things first: you need to take a look at a few things on the certificate. Look for the company name and location of incorporation, a CUSIP number (explained in detail below) and the name of the person with whom the security is registered. All of these items are important and can likely be found on the face of the certificate.

Company Name
If the company still exists, your search ends here. You can go to the library or use the internet to find out exactly what has happened to the company. Yahoo Finance has a good symbol lookup tool where you can search the name of the company for its ticker. The problem is that the name probably isn't the same. Unless your company is a household name, like General Electric, chances are that at some point the company either was bought out or changed its name due to a merger.

CUSIP Number
This piece of information provides a vital piece of information for searching out a security; it's like stock DNA. Each security has a unique and individual number (the CUSIP), and changes and splits are recorded accordingly. That is, every time a stock decides to change its name, split or do anything that will affect its stock certificate, a new number is assigned to it. By doing a search starting from the original number, we can find out the final/current equivalent of the security. Outside North America, other numbering systems are used, such as SEDOL or ISIN.

Most large discount brokerages are able to help clients track down securities that are defunct for over 10 years. With the CUSIP number the brokerage will be able to uncover all splits, reorganizations and name changes that have occurred throughout the life of the company. It will also be able to tell you whether the company is still trading or out of business.

Location of Incorporation
Should the previous two methods of searching for a company not pan out, the location of incorporation provides you with a last resort. Each stock is incorporated in a state, and the records are kept at a central location. Generally, incorporation will have to go through the Secretary of the State, and the name of the business will be documented in their databases. You should be able to contact the Secretary of the State and find out more information about your certificate. Keep in mind that a fee is usually charged for this service.

If you have been successful in finding all this information, you will need to locate the name of the transfer agent. The easiest method for this is to contact the company and ask it directly. You can usually find the number of the company or the name of the transfer agent on the company's website. Generally, publicly listed corporations have an investor-relations link on their sites.

The main reason that you need to go to a transfer agent is that companies rarely handle their own securities personally. They will rather have another company take care of the bookkeeping and issuing of securities. The transfer agent will have a record of the name of the person on the stock certificate; ownership can then be transferred to your name. This can be done many different ways; however, it's always best to contact the transfer agent and request instructions. Many of them are extremely picky.

If the company is no longer public, your search ends. In this case, there may be some legal repercussions, and you will need to speak to a lawyer. If the company has in fact changed names, merged, split, reversed split, reorganized, restructured or undergone any combination of these, you might have something to work with.

The Importance of Documentation
In the instance that you are inheriting some securities, ensure that the individual whose name is on the certificate has bequeathed it to you. A probated will with the necessary signatures of the executors may be required by the transfer agent before it will transfer ownership.

Once the certificates have been delivered back to you in your name, you are finished. Now you can deposit them with a broker and sell them accordingly.

Conclusion: Have Someone Else Do the Work for You
For those of you who have gone through all of these tips without any success, there are other means by which you can have your old stock certificates researched, but these ways will cost you some money.

For a fee, stock-search companies will do all of the investigation work for you and, if the certificate ends up having no trading value, they may offer to purchase it for a collector's value. Here are a couple of such companies: Scripophily.com and R.M Smythe.

Some of the companies listed above may also publish or help you find stock guides that may help you on your investigation of an old stock.

The Ups And Downs Of Investing In Cyclical Stocks

Think of being on a Ferris wheel: one minute you're on top of the world, the next you're at the bottom - and eager to head back up again. Investing in cyclical companies is much the same, except the the time it takes to go up and down, known as a business cycle, can last years.
What Are Cyclical Stocks?
Identifying these companies is fairly straightforward. They often exist along industry lines. Automobile manufacturers, airlines, furniture, steel, paper, heavy machinery, hotels and expensive restaurants are the best examples. Profits and share prices of cyclical companies tend to follow the up and downs of the economy; that's why they are called cyclicals. When the economy booms, as it did in the go-go '90s, sales of things like cars, plane tickets and fine wines tend to thrive. On the other hand, cyclicals are prone to suffer in economic downturns. (For more on the business cycle, see Recession: What Does It Mean To Investors?)

Given the up-and-down nature of the economy and, consequently, that of cyclical stocks, successful cyclical investing requires careful timing. It is possible to make a lot of money if you time your way into these stocks at the bottom of a down cycle just ahead of an upturn. But investors can also lose substantial amounts if they buy at the wrong point in the cycle.

Comparing Cyclicals to Growth Stocks
All companies do better when the economy is growing, but good growth companies, even in the worst trading conditions, still manage to turn in increased earnings per share year after year. In a downturn, growth for these companies may be slower than their long-term average, but it will still be an enduring feature.

Cyclicals, by contrast, respond more violently than growth stocks to economic changes. They can suffer mammoth losses during severe recessions and can have a hard time surviving until the next boom. But, when things do start to change for the better, dramatic swings from losses to profits can often far surpass expectations. Performance can even outpace growth stocks by a wide margin.

Investing in Cyclicals

So, when does it pay to buy them? Predicting an upswing can be awfully difficult, especially since many cyclical stocks start doing well many months before the economy comes out of a recession. Buying requires research and courage. On top of that, investors must get their timing perfect.

Investment guru Jim Slater offers investors some help. He studied how cyclical industries fared against key economic variables over a 15-year period. Data showed that falling interest rates are a key factor behind cyclicals' most successful years. Since falling rates normally stimulate the economy, cyclical stocks fare best when interest rates are falling. Conversely, in times of rising interest rates, cyclical stocks fare poorly. But Slater warns us to be careful: the first year of falling interest rates is also unlikely to be the right time to buy. He advises that it's best to buy in the last year of falling interest rates, just before they begin to rise again. This is when cyclicals tend to outperform growth stocks.

Before selecting a cyclical stock, it makes sense to pick an industry that is due for a bounce. In that industry, choose companies that look especially attractive. The biggest companies are often the safest. Smaller companies carry more risk, but they can also produce the most impressive returns.

Many investors look for companies with low P/E multiples, but for investing in cyclical stocks this strategy may not work well. Earnings of cyclical stocks fluctuate too much to make P/E a meaningful measure; moreover, cyclicals with low P/E multiples can frequently turn out to be a dangerous investment. A high P/E normally marks the bottom of the cycle, whereas a low multiple often signals the end of an upturn.


For investing in cyclicals, price-to-book multiples are better to use than the P/E. Prices at a discount to the book value offer an encouraging sign of future recovery. But when recovery is already well underway, these stocks typically fetch several times the book value. For instance, at the peak of a cycle, semiconductor manufacturers trade at three or four times book value.

Correct investment timing differs among cyclical sectors. Petrochemicals, cement, pulp and paper, and the like tend to move higher first. Once the recovery looks more certain, cyclical technology stocks, like semiconductors, normally follow. Tagging along near the end of the cycle are usually consumer companies, such as clothing stores, auto makers and airlines.

Insider buying, arguably, offers the strongest signal to buy. If a company is at the bottom of its cycle, directors and senior management will, by purchasing stock, demonstrate their confidence in the company fully recovering. (For more on how to research insider activity, see Keeping An Eye On The Activities Of Insiders And Institutions.)

Finally, keep a close eye on the company's balance sheet. A strong cash position can be very important, especially for investors who buy recovery stocks at the very bottom, where economic conditions are still poor. The company having plenty of cash gives these investors more time to confirm whether their strategy wisdom was a wise one.

Conclusion
Don't rely on cyclicals for long-term gains. If the economic outlook seems bleak, investors should be ready to unload cyclicals before these stocks tumble and end up back where they started. Investors stuck with cyclicals during a recession might have to wait five, 10 or even 15 years before these stocks return to the value they once had. Cyclicals make lousy buy-and-hold investments.
Earnings: Quality Means Everything

There is no debating that stocks with high-quality earnings are more likely than others to beat the market. High-quality earnings can be characterized as repeatable, controllable and bankable. So how do you know quality when you see it? Here we help you answer this question.
Quantity versus Quality
Earnings quantity (not quality) tends to get the lion's share of attention during quarterly reporting seasons. Investors focus on actual cents per share delivered, resulting either in share prices going up when companies beat earnings estimates, or falling when numbers come in below projection. At first glance at least, when it comes to earnings, size matters most to investors.

Savvy investors, however, take time to look at the quality of those earnings. The quality rather than quantity of corporate earnings is a much better gauge of future earnings performance.

Firms with high-quality earnings typically generate above-average P/E multiples. They also tend to outperform the market for longer time. More reliable than other earnings, high-quality earnings give investors a good reason to pay more for them.

Defining Quality
So, how do investors identify a firm with quality earnings? When analyzing quarterly reports, investors should ask themselves three simple questions: Are the company's earnings repeatable? Are they controllable? And finally, are the earnings bankable?

Repeatable Earnings
Consider Motorola's 2001 third-quarter earnings, which demonstrated the importance of repeatability. In spite of a slowing economy and sales shrinkage, the technology giant posted earnings of four cents a share, well ahead of Wall Street estimates. Some of those earnings came by way of job cuts, and a sizable chunk came also from the sale of investments.

In the weeks following, the stock dropped by 15% because the market realized that Motorola's earnings quality was questionable: the sale of assets is never repeatable. Once sold, assets cannot be sold again to produce more earnings. At first investors were unwilling to pay for high quarterly earnings, but found later that the company would never be able re-produce such future earnings.

Sales growth and cost cutting are the best routes to high-quality earnings. Both are repeatable. Sales growth in one quarter is normally (albeit not all the time) followed by sales growth the next quarter. Similarly, costs, once cut, typically stay that way. Repeatable and fairly predictable earnings that come from sales and cost reductions are what investors prefer.

Controllable Earnings
There are many factors affecting earnings that companies cannot control. Consider the effects of exchange rates. For example, if a company must convert its European profits back into the U.S. dollar, a dollar that is falling against the euro will boost the company's earnings. But, management has nothing to do with those extra earnings or with repeating them in the future. On the other hand, if the dollar moves upwards, earnings growth could come in lower.


There are other uncontrollable factors that can raise earnings. Inflation, for instance, can give companies a brief profits boost when products in inventory are sold at prices increased by inflation. The price of inputs is another uncontrollable factor: falling jet fuel prices, for example, can improve airline industry profits. Even changes in the weather can boost earnings growth. Think of the extra profits that electrical utilities enjoy when temperatures are unusually hot or cold.

Let's face it, the highest-quality earnings go straight to the bank. Indeed, cash sales – which the company does control - are the source of the highest-quality earnings; investors should seek firms with earnings figures that closely resemble cash that is left after expenses are subtracted from revenues.

Bankable Earnings
Most companies, however, must wait before they can deposit revenues in the bank. Cash payments often arrive later than receivables, so most companies, at times, enter sales as revenues even though no money has exchanged hands. The fact that customers can cancel or refuse to pay creates large uncertainties, which lower earnings quality. At the same time, generally accepted accounting principles give room for choices about what counts as reliable revenues and earnings.

For some firms there is a strong temptation to count their eggs before they hatch. For instance, Harley Davidson's 26% profit growth in 2001 looked impressive until you note that a good chunk of its profits came from packaging and selling loans made to motorcycle buyers. Harley Davidson Financial Services contributed 13 cents to its parent's 2001 earnings.

Or consider Circuit City, a big electronics retailer. Its stock went down 40% in 2002, partly because the company showed a worrisome increase in accounts receivables. While sales and earnings were up, receivables more than doubled. Smart investors see surges in accounts receivable as a warning sign, a good reason to take the time to examine earnings quality in detail.

Conclusion
Clearly, high earnings are not as important as high-quality earnings: those that are repeatable, controllable and bankable. Earnings that experience a surge because of a one-time, uncontrollable event are not earnings that are inherent to the activities of the business. These earnings are the result of luck, which is never a reason to invest. Finally, those business who generate revenue but not cash are not engaging in profitable activities. When you invest, make sure your company is taking its earnings to the bank!
Consumer Confidence: A Killer Statistic
Consumer spending is the one key to any market economy. On the airwaves, there's never a shortage of data, analysis and cable commentary regarding consumer behavior. So what are the key fundamental consumption indicators in a good economy? How about in a bad economy? The following article will recap the vital economic indicators of overall consumption, outlining what trends to look for and when to look for them.

There is no doubt that consumer spending is the most vital component of any economy. Why? Depending on the economy's sheer breadth, consumer spending can range anywhere from 50-75% of GDP. In the U.S. and most highly industrialized nations, this percentage is about 65% of total spending. The first part of measuring total consumption is measuring consumer sentiment, which is derived completely from a consumer's standpoint.

Consumer Sentiment
The two numbers expressing consumers' feelings about the economy and their subsequent plans to make purchases are the Consumer Confidence Index, prepared by the Conference Board, and the Consumer Sentiment Index, prepared by the University of Michigan. Both indexes are based on a household survey and reported on a monthly basis.

In analyzing any consumer sentiment index, it is most important to determine the trend of the index over several months. Simply put, the trend graphed out over four or five months is critical. Keeping this in mind, one needs to remain astute and block out news bits such as "the index is at 80 so things look gloomy" or "the level of consumer sentiment is up slightly from last month". The trend over several months - not a comparison of this month to the same month last year- is the undeniable benchmark. Commentary that focuses only on the single monthly figures, without looking at the developing trend, is misleading.

For many, the importance of the trends of consumer sentiment rests in the fact that the consumer sentiment indices originated in the middle of the 20th century, when it was safer to assume that the concept of the "typical" consumer was more homogeneous. Acknowledging this historical fact, as well as potential sampling bias and possible subjectivity across regions, the safe bet is to focus on trends forming some sort of linear progression, whether upwards or downwards, (or the progression can hit a general plateau, which sometimes happens when the economy shifts from stages in the business cycle).

Business Spending: A Leading Indicator
Though not as powerful an indicator as consumer spending, business capital spending can be a killer statistic - since things can get ugly in a hurry when overall business investment precipitously cuts back: the impact on the economy can be felt at an even faster pace than as if the cut occurred purely along consumer lines. The rationale is that today's sophisticated and large inventory-lean corporations often can gauge future demand before policy makers can implement changes, which often take months to kick in due to embedded policy lags. Corporate spending is therefore very similar today to the role the stock market has played in most recoveries: improvements can be foreseen as a leading indicator for things to come. On the flip-side, cutbacks in corporate capital spending are indeed an ominous indicator. The PMI, or Purchasing Managers Index, is a representation of the progress in corporate spending For analyzing consumer spending, ascertainable trends are more telling than actual figures. The opposite is true for analyzing corporate spending through the PMI: there is a concrete threshold level for analyzing corporate investment spending and subsequent production. A PMI below 50 designates a contracting manufacturing sector, while above 50 highlights expansion across corporate spending and investment. Obviously, clear awareness of the current trend analysis is always better than a stand-alone result; nevertheless, the 50

threshold can be utilized as a simple benchmark to assess corporate activity. In good times, the index is roaring in the high 50s, while in slow times the index can fall towards the low 40s.

Other Spending Items
There are other spending indicators, such as purchases of durable goods orders and overall auto sales; however, in terms of aggregating the data, these metrics are narrowly defined extensions of overall individual consumption. Trends across personal consumption will usually be reflected and correlated across these two metrics as well as others. For instance, during the end of 2001, while the world economy was suffering on many fronts, steady consumer spending helped fuel auto sales that originated from generous no-financing from Detroit. This stimulus ultimately helped erode the three-quarter recession that had developed from the beginning of the year. Awareness of these symbols of consumption can give you more insight into exactly why and how consumption is impacting the economy. This awareness will help you judge the sustainability of these trends.

From a pure corporate standpoint, auxiliary spending, besides durable orders and big-ticket items such as auto purchases, can often indicate a great deal about overall corporate sentiment. Recall from above that the PMI for corporate spending is a definite quantitative measure, and the consumer sentiment index is a qualitative metric. In the eyes of large corporations and from a sheer qualitative standpoint, auxiliary spending on services such as advertising, consulting and information technology may reveal information about attitude and sentiment, just like the consumer sentiment indices reveal information about personal and individual consumption.

Just as a murky outlook will depress consumer sentiment, a weak forecast for the demand for goods and services will sidetrack corporate spending on auxiliary measures that can be budgeted away if necessary. The end-victims are advertising/marketing, media campaigns, consulting fees and information technology overhauls. When the headlines indicate that layoffs and slowdowns are rampant in any of these fields, it can be safe to bet that corporate appetite for auxiliary spending is weak. Because the performance of these industries is largely tied to the level of corporate sentiment, a savvy investor should keep an eye out for companies within these industries and how they are performing.

Conclusion
Consumption is ultimately the stimulant behind almost every fundamental aspect of the worldwide economy. In sophisticated economies, the impact of consumption may be less than in emerging economies that are largely import-export driven, but the consumption magnitude is even more pronounced due to both a greater wealth effect and standard of living that enable individuals to spend more freely with disposable income.

The data for analyzing overall consumption contains many underlying factors. To scrutinize the daily volumes of indicators, focus on the indicators according to the above ranking system. This will help you capture the main elements and the interaction between the various areas of spending.
Impairment Charges: The Good, the Bad and the Ugly

"Impairment charge" is the new term for writing off worthless goodwill. These charges started making headlines in 2002 as companies adopted new accounting rules and disclosed huge goodwill write-offs (for example, AOL - $54 billion, SBC - $1.8 billion, and McDonald's - $99 million). While impairment charges have since then gone relatively unnoticed, they will get more attention as the weak economy and faltering stock market force more goodwill charge-offs and increase concerns about corporate balance sheets. This article will define the impairment charge and look at its good, bad and ugly effects.
Impairment Defined
As with most generally accepted accounting principles, the definition of "impairment" is in the eye of the beholder. The regulations are complex, but the fundamentals are relatively easy to understand. Under the new rules, all goodwill is to be assigned to the company's reporting units that are expected to benefit from that goodwill. Then the goodwill must be tested (at least annually) to determine if the recorded value of the goodwill is greater than the fair value. If the fair value is less than the carrying value, the goodwill is deemed "impaired" and must be charged off. This charge reduces the value of goodwill to the fair market value and represents a "mark-to-market" charge.
The Good
If done correctly, this will provide investors with more valuable information. Balance sheets are bloated with goodwill that resulted from acquisitions during the bubble years, when companies overpaid for assets by using overpriced stock. Over-inflated financial statements distort not only the analysis of a company but also what investors should pay for that stock. The new rules force companies to revalue these bad investments, much like what the stock market has done to individual stocks.

The impairment charge also provides investors with a way to evaluate corporate management and its decision-making track record. Companies that have to write off billions of dollars due to impairment have not made good investment decisions. Managements that bite the bullet and take an honest all-encompassing charge should be viewed more favorably than those who slowly bleed a company to death by deciding to take a series of recurring impairment charges, thereby manipulating reality.

The Bad
The accounting rules (FAS 141 and FAS 142) allow companies a great deal of discretion in allocating goodwill and determining its value. Determining fair value has always been as much an art as a science and different experts can arrive honestly at different valuations. In addition, it is possible for the allocation process to be manipulated for the purpose of avoiding flunking the impairment test. As managements attempt to avoid these charge-offs, more accounting shenanigans will undoubtedly result.

It's doubtful that very many corporate managements will face reality and take their medicine. Compensation packages will incite managers to delay the inevitable as they hope for a stock market rebound that will boost fair value.

A delay, however, could backfire and adversely impact EPS in 2003. According to the rules, impairment charges that occur within the first year of adopting the new accounting rules (calendar 2002 for most corporations) are accounted for as a charge to equity. After the first year, impairment charges hit the income statement. Consequently, postponing may help results in 2002 but could reduce EPS in 2003.

The other bad thing is that investors will have a hard time evaluating how management is handling this issue. The process of allocating goodwill to business units and the valuation process will be hidden from investors, which will provide ample opportunity for manipulation. Companies are also not required to disclose what is determined to be the fair value of goodwill, even though this information would help investors make a more informed investment decision.

The Ugly
Things could get ugly if increased impairment charges reduce equity to levels that trigger technical loan defaults. Most lenders require companies who have borrowed money to promise to maintain certain operating ratios. If a company does not meet these obligations (also called loan covenants), it can be deemed in default of the loan agreement. This could have a detrimental effect on the company's ability to refinance its debt, especially if it has a large amount of debt and in need of more financing.

An Example
Assume that NetcoDOA (a pretend company) has equity of $3.45 billion, intangibles of $3.17 billion and total debt of $3.96 billion. This means that NetcoDOA's tangible net worth is $28 million ($3.45 billion of equity less debt of $3.17 billion).

Let's also assume that NetcoDOA took out a bank loan in late 2000 that will mature in 2005. The loan requires that NetcoDOA maintain a capitalization ratio no greater than 70%. A typical capitalization ratio is defined as debt represented as a percent of capital (debt plus equity). This means that NetcoDOA's capitalization ratio is 53.4%: debt of $3.96 billion divided by capital of $7.41 billion (equity of $3.45 billion plus debt of $3.96 billion).

Now assume that NetcoDOA is faced with an impairment charge that will wipe out half of its goodwill ($1.725 billion), which will also reduce equity by the same amount. This will cause the capitalization ratio to rise to 70%, which is the limit established by the bank. Also assume that, in the most recent quarter, the company posted an operating loss that further reduced equity and caused the capitalization ratio to exceed the maximum 70%.

In this situation, NetcoDOA is in technical default of its loan. The bank has the right to either demand it be repaid immediately (by declaring that NetcoDOA is in default) or, more likely, require NetcoDOA to renegotiate the loan. The bank holds all the cards and can require a higher interest rate or ask NetcoDOA to find another lender. In the current economic climate, this is not an easy thing to do.

(Note: The numbers used above are based upon real data. They represent the average values for the 61 stocks in Baseline's integrated telco industry list.)

Conclusion
New accounting regulations that require companies to mark their goodwill to market will be a painful way to resolve the misallocation of assets that occurred during the dotcom bubble (1995-2000). In several ways, it will help investors by providing more relevant financial information, but it also gives companies a way to manipulate reality and postpone the inevitable. If the economy and stock markets remain weak, many companies could face loan defaults.

Individuals need to be aware of these risks and factor them into their investing decision-making process. There are no easy ways to evaluate impairment risk, but there are a few generalizations that should serve as red flags indicating which companies are at risk:
1. Company made large acquisitions in the late 1990s (notably the telco and AOL).
2. Company has high (greater than 70%) leverage ratios and negative operating cash flows.
3. Company's stock price has declined significantly since 2000.
Unfortunately, the above can be said about most companies