The Meaning of “Excess”

Over the past few months, I have commented about how large corporations are using their company pension funds to bolster their corporate earnings. Under accounting rules, if a pension fund has "excess" funding, the excess can go to the bottom line of the corporation. Nothing particularly wrong with that, except the meaning of the word "excess" is as loose as Bill Clinton's definition of "is." Today we will visit an amazing statistic that clearly shows just how deceitful, large and widespread this practice is.

It seems corporations can project what they are going to earn in the future, and if their projections show that in the future they will have excess, then that helps their earnings today. The problem is that corporations are making very aggressive assumptions. Warren Buffet notes that GE assumes they are going to make 9.5% on their pension fund investments. The "profits" from these assumptions allowed them to post $1.7 billion to earnings in 2000, which was 2.5 times what their appliance division made. That was 10% of GE's profits that year.

IBM assumed they would make 10%. General Motors likewise assumes 10%. You can bet most corporations assume something similar, as they all use the same consultants to back up their assumptions and give them an outside, supposedly independent group, to support the reasonableness of their assumptions. The pressure upon a consultant to give the Chief Financial Officer a number that works with their earnings forecast is huge. If you don't give them a number that helps their bottom line, and is consistent with what your competitors are saying, what chance do you think you will have to get hired for next year's work?

The research we looked at last week showed that such assumptions, except during major bull markets, are very unrealistic. If you have a third of your portfolio in bonds, averaging 5-6% across the spectrum, to get to 9.5-10% on the total portfolio, you have to make 11-12% on the rest of your portfolio.

Yet I have shown you study after study over the past year that shows that if you are a large institution with a broad portfolio, 6-7% on your stock portfolio is about the best you can hope for, and that is if you are good. That is especially true for pension funds that are laboring under the burden of Modern Portfolio Theory.

The vast majority of historical real returns on stocks have come from re-invested dividends, and not from the growth of the underlying stock. The past 20 years has been a major exception to that rule. Because we have been participants in this bull market, we expect the party to continue.

Historically dividends have been in the 4-5% range. Today dividends are less than 2%. That means future projected growth based upon historical patterns can be very misleading. One can argue that companies which do not pay dividends, but buy back shares or invest for more growth are in effect paying a dividend which does not have to be taxed. But the data does not support that conclusion.

Dividends don't lie. They are not pro forma earnings, or accounting magic. They are real dollars in your pockets.

Cisco Cooks the Books Again

Cisco told us this week that they will make $.20 per share pro forma earnings, if you ignore all those inconvenient losses. If you choose to look at the real number, it is closer to $.10, and that is before the end of the year write-offs from over-priced purchases of other companies.

Want an interesting exercise? Go to Get a quote on Cisco. At this moment the consensus estimated forward earnings are projected to be $.35 with a Price to Earnings (P/E) ratio of 59.

But if you go to and retrieve the same information, you find they suggest earnings at $.15 with a P/E of 102. If you look at the 2001 year fiscal year-end for Cisco, you find losses of over $1 billion dollars.

Who is right? Looking at the actual quarterly tax filings, apparently uses past or trailing actual earnings. Bloomberg uses projected pro forma earnings, and of course don't refer to those inconvenient write-offs that will happen later this year, which will possibly once again have the company showing a loss.

This is the company which said this week, "Sales are flat, we are not sure when we will see some real growth, but we fired a lot of people and cut costs so we made more money than you guys projected." Well, maybe Chief Cheerleader John Chambers actually put a little better spin on it than I did. This sparked a 300 point Dow rally, two-thirds of which has been lost as I write.

Let's get some perspective. At the end of the last recession, Intel was selling for 1.5 times sales with solid growth potential. Today it is selling for 7 times sales with no growth in sales since 1998! Microsoft, with powerhouse growth, was selling for a P/E of 24 in 1991. Today it is at 31 with flat sales. These are great companies, well-managed and with great franchises which will be with us for decades. I love Microsoft. I am so much more productive because of that company than I was 20 years ago it is hard to describe. I would kiss Bill Gates, except that we don't do such things in Texas, at least in public.


Trees don't grow to the sky. Microsoft and Intel simply cannot grow at 15% per year, which is what their current prices say the market believes. 15% a year says they will double in size in less than 5 years. It won't happen. It has taken 25 years for Microsoft to grow to $25 billion in sales. Where is there another $25 billion they can find in the next five years? The answer is, there is no such growth in the wings. Will they grow? Will they be more profitable? Yes. But they will not double.

Yet investors hope for a continuation of the past. And consultants look at these companies, and thousands of others, and make projections which have no hope of coming true in a Muddle Through Decade. These projections are a house of cards built on false assumptions.

Your Basic $90.2 Billion Lie

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Now, I will share with you the amazing stat I found in Bill Staton's Money Digest that started this line of thinking. I read it nowhere else, yet it is absolutely staggering in its implications. "Funny money in the world of pensionland. According to benefits consultants Milliman USA, the 50 largest U.S. companies last year reported $54.4 billion in profits from their pension-fund investments, which was interesting because the same 50 actually saw portfolios decline by $35.8 billion. How does a loss become a gain? Rack it up to accounting, accounting that is legal. Think a change might be needed? I certainly do."

So do I, Bill. That is a $90.2 swing.

Over the next few years, corporations are going to have to begin to lower their estimates of future growth for their pension funds. This means they are going to have to take a loss to earnings because of currently aggressive assumptions. For some of these corporations, the losses could be substantial. And the longer they maintain their aggressive assumptions, the worse the day of reckoning will be.

I will make you a side bet right now. When these companies take the hit, it will not be to current or future earnings. They will go back and re-state prior year earnings. They will blame the economy, the stock market and sun spots. They will fire their consultants, and hire new ones with more conservative projections. But future earnings will still be pro forma positive. All the loss will be relegated to the past, because of past mistaken assumptions, so pulleeze do not even think about selling our stock.

Call me cynical, but if the bulk of your income is based upon stock options, as is the case with most large company CEO's, what else would you do? This is going to cause a lot of musical chairs in the corporate boardrooms.

Baby Berkshire Hathaway Inside the Washington D.C. Beltway

It is time once again for income manager Tom Donaldson to give us yet another investment idea for your income portfolios. This time he gives us a firm which has a long history of making money for its investors. It can be a little volatile, but the dividend and long term growth is steady. Let's take a look at what Tom says about Allied Capital:

"After 40 years Allied Capital Corporation (ALD on the NYSE) of Washington D.C. sports a record to be envied by any long term investor. Selling at $25.42 with a recently increased annual dividend of $2.20 for a current yield of 8.65%, Allied had produced an average annual total return to its shareholders of 18% for the last forty years with dividends reinvested. Allied Capital is the nations largest business development company engaged in private equity investing, an area not accessible to most investors. With 82% debt securities and 18% equity securities and a portfolio totaling over $2.2 billion in assets, Allied has a unique niche in the investment world. The company targets industries for investment in business services, broadcasting, education, consumer products and light industrial products. In addition the company has over $649 million in commercial real estate financing as part of its portfolio. With a Standard and Poor's beta of .71 and an A- rating, ALD should have a place in every total return portfolio. Hint - if you buy before June 11th you will catch the next .55 cents dividend. The regular dividend has never been cut and total annual dividends have been steady or increasing every year since 1973." (Full disclosure: My money management firm, Millennium Wave Advisors, LLC represents Tom.)

Inflation, What Inflation?

The Producer Price Index came out today, and showed a drop last month of 0.02%. This is probably a good indication that next week's CPI numbers will be small as well. We are well on our way to a yearly inflation number of less than 1%, as I predicted years ago.

Commodity prices have stopped their recent rise, and started to come back down, and are roughly where they were in 1987. Unemployment is up to 6% and rising, and the growth in consumer credit card spending is dropping, partially as a result of job worries.

Business sales are slumping dramatically. "The recession was mild indeed by most measures, but business sales were hit harder than in 1990-91, says John Lonski, of Moody's. For the 12 months ended March 2002, the 2% year-over-year decline in business sales -- defined as the sum of retail sales and manufacturing shipments plus wholesale sales -- was the steepest since 1982." (Apogee Research)

Slowing sales are not an atmosphere in which inflation raises its head. Capital expenditures are not developing, as companies are being very cautious.

Greg Weldon notes that productivity is soaring and that labor costs have shown their steepest deflation since 1983, and manufacturing labor costs are in their steepest deflationary period since 1961.

Yes, the dollar is going to get weaker, as I predicted for this year, but it is not going to fall out of bed. While that can be inflationary, there are so many deflationary forces in the economy (such as massive over-capacity) that inflation is not the problem the Fed is concerned about.

In fact, a few Fed governors have openly speculated about deflation in recent weeks. That is a major shift in Fed thinking. Greenspan is clearly signaling that while he thinks we are in a recovery, that it is not robust. He is also clearly telling us that inflation is not something to worry about.

I did something I rarely do this morning. I turned on CNBC to watch the announcement of the PPI numbers. As I was getting ready, they had an economist from Prudential that astounded me with her analysis. "We need to be worried about inflation. The Fed is not tightening and this is a concern." The other economists gently took her to task, pointing out that inflation was not in the immediate future, and that getting the economic recovery on solid ground took precedent.

Like generals fighting the last war, there is a huge element of the bond market simply refusing to acknowledge or believe that low inflation is anything more than a temporary blip. They have experienced inflation all their lives, and are rooted in their belief it will come roaring back unless the Fed raises rates.

We can criticize Greenspan and the Fed (and I do from time to time), but they understand that if they pull the trigger on rates too soon, they will tank the stock market. Such a move will hurt corporate earnings, which are already remarkably weak for a quarter in which there is supposed to be a recovery.

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I do not think Greenspan raises rates before the November meeting. September would be the first time they would consider it, and the Fed is normally reluctant to do anything which might be considered political prior to an election. Unless something happens which shows inflation coming back strongly, or employment picking up rapidly, I think they hold off till after the election, at the earliest.

Saving Money on Health Care

I am simply appalled at the rise in the cost of health insurance. There, I agree, we are seeing rampant, take no prisoners, inflation. I have a small firm with four families who are eligible for and use health care insurance. I have heard about Medical Savings Accounts but have not investigated them. The last round of cost increases brought a directive from the boss to find something cheaper. Going to a Medical Saving Account saves my firm over $1,000 per month, and we are getting better coverage. My employees are happy. If they do not get sick, they get to keep the savings as a form of tax free retirement money.

My brilliant son-in-law, the insurance salesman, did the research, got us the best quote and company for us and, of course, the savings. (He is primarily brilliant for being wise enough to marry my oldest daughter, who works with me and is one of the happy employees.) You should have your insurance agent check out Medical Savings Accounts, or you can email me and I will forward it to #1 son-in-law to get you a quote.

Dallas and New York

This is the week of the Byron Nelson golf tournament in Dallas, so by tradition it should be raining in North Texas this weekend. I will take an umbrella, even if the sun is shining. But I will be with my Saint of a Mother this Sunday, though I may sneak a peek at the last round. It is always good to have family together. Family relationships pay the highest dividends of all.

I will be in New York City (Mid-town) June 2-5 speaking at the annual Hedge Fund Forum. My topic will be the future issues facing the hedge fund world, and my views should spark a few lively debates. I believe there are a lot of changes coming to the entire world of investments, and not just hedge funds. In five years, we will be amazed at the new investment choices we will have, and at how we all view investing. I will also be available to meet with clients or potential clients.

Have a great weekend,

Your ready for a Mother's Day weekend analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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