Bull!

by Maggie Mahar

  SWIMMING AGAINST THE TIDE

  Allan Sloan, a financial columnist at Newsweek and its sibling The Washington Post, agreed with Russell. In 2001, Sloan won the Loeb Award for Lifetime Achievement—the Pulitzer of financial journalism—and in his acceptance speech he was forthright. In the nineties, said Sloan, too many journalists “pandered,” not only to their sources but to their readers:

  “Instead of doing our job and being observers and analysts and truth tellers, we started to identify with our sources,” Sloan declared. “It is not our job to kiss up to CEOs, to kiss up to mutual fund managers, especially not to kiss up to analysts.” But in the nineties, he suggested, too many journalists were “running scared, and trying to give our readers what we thought they wanted—instead of sucking up our gut and maybe sacrificing a few short-term ads and readers by doing what’s right. And telling them things they may not want to hear, but should hear.”57

  Why were so many journalists caught up in the mania? “Because it was fun,” Sloan said in a 2002 interview. “It’s fun to have access. It’s fun to be part of the new thing. It attracted readers. It attracted ads. It created buzz. It made you hot and trendy.”58

  By 1996, however, Sloan was not feeling hot and trendy. He was feeling old and a little cranky—or, at least, alarmed. In May, he directed his readers’ attention to a recent stock offering by Berkshire Hathaway, Warren Buffett’s company. For weeks before the offering, Buffett had warned investors that the stock was overpriced, and that they should not buy it. “He practically put a skull and crossbones on his prospectus,” Sloan wrote. “So what happened? The more Buffett bad-mouthed his stock, the more people lusted after it. Investors bought $500 million worth—five times what Berkshire originally offered to sell.”59

  Perhaps Warren Buffett was using a little reverse psychology to drum up interest in his offering? No, in fact, by March of 1996 Buffett believed that the market as a whole was rising without rhyme or reason: “This was a year in which any fool could make a bundle in the stock market,” he noted in his annual letter to investors. “And we did. To paraphrase President Kennedy,” he added slyly, “a rising tide lifts all yachts.”60

  Buffett made it clear that, in his view, Hathaway’s shares were overvalued, along with everything else: “Though the per-share intrinsic value of our stock has grown at an excellent rate during the past five years, its market price has grown still faster. The stock, in other words, has outperformed the business.

  “That kind of market overperformance cannot persist indefinitely, neither for Berkshire nor any other stock,” he added. “Inevitably, there will be periods of underperformance as well. The price volatility that results, though endemic to public markets, is not to our liking. What we would prefer instead is to have the market price of Berkshire precisely track its intrinsic value.”61

  Why, then, was he offering new shares of Berkshire? Buffett had been backed into a corner by two promoters who had devised a scheme to peddle Berkshire stock to individual investors. Since Berkshire was trading at $35,000 a share, few small investors could afford to buy it directly. Enter the promoters who created “Affordable Access Trust.” They planned to sell units to individual investors for $1,000, charge a fee, and use the money that was left over (after they took their fee off the top) to buy Berkshire stock. When Buffett heard of their plans, “he went ballistic,” Sloan reported. “Buffett felt the trust would gouge small investors [with its fees] and hurt Berkshire’s good name. Buffett resents people poaching on his fame and expertise and he was clearly worried that the trust’s buying would [further] artificially inflate the price of Berkshire’s stock.” When the promoters refused to abandon their project, Buffett resolved to sell Berkshire shares to small investors himself. He did this by creating B shares of Berkshire equal to one-thirtieth of a regular share, which he sold at $1,100 apiece in May of 1996.

  Sloan understood why Buffett issued the shares, but he did not understand why investors bought them, flying in the face of Buffett’s warnings that Berkshire’s shares were bloated.

  “Think about it,” Sloan wrote. “Investors disregarded stock-picking advice from the person to whom they were entrusting money to pick stocks. Hello? And then the stock ran up 8% in its first two days of trading.” He titled the column “The Baby Berkshire Frenzy May Reflect a Market Gone Mad.”

  THE RISKIEST TIME TO BUY STOCKS

  A financial journalist since 1969, Sloan understood the market’s cycles. Indeed, only a month earlier, he tried to share a little financial history with his readers by recalling the seventies, a decade when buy-and-hold investors were sandpapered to death:

  “I still had hair and was writing about stocks for the first time,” he recalled. “Many of today’s money managers were in grade school…. Owning stocks then was water torture—prices kept falling drop by drop…. Back then, it took real courage to buy stocks,” he explained. “Now, in the longest-running bull market ever, it has taken courage to stay out of the market…. Many people have come to believe that baby boomers will pour their retirement money into stocks forever, propping up stock prices forever,” Sloan added, “but investing on this basis is a good way to spend your retirement living on Hamburger Helper and day-old buns.”62

  Sloan recognized a truth that would seem, to most people, counterintuitive: the riskiest time to buy stocks is during a roaring bull market. Because when prices are highest, the downside is steepest. Meanwhile, the upside is founded on hope, and hope alone. By contrast, once a bear market has scraped bottom, stocks are cheap, the downside limited.

  Late in 1996, by contrast, the downside was enormous. An investor was buying into a market that had doubled in roughly five years. When the market reverted to a mean, he was positioned to lose a large chunk of his savings. And over time, markets do tend to revert to a mean—a midpoint between the high prices of strong cycles and the rock-bottom prices of weak cycles. Historically, at the mean stocks have fetched roughly 15 times earnings. Over a long period of time, the mean may move; 25 years from now, the mean price/earnings ratio might well be higher or lower than 15. Much depends on economic conditions, global politics, and investors’ expectations. But there will still be a mean, and it will still be safer to buy stocks when the market is trading below its past averages than when it is trading above them.

  In April of 1996, Sloan stressed that each investor had to assess his own situation, based on his age, risk tolerance, and how much he could afford to lose. But “if you can’t afford a 20 percent or 30 percent loss,” he advised, “you might want to take some of your winnings off the table.”63 Investors who heeded his advice, and stashed some of their winnings in plain-vanilla 10-year Treasuries at the end of the first quarter of 1996, would watch that money grow by 78 percent over the next seven years. If, on the other hand, they decided to ride the S&P 500 all the way, they would take a round trip that left them with total capital gains of just 31 percent. Even if they faithfully reinvested dividends, their total return over seven years would equal just 46 percent—32 percent less than Treasuries.

  —10—

  THE INFORMATION BOMB

  By the mid-nineties, investors were riding a wave of information, a never-ending tsunami of news and numbers. No one could resist or stem the explosion of financial information—it became part of the cultural landscape. After all, the bull market of the mid-nineties, like the go-go market of the sixties, was a People’s Market, and the democratization of information was part of the process.

  As CNBC’s Maria Bartiromo put it, “Why shouldn’t Joe Smith who works at a deli have the same information as Joe Smith who works at an investment bank?”

  The answer: absolutely no reason why he shouldn’t. There was just one question: what good would it do him?

  As information flooded the marketplace it became more difficult to assemble the bits and pieces into a coherent pattern. Ultimately, the bull market of the nineties was all about excess capacity: too many microchip factories, too many wireless carri
ers, years’ worth of fiber optic capacity in the ground. The excess extended to the information industry.

  “The enormous flow of information that we have today doesn’t necessarily reduce uncertainty,” observed Peter Bernstein, the economic consultant who authored Against the Gods. “My favorite example is that on the morning of September 11, 2001, my wife and I were packed to go to California. We were in Manhattan, waiting for the limo to come. We had a lot of information—it was a lovely day, the limo was on time, the flight was scheduled to take off on time….

  “But you never know. With all the information you can possibly get, you never know whether it’s sufficient.”1

  The problem is that much of the information that investors want—and think they need—is just that, “information,” not knowledge. Knowledge comes only through time. It dawns on us gradually, as we digest bits of information, reflect on them, and rearrange them, revising and refining our interpretation. But the New Age of Information aimed to collapse time. An investor no longer had to wait for tomorrow’s newspaper to hear the news: the future was now.2

  That explosion of information can mask the few facts that are truly important. “Rarely do more than three or four variables really count. Everything else is noise,” Marty Whitman, manager of the Third Avenue Funds, confided. As a long-term value investor, Whitman paid virtually no attention to whether a company beat Wall Street’s quarterly earnings estimates. Ignoring the chatter, he zeroed in on a company’s balance sheet. There he found less transient numbers—a summary of the company’s assets and liabilities. “For many—if not most—companies, analysis of the amount and quality of resources that a management has to work with is as good or an even better tool for predicting earnings per share than past earnings growth,” Whitman remarked. It was a method that worked: over the 10 years ending in January of 2003, his Third Avenue Value Fund rewarded investors with returns averaging more than 10 percent annually.3

  But as the market heated up, the emphasis was on speed, and investors addicted to a constant stream of information came to prefer the illusion of knowledge spun from the tips and tidings that came to them with the absolute speed of electronic impulses—online, on television, all day, every day.

  Trouble is, that stream of information is always changing. Today’s numbers will be revised tomorrow: this quarter’s reported earnings; analysts’ estimates for the next quarter; the results of this week’s poll of 50 economists…

  The critical process of analyzing that stream of imperfect information, sorting out what is relevant, checking the accuracy of the facts, and then synthesizing the bits of data into a meaningful context is labor intensive.

  This makes it expensive.

  BEHIND THE NUMBERS

  Throughout the nineties, some of the very best financial research was being done, not on Wall Street, but by independent research boutiques. Savvy professional investors knew this and were willing to pay for it. Some paid as much as $10,000 a year, for example, to subscribe to David Tice’s newsletter, Behind the Numbers, a report that offered in-depth analysis of corporate earnings.

  In the late eighties, Tice had noticed that Wall Street analysts were no longer writing “sell” recommendations, and the 33-year-old Dallas money manager set out to fill the gap. A certified public accountant, he knew how to do the nitty-gritty detective work needed to pierce the veil of corporate accounting, and in 1987 he founded his own independent research service, David W. Tice & Associates. Tice started his research boutique at home; his only “associates” were his wife and a wailing baby in the next room.4

  Dressed in jeans and an open-necked shirt, Tice did not look like a CPA. Rather, he looked like the Texan that he had become—though in fact, he had been born in the show-me state, “home of Harry Truman,” as he liked to point out. In the late seventies Tice earned an MBA in finance at Texas Christian University. But MBA programs do not teach financial analysts what they need to know to sleuth phony books. Tice earned his stripes by going to work as an internal auditor, first at Atlantic Richfield, then at ENSERCH, a diversified energy company where he evaluated potential acquisitions. In those jobs, he developed the skills that so many Wall Street analysts lacked, learning how to scour balance sheets, income statements, and cash flow statements with a fine-tooth comb.

  Tice had not always been a bear. In the early eighties, at the very beginning of the bull market, he left the energy industry and went to work for a Dallas financial advisor. While there, he urged wealthy clients to move their money out of oil and gas and into stocks. But as the mania for growth grew, he became queasy about equities.

  Tice recognized that “the most reckless fund managers, the most reckless auditors, the most reckless investment bankers, the most reckless corporate officers made the most money. So you had greater and greater incentives to promote the most reckless guys.” Meanwhile, “the most reckless CEOs hired the most reckless CFOs [chief financial officers].” As the bull market unfolded, Tice watched hundreds of companies buying back their own shares at stunning prices, “and taking on massive debt loads—even while their business prospects deteriorated.” In his view “a culture of growth with no regard to risk had permeated the economy.”5

  Tice’s research filled a niche. Before long, a “Who’s Who” of institutional investors were buying his newsletter. His often scathing reports became popular because they served as an early-warning system for savvy investors, alerting them to the dangers of overly aggressive accounting at companies such as AOL, Sunbeam, Lucent, TWA, Providian, Gateway, and Tyco. “We’re that little voice in the back trying to point out the potential problems that the bulls overlook,” Tice said in 1994.6

  In the meantime, Tice became one of the better-known shorts on Wall Street. In 1995, he launched the Prudent Bear Fund—a fund that was able to short stocks, giving small investors an opportunity to share in the fruits of his research.

  Tice’s hard-nosed fundamental analysis drew scorn both from Wall Street’s boosters and from corporate chieftains who howled when they were caught. Nevertheless, by the middle of 1994, nearly 60 percent of the stocks Tice had flagged since he founded his business six years earlier had underperformed the S&P, while 46 percent had declined in price. Not a bad record, given that over the same period, the S&P as a whole had risen from 247, at the beginning of 1988, to 457, in June of 1994.7

  It is worth noting that many of the companies Tice shorted belonged to the Old Economy. At the end of the century, some observers would blame the excesses of the bull market on the Internet—as if seedy accounting was limited to dot.coms and telecoms. In truth, bogus bookkeeping was pervasive. The problem in a runaway bull market is that too much money (and too much credit) is chasing too few stocks in virtually every sector of the economy. And whenever there is too much money on the table, the crooks come out of the woodwork. In the nineties “creative accounting” became an accepted management technique in even the most old-fashioned industries. Sunbeam, a maker of small appliances, stood as a homely example.

  Sunbeam came under Tice’s microscope in 1995, and at the time, he put his finger on the company’s essential problem: Sunbeam was in the business of making toasters, blenders, and electric blankets, a market where competition was intense and growth slow. Meanwhile, Tice noted, Sunbeam already had done all it could to boost its earnings with “liberal accounting” and “one-time events.” (For example, the appliance maker had eliminated medical and life insurance for retirees eligible for Medicare.)

  Before long Sunbeam’s CEO, Roger Schipke, was ousted, and Al Dunlap took his place. Known in the corporate community as “chainsaw Al”—a reference to his reputation for slashing jobs—Dunlap was brought in to turn the company around. Investors impressed by Dunlap’s press ignored the numbers. But those who had read Tice’s careful analysis in 1995 would recognize that Dunlap had little hope of success.

  As Tice put it when he wrote about the company again in December of 1996: “Wall Street will probably be ‘snowed’ for a whi
le longer by the turn-around plan, but we believe the current euphoria has given investors a great second chance to get out of this stock. [Dunlap] still has to overcome the inherent problem that everyone already has a toaster and an electric blanket.”8

  Tice quoted one of Sunbeam’s competitors: “‘All consumer appliances cost what they did 20 years ago. We wish we could raise prices like the automakers. But we can’t.’” At the 1996 International Housewares Show, one marketing executive displayed a 1950s advertisement for a toaster that cost $15.99. “Today, 40 years later, a toaster still costs $10–$20,” he observed.

  Dunlap arrived on the scene with a much-ballyhooed restructuring plan that included cutting the number of products Sunbeam manufactured, eliminating “non-core” items such as outdoor furniture and decorative bedding, which once accounted for about one-quarter of total sales.9 But, Tice pointed out, “The key theme to keep in mind is that the restructuring will put even more emphasis on small appliances.” Meanwhile, the small-appliance industry only had unit sales growth of 0.7 percent in 1995. “It is difficult to grow a non-growth business,” Tice concluded.

  This was the essential fact to understand about the company: it made small appliances, and it had no pricing power. No matter how you cooked the books, you could not get past that fact.

  But once Dunlap came on board, a blizzard of press releases tried to obscure the limits of Sunbeam’s situation, and the media picked up on the news: “Dunlap Makes Plans to Shine Up Sunbeam: A $12 Million Ad Blitz, Focus on Home Products May Spruce Up Image”; “Sunbeam Plugs into Overseas Market”; “Sunbeam 3Q—Better Times Seen Ahead Under Dunlap”; “Sunbeam Profit Seen on Slimmer Product Line.”10