On Wall Street, sizzle apparently is more important than the steak.
Since plunging to a multi-year low on March 9, the stock market has experienced the biggest rally and turnaround of our time.
It seems like ancient history. In October 2007, the S&P 500 notched a record high 1,565.15.
Then the wheels came off.
A Mammoth Reversal
As the credit markets unraveled, the falling stock market wiped out $11 trillion in value. More than $1.7 trillion in bank losses and write-downs stemming from the implosion of the subprime mortgage market caused the collapse of Lehman Brothers and Bear Stearns companies, forcing the U.S. government to bail out the likes of AIG, General Motors and Citigroup.
That was then.
Today, all seems to have been forgotten. After the government lent, spent or guaranteed more than $11 trillion to end the worst financial crisis of our time, the stock market has rallied nearly 67 percent from its historic bottom.
Even though companies across the business spectrum benefited from the 2009 rally, fewer than 215 companies on the S&P 500 actually added value to the greater economy. Despite this financial disparity, investors, like value shoppers, were quick to snap up stocks whose share prices had fallen from their 2007 peaks to their March 2009 lows.
Investors were like a starving man at a half-price buffet – indiscriminate. Filling their plates was more important than actual nutrition.
According to the most recent data, investors and their money managers ignored corporate profitability in favor of stocks that dropped the most in the credit crisis. Many well managed companies with good balance sheets simply were overlooked
In retrospect, it appears that the price line of individual stocks outweighed the more critical bottom line.
The Meaning of EVA
In corporate finance, Economic Value Added or EVA is an estimate of economic profit. EVA can be determined, among other ways, by making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. The concept of EVA is nothing more than the traditional, commonsense idea of profit.
The advantage of having a separate and more precisely defined term such as EVA or Residual Cash Flow is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while in fact being in the final approach to becoming insolvent. Simply put, EVA can be measured as Net Operating Profit After Taxes (or NOPAT) less the money cost of investment capital (e.g. interest rate on borrowing).
Most economists agree that EVA, also known as economic profit, is a more reliable gauge of management performance because it treats the price of intangible assets, such as research, as an investment, while measuring all returns against the cost of raising money for the business.
Well-managed companies like Johnson & Johnson – the world’s largest health products company – and Brown-Foreman, maker of Jack Daniel’s Whiskey and Southern Comfort, were left behind in the 2009 rally because their share prices had not fallen as far as other issues. Despite the fact that these companies posted better- than-average sales throughout the depth of the recession, their stock prices rose comparatively less than the market as a whole.
During the nine-month rally on the S&P, bargain-hunting investors seemed to routinely favor the companies with the weakest balance sheets. This was due in large measure to the fact that the shares of these companies suffered the most during credit crisis.
A review of the past nine months shows that the 25 companies in the S&P 500 that had the lowest EVA ratings this year posted a median stock rally of 95 percent in 2009. This contrasted with a 51 percent median price gain for the 25 publicly-traded firms that did the best.
The obvious conclusion is that expectations were more important to investors than actual performance. As the fundamentals of the economy and each of these companies come home to roost, the real question is whether these rapidly inflated share prices will be sustainable in the near-term.
In my view, the answer is no.
Entering the New Year, investors and money managers will have to take a harder look at the bottom line of the hundreds of firms that were incidental beneficiaries of the 2009 rally. If and when this happens, the stock market likely will see a substantial price correction.
Hopefully, at that juncture, investors will start to focus their attention more on the beef than on the sizzle.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles.
