Pennsylvania Investment Observer

Cracks in the Façade

by Daniel J. Nestlerode

People have selective perceptions and memories. From these incomplete reservoirs of information, we make deductions and conclusions about the world around us. A lot of the time, this process is adequate to our daily lives. Sometimes, however, we need to recognize our inherent limitations and dig into data with rigor to avoid real problems in life.

The technology sector of the stock market has been surging ahead for many years now. Some stocks find their roots in the late eighties while others have been with us for only a few years. Yet nearly all the tech stocks have been a favorite with the investment community. This favorite stock mentality has proceeded to the point that my clients are now calling me and telling me that they want a particular stock in their portfolio because they know it is a really great company. Of course, the assessment is that the only possibility for the company is higher stock prices as far as the investor can imagine. The truth about the future of the price of a stock is that sometimes we are right and sometimes we are wrong. Sometimes we are dead wrong. So, the notion of any company only having a rising stock price is very likely to be dead wrong. If nothing else, the stock market and stock prices will vary over time. How they vary is another issue and the result is far from certain ahead of time.

Like Wile E. Coyote, stock prices often seem to levitate after fundamentals have started to deteriorate. Wile E., as you might remember from Road Runner cartoons, often ran off the cliff. But he fell into the abyss only after he noted he was no longer on solid ground. Investors often do not notice they are no longer on solid ground until the stock price has declined and the losses are real. After all, if the stock price is holding up, then everything must be OK with their investment, right? Wrong!

Problems often show up in the course of daily events and do not seem to have an impact on the price of your favorite stock. In the world of sports, the analogy seems to be "no harm no foul." Investors discount negative news because the stock price seems to ignore it. However, behind the scenes, important investors might have begun to sells shares even while the stock price advances or holds even. If the negative news about a particular stock or sector of the market continues, sooner or later the stock prices will break or decline sufficiently for investors to change their attitude. Importantly, the attitude change occurs after the prices have declined and investors have losses or much smaller profits.

All these notions are prologue to the current stock market and the prices of some technology stocks. Barron's recently reported that many companies that manufacture telecommunications equipment have been lending money to their customers, the telecommunications companies, in order to maintain their sales growth. While the numbers do not appear to be a major problem, the practice is disturbing to me as a portfolio manager. All other things being equal, I would always buy the company that was not lending money to their customers. This practice has all the attributes of a crack in the façade of the growth sales of communications technology companies. Next, Grant's Interest Rate Observer, an investment newsletter published by James Grant, ran an interesting article on the quality of Cisco Systems accounting and performance reporting. Cisco is one of the Internet communication darlings of Wall Street and peaked last March at over eighty dollars per share. Growing by acquisition, the company has been experiencing declining profit margins, lower returns on equity and more dependence on "other income" to maintain their profit growth. There seems to be some difference between GAAP (Generally Accepted Accounting Principles) accounting and Cisco's reporting, who seems to claim that GAAP is somehow misleading. As you can guess, Cisco's numbers are higher than the GAAP numbers. While these technical issues can be argued back and forth all day long, the truth is that Cisco's stock price has not recovered yet to the levels of last March. Somehow to me, this looks like another crack in the façade of the limitless growth (of stock prices, profits and sales) of some technology stocks. I recommend caution when buying Cisco and other suppliers of communications equipment to the telephone and Internet sectors. There is a distinct possibility that the heady growth in this sector might slow and the questionable practices that were swept under the all-covering carpet of rapid growth might come home to roost.

Put more bluntly, good stock price performance does not mean that all is well with your portfolio. Rotten beams are usually discovered after the building has collapsed. Good portfolio stewardship detects and corrects problems long before the structure collapses. Call me an optimistic skeptic. Look under the rug.

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