As a Bear, there are periods when the stock market is particularly satisfying, and the economic and earnings numbers released each morning cause a contented growl. This is one such period. However, even within this enjoyable landscape there are certain sectors which are particularly Bearishly attractive — they form, if you will, Bear Food.
At this stage, much of the juiciest Bear Food in the New Economy has been eaten. Pets.com was breakfast, and e-toys has effectively been lunch — The stock is now so low, at 3/16 recently, that it’s not worth shorting. Indeed, if somebody buys it for its mailing list, it could even go up. But the memory of Bear gustatory delights, stocks that dropped 98 or 99 percent in a few months, will remain with all right-thinking Bears for many years to come.
There are probably not many more stocks that can be relied upon to drop 99 percent, although clearly some will. There are however many stocks, in both New and Old Economies, that can be relied upon to drop 80 percent in the next 18-24 months, with a percentage of them going out of business. It is these succulent items of Bear Food that must be foraged for now.
These new Bear Food values, some of which are very large indeed, are by no means all concentrated in the New Economy. With the NASDAQ composite index down more than 50 percent since March last year, it is not much more overvalued than the market as a whole, which has barely declined. Indeed some stocks, which have been bought as defensive purchases without really being defensive, have become Bear Food even while the ursine friends were munching on the dot-coms.
One thinks for example of Marriott International, recently trading at around $46, up from $26 in early 2000 and now on a price/earnings ratio of 28, based on earnings in 2000, clearly the peak of the cycle. Hotel earnings are notoriously cyclical; Marriott’s Net Income profit margin in 1992-93, coming out of the last recession, was 1.6 percent. Since this Bear believes that the upcoming recession will be considerably deeper than the feeble 1990-91 effort, that 1.6 percent net income margin is at the top of the range of expected earnings at the bottom. Based on that margin, and assuming sales remain as in 2000, Net Income would decline to 1.6 percent of $9.5 billion, or $152 million, i.e. about $0.60 per share. Assuming a 15 times P/E ratio in a bear market, Marriott would thus bottom out around $9, a drop of 80.5 percent from its current level.
In general the hotel sector, which has been expanding again in 2000 after a rough 1998, can be expected to find itself overbuilt in a substantial downturn, since it is not expecting one; hence hotel and real estate stocks as a whole are prime Bear Food. And that’s without an Internet connection in sight!
Even better Bear Food than hotels and real estate, however, lies in the financial sector, again innocent of New Economy shenanigans. West Coast banks such as Wells Fargo are horribly exposed to the California utilities, which arranged big bank lines before they got in trouble. East Coast banks such as JPMorgan Chase are heavily exposed to leveraged buyout and high tech lending, in both of which they indulged heavily before the music stopped. (It is puzzling to outsiders why banks do this; in every business cycle they lend far too rashly at the top of the cycle, only to spend the next half decade digging themselves out from the rubble. Like Charlie Brown with the football, one is surprised that no learning appears to take place. The reason, I think, is that senior bankers own almost no stock in their institutions, but instead are paid mainly through bonuses, which depend on the results of their unit, and stock options, which depend on the bank as a whole showing good results in the short term. Consequently, they have every incentive to maximize up front fee income, at the expense of incurring lending risks that may not become apparent for 2-3 years, by which time, with luck, they will be in another job or even with another institution. Like many corporate reward structures, this one involves a very high degree of moral hazard, and bank stockholders suffer.)
Consumer based banks and financial institutions also will suffer during the downturn, with the negative savings rate and record consumer borrowings reported last Tuesday being key forward indicators of trouble.
However, the biggest Bear Food in the financial sector comes from the publicly quoted investment banks, in particular Goldman Sachs, the most recently floated and the most enthusiastically valued by the market. Goldman Sachs reported Net Income for the year to November 24, 2000 of $3.07 billion, or $6.00 per diluted share; the stock traded recently around $105, giving it a market capitalization of $53 billion, compared with book net worth of $16.5 billion.
Investment banking is a highly cyclical business, and has been in an up-cycle since 1982 (stock markets were relatively strong in 1990-91, except for a brief six month period.). At Goldman, trading and principal revenues were almost 40 percent of total revenues in the year to November 2000. This gives rise to a particularly interesting accounting phenomenon; a $100 million gain on a private equity position, recorded as revenue, is worth not $100 million but $1.7 billion, because of Goldman’s 17x price/earnings ratio. If trading and principal revenues decline, or turn into losses, as they must during a recession, Goldman’s Net Income would be wiped out entirely, even if investment banking revenues and asset management were maintained (which they won’t be).
Remuneration levels in the investment banking business have soared to an entirely new planet. Of all investment banks, Goldman Sachs is among the best remunerated, both because of its leading market position and because of the deals done with senior staff at the time of the 1998/99 IPO. Jon Corzine, after all financed a record-breakingly expensive Senate campaign from the fruits of an undistinguished 2 year tenure as CEO. With 15,361 employees at November 1999, Goldman’s compensation and benefits totaled around $8 billion, or $520,000 per employee, including trainees, secretaries and janitors. While this figure inspires even Bears to send off their resume, in fact it is totally unsustainable; there is no business on earth which can support such salaries in anything but a raging bull market. Yet Goldman cannot afford to scale back too hard, or they will lose the “rainmakers” to other firms.
Hence in a downturn, Goldman’s costs are relatively fixed, while its revenues are highly variable. Trading and principal profit is likely to disappear altogether, or turn into losses. Investment banking revenue will shrink sharply, because the IPO market will close, and the mergers and acquisitions market will become less active and involve smaller amounts of money. Asset management is a better business, but fees on this, being pro rata to assets, will diminish as the stock market retreats, and performance fees (now a significant part of the total, according to Goldman) will disappear. Goldman’s capital of $48 billion is in fact two thirds debt, so a serious decline in securities markets will eat heavily into its equity.
It must be remembered that, according to Fortune magazine of June 1941, Merrill Lynch, then the largest investment bank in the U.S., lost money over the 1930’s as a whole, was only kept alive by Charles Merrill’s mother’s trust fund, and had about $1.1 million (with an M not a B) of capital in 1940. Goldman Sachs itself had capital of only $50 million as recently as the mid 1970’s. The growth of investment banking activity as a percentage of GDP has been spectacular, but is not irreversible, and it is difficult to see why a true investment bank, which does not indulge excessively in speculating as principal, needs more than $500 million – $1 billion of capital however prominent its business. We would thus forecast that Goldman’s equity capital will approximately halve during the downturn, from securities losses, and that the stock will then trade at a 25-30 percent discount to net capital, since it will be viewed as a closed end mutual fund with very high overhead. That implies a stock price of about $10-11 per share, a 90 percent decline from current levels.
A third area where Bear Food is plentiful is that of telecoms. In the Old Economy area, spectacular destruction of value was achieved during 2000 in the third generation mobile system licenses of the UK (bids for which totaled $34 billion) and Germany (where bids totaled $46 billion.) There were five winners in the UK and six in Germany, all of whom won merely the right to devote untold further billions to develop a system that will offer consumers few usable (as distinct from flashy but meretricious) advantages over the present GSM system. “Successful” participants in both auctions were British Telecom, France Telecom, Deutsche Telecom and Vodafone, all of which have already yielded substantial Bear fodder, and will offer much more. Best Bear grazing of the four is probably Vodafone, still, surprisingly only 50 percent off its high, since it is not a former state telecoms monopoly and thus is unlikely to be rescued by the taxpayer. With 2000 revenues expected to total about $35 billion and a market capitalization of $196 billion, an 80 or even 90 percent drop in Vodafone from its present level would seem likely.
In the New Economy telecom sector, the Bear star is of course Cisco, at around $34 with a capitalization of $296 million down 58 percent from its high, at which point it had the largest capitalization on the NYSE. Since Cisco gave away more than four times its 1999 earnings to employees through stock option exercise, and has given more than its earnings through such exercise every year since 1996, it is difficult to see where stockholder value is being created, and easy to see that earnings will take a sharp downward lurch when employees have to be paid in cash. Assuming 2001-2 sales are in the $25-30 billion range, a reasonable stock price for this sector leader is probably about 1.5 times sales, giving a capitalization of about $40-45 billion, or a stock price around $5-6, down 82-85 percent from its current level and 93-94 percent from its high.
It’s not quite that the Emperor has no clothes. Marriott, Goldman Sachs and Cisco are all leaders in their field and, on balance, I would expect all three to be around in ten years, although possibly not independent. But if 80-90 percent of the Emperor’s clothes are fictitious then he is, at most, clad only in a G-string.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.