Subject: Options & Earnings

Date: Fri, 02 July 1999 07:22 PM EDT

From: Texirish

Message-id: <19990702192257.22729.00004197@ng-ch1.aol.com>

Warren Buffett has spoken to the "hidden" cost of options that are not reported in GAAP earnings in his usual direct fashion: "If options aren't compensation, what are they? and If compensation isn't an expense, what is it?"

In the current "bonus" edition of OID, Bob Goldfarb of the Sequoia fund spend some time discussing the impact of understated compensation expenses and restructuring charges on the true earnings picture for the S&P 500. He summarized his position in a takeoff of the old Ben Graham testimony:

"Common stocks look high, and they are high, but they are higher than they look."

With full credit to the Sequoia management, and to OID's reporting of same, I'll try to summarize some of his points for this board.

First a word about the concentration of market value growth in the S&P 500. Marshfield Associates in their May 1999 Letter to Clients pointed out the following. In 1998, the S&P 500 rose 26.70% not counting dividends. Take out the top 5 stocks in the index, as measured by market capitalization, and the increase drops to 20.51%. The S&P 500 gain excluding the top 10 and top 20 stocks was 16.93% and 12.87%. Aster Investment Management Co.,

Inc. pointed out the following for the first quarter of 1999. The S&P 500 gained 4.6% during the quarter. However, just 21 big stocks contributed all the S&P 500's advance. (again, thanks to OID for this source material)

Marshfield Associates concluded: "The valuation disparity between the anointed and the unwashed is unprecedented."

With this background, let's turn to some of the work done by Sequoia management to more accurately evaluate the true earnings picture for many of these "anointed".

I can't report all their good work, so I'll jump to the punch lines. They looked at the true cost of stock options issued in 1995 for 10 of the top 12 companies (Lucent and MCI Worldcom were excluded, since they didn't exist in their current form in 1995 - they were replaced with Merck and Home Depot). Based on the actual increase in the value of these stock options since 1995, they would have reduced the 1995 options-adjusted earnings for these

companies by 65%. In the cases of Microsoft and Cisco, the derived options expense was roughly 10 times reported earnings!

Still on Microsoft, at its current market price Sequoia estimates the value of options granted since Microsoft went public in 1986 is many times the company's cumulative net income since its founding.

Goldfarb asks: "What is the economic value of an enterprise that dazzles Wall Street with reported earnings growth of 20-25% or more quarter after quarter, year after year, ad infinitum, but all of whose earnings are consumed to fund and cap employee compensation expense?"

Later, in answer to a question, Goldfarb said that they had extended the analysis to the top 20 companies in the S&P 500. The resulting earnings dilution was lower, but not significantly lower.

There is a great deal of other good stuff in the OID report, but that will have to be covered at another time by other posters or myself. I'll limit this post to the valuation issue.

Stepping back, I am astounded by the implications of (a) the concentration of growth in the S&P 500 plus (b) the overstatement of earnings due to options costs - even excluding the frequent use of "one-time" restructuring charges to further mask the true earnings picture. I knew the "anointed's" market value was overstated, but I had not realized to what extent until I read the Sequoia annual meeting report. What do you suppose is the true P/E of

these companies? Do you still wonder why Warren Buffett avoids investing in them?

Some on this board will undoubtedly point out all the money they've made by investing in these hot stocks. I will reply that they haven't made any money until they cash in, pay their taxes, and place the money somewhere where it will retain its value and pay a decent return. In all bubbles, the ones that get in early and get out in time do very well. The ones that get in late and stay around lose everything - just as in a Ponzi scheme.

How many gamblers die rich?

Tex