Investing and Economy and Investing Column

Data can be deceiving when the economy slows

May 4, 2009
I begin with a few corrections and amplification to my column two weeks ago.

The April 20-26 column entitled "Complex Bond Schemes Haunt Indy, Other Cities" incorrectly stated that the Indiana Bond Bank entered into derivative contracts on bonds issued on behalf of the Indianapolis Water Co. in 2005. Instead, the derivatives (interest rate swaps) were established on bonds issued by the Indianapolis Local Public Improvement Bond Bank to refinance outstanding bonds of Indianapolis waterworks—the government entity that purchased IWC in 2002—and to fund new projects.

Additionally, the point of the column was not to vilify, but to sound a warning to take a jaundiced view when sellers of complex financial strategies come calling with the promise of extraordinary results.

The municipal derivative problem is a global issue. Recently, Italian authorities have taken action over failed swaps on a $2.2 billion bond issue for the city of Milan. These swap transactions were very lucrative for the Wall Street firms that sold them, so more incidents will likely surface.

Switching subjects, investors today are dealing with a variety of calculation problems when attempting to determine if stocks are attractive values. Some of the more common ratios and statistical measures that investors regularly employ to value businesses become skewed in an economic downturn. As such, investors should be careful when reviewing data.

For example, be careful with published price-to-earnings ratios (stock price divided by earnings per share) shown in sources such as Yahoo Finance or Value Line. Investors often seek low PE stocks and there are many single-digit PE stocks listed in their data.

However, in today's environment, a low-published PE could be the result of a stock price that has dropped considerably, divided by high earnings achieved in the previous 12-month period. Those past earnings may be headed lower in the near future, and thus the stock may not be the bargain it seems.

Conversely, companies currently reporting losses will show no calculated PE or a "not meaningful" PE. To dismiss these stocks as unworthy may be overlooking earnings they will generate in the future. Other calculations, like profit margins and return on equity, also can become distorted during recessions.

In market downturns, investors may find an easier road to appraising business values by studying corporate balance sheets. The approximate market value of a company's assets less total liabilities can yield base valuations for investors.

That said, it would be a mistake to outright abandon analysis of the income statement during recessions. Some truly outstanding bargains can be discerned if one can develop approximations for the future "earnings power" inherent in stocks that are presently depressed in price.

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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