Last Updated March 2000

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UESTIONS, QUESTIONS, QUESTIONS. IF ONLY you had the answer to a few, it could really help. Some questions will probably never be answered while the solution to others is rather obvious. This month we have one of each.

Up first is an issue involving corporate reporting. Supposedly one of the advantages of investing in U.S. stocks is the consistency of corporate disclosures. For example, any publicly owned and traded company has to make certain filings at specified times during the year. These are accessible (although mostly not understandable) to the general public. The government oversees this process in an effort to not only provide consistency of reporting, but to ensure unscrupulous management doesn't cook the books.

But recently, more and more "reputable" companies are experiencing difficulties in this area. The problem isn't the disclosures themselves, but rather the lack of accuracy -- often to the company's own surprise. It makes you wonder, Where Are the Accountants?, or at least "What are they being paid for?"

Our second question concerns what appears to be a conservative means of protecting profits in a volatile market. With so many stocks in nosebleed territory and given the punishment doled out for the slightest misstep, doesn't it make sense to use stop-loss orders to limit any downside risk? Or does it come down to Stop Loss or Stop Gain? The answer, although surprising, is pretty clear.

What are you questioning? Or do you have the answers? Either way, e-mail us.

Where Are the Accountants?

"No man acquires property without acquiring with it a little arithmetic also."

-- Ralph Waldo Emerson

 

NYTHING THAT APPEARS TOO GOOD TO BE TRUE probably is. That's what analysts were worrying about in 1998 when HBO -- the medical software manufacturer, not the cable channel -- was reporting blockbuster earnings quarter after quarter. Sales were rising like a rocket and so were profits.

In the fall of the year, analysts' skepticism remained high when McKesson Corp. (now McKessonHBOC) announced its acquisition of HBO. Why would McKesson, a successful medical products distributor, want to purchase a software company -- especially one with questionable earnings? McKesson obviously thought there'd be some synergies between HBO's IT software and their product distribution.

The merger closed at the start of 1999 and the new company's stock peaked just over $96. Then the proverbial poop hit the fan. Apparently the analysts' suspicions were right all along -- HBO had consistently booked sales that never occurred. In fact, they'd done it for at least three years running.

On April 28, McKesson revealed their accountants had found "accounting irregularities" that would require restating earnings from the three tainted years. Two months later, the scene repeated itself with McKesson announcing further reductions in prior earnings. All in all, over $190 million in earnings were simply wiped out. The stock fell 74%, losing almost $20 billion in market value.

Off With Their Heads!

But from where we sit, all these questions miss the real point: Where were the accountants who supposedly signed off on HBO's filings? What were

Whose Fault is This?

Source: Baseline McKesson was sailing along just fine until its ill-fated acquisition of HBO. There's nothing like due diligence and evidently that's exactly what this was -- nothing like due diligence.

they supposed to have been doing? You can be pretty certain they weren't hired for their bubbly personalities and sparkling repartee. Being from one of the major accounting firms in the U.S., you might have thought they'd be reviewing HBO's numbers before signing off on them.

But apparently not. And sadly enough, this wasn't the only recent case like this. No, similar "accounting irregularities" turned up at Cendant, Pediatrix, Medaphis, and Sabratek. And by the way, this list isn't exhaustive. Evidently their accountants were also missing in action.

So while heads roll at the management level and lawyers collect yet more fees for class action suits, the real culprits escape unscathed. Granted, sly CEOs and duped board members are much more interesting than accountants will ever be, but then none of these problems would have gotten this far if the allegedly "independent" accountants had blown the whistle on the book cookers.

Place the blame where it's really due and hold the accountants accountable.

Stop Loss or Stop Gain?

"I do not know which makes a man more conservative -- to know nothing but the present, or nothing but the past."

-- John Maynard Keynes

 

NE OF THE ONLINE BROKERAGES RUNS A COMMERCIAL showing a poor working schlub eating lunch at his desk and checking his stocks. Much to his delight, one has gone straight up. Having made that much money, he certainly doesn't need to work there anymore, so he barges into the boss's office and resigns. Unfortunately, when he returns to his desk, the stock has gone all the way back down to where it started. The commercial's tagline is something to the effect of "Don't get carried away."

While its certainly refreshing to see an online broker encouraging moderation in regard to short-term paper gains, the opposite also holds true: If you're going to be in the market, don't get overly anxious about short-term paper losses either.

Fear of Flying

Stop-loss orders are a major tool of daytraders who quickly jump in and out of stocks, making numerous trades each day. For them, one cratering stock can wipe out a whole day's or even week's of transactions. But then they aren't really investors, they're traders.

Unfortunately some investors think stop-loss orders are what they need, too. After all, you've carefully built your portfolio and don't want to see the the gains you've amassed over the years disappear in one afternoon selloff. So doesn't it make sense to place stop-loss orders 5% or 10% below the current price of your holdings? That way you might lose a little when there's a stumble, but at least the potential loss is limited.

The Aftermath

For example, what are you going to do with the proceeds? Presumably you own what you think are the best stocks, or at least the best ones you could find. If stop-loss orders cause you to sell them, are you going to replace them with those of lesser quality?

And what about your portfolio balance? Odds are, if one financial stock is falling, most others in the sector are too. If you're using stop-loss orders on all of them, your entire financial sector will be wiped out in one day. How do you replace it?

Of course you may be content to sit in cash if the entire market is falling. But then again, if you want to buy low and sell high, that's actually the time to be buying. Indeed, the market rises more days than it falls and most of its major gains come in just a few trading days each year. If you're out for them, you may as well wait until next year.

Short Term vs. Long Term

Applied Materials

Source: Baseline Price Percentage Changes January 1, 1999 - February 18, 2000 Days Days Loss> 5% 20 Gain> 5% 41 Loss> 10% 1 Gain> 10% 3 Beta = 1.63

To illustrate, consider Enzo Biochem, a small cap bio-pharmaceutical company and silicon chipmaker Applied Materials. Both are in hot sectors and it's been reflected in their prices.

Suppose you purchased each on December 31, 1998. From that date through February 18, 2000, there were 20 days when Applied had a 5% loss or more, while this happened 24 times for Enzo. There was one day when Applied had a loss of 10% or more, while Enzo experienced a loss of that magnitude on five days.

As shown on the accompanying table, if you had set stop-loss orders each day at 5% below the previous day's closing price, you would have sold Applied on February 26, 1999 at $55.63, a gain of 30.32%. You would have sold Enzo

Enzo Biochem

Source: Baseline Price Percentage Changes January 1, 1999 - February 18, 2000 Days Days Loss> 5% 24 Gain> 5% 43 Loss> 10% 5 Gain> 10% 18 Beta = 0.43

on March 23, 1999, for loss of 1.16%. If you set the stop-loss orders each day at 10% below the previous day's close, you'd still have sold Applied on February 26, 1999 at $44.63 for a gain of 30.32% -- it was down over 12% that day. You would have held your Enzo longer, selling it on September 15, 1999 for a gain of 180.12%. Not bad for short-term holdings.

But as of February 18, 2000, Applied was up 316.40% and Enzo was up 675.95%. If you had used stop-loss orders during that period, you would have locked in short-term profits at the expense of these long-term profits. If you're going to take the long-term highway, you can stand a few bumps in the road.

Protect Your Principal, Let Your Profits Run

That's a valid concern. So if a rising stock and/or market make you nervous about losing what you've gained, there's a middle of the road approach that may help put you at ease.

If you're like most folks, you worry more about losing your principal -- what you started with -- than your profits. So here's a simple rule to help when stocks and markets are volatile: When your investment in a stock doubles, sell half and reinvest the proceeds elsewhere. Essentially what that does is pull your initial investment back out of the stock, leaving only your profits. At that point you're playing with house money so you can afford to take a few more risks.

If you followed this approach with our example stocks, you'd have sold half of the Applied Materials on October 15, 1999 and by February 18, 2000, you'd have a profit of 208.42%. You'd have sold half your Enzo on August 20, 1999, and have a February 18th profit of 401.65%.

In both cases the returns are less than if you'd kept the entire position but exceed the returns from using stop-loss orders. What these returns don't consider is what you'd have done with the proceeds when you sold the half positions. If you invested them in other stocks with positive returns, the overall result might be better than simply holding Applied and Enzo.

Volatility of the Stock vs. Volatility of the Market

When markets are volatile, individual stock prices can swing in fairly large ranges, but they're only moving with the market. A stop-loss order would probably have you selling on those days. On the other hand, when a stock itself becomes inordinately volatile, stop-loss orders can actually help you maintain short-term gains.

To see why, look back at the charts of Applied Materials and Enzo Biochem. Applied is a volatile stock. With a beta of 1.64, you'd expect it to have some wide swings. If you're a long-term investor, you wouldn't want to use stop-loss orders in the 5-10% range here.

On the other hand, Enzo is not a volatile stock. As its chart shows, until early 2000, its price was fairly steady, mainly fluctuating with the market itself. As you'd expect, Enzo's beta is 0.43.

But in January 2000, the stock price shot up to $122. Here you have a non-volatile stock acting quite abnormally. This is when stop-loss orders can be beneficial. If you owned Enzo as the price was moving from $40 to $122, and if you didn't think these prices were sustainable for the long-term, then stop-loss orders on the days of the price spikes could have helped lock in the short-term profits.

Which again brings us back to the major point here -- stop-loss orders are short-term tools for traders, not long-term investors. Failure to realize this can lead to some really poor decisions, just like that guy in the commercial.

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