Thursday, August 01, 2002

The Poor Standard of Standard & Poor's

How the S&P 500's bad bubble-stock picks have cost investors billions.
By Daniel Gross Posted Thursday, Aug. 1, 2002, at 9:55 AM PT

For decades, investors have regarded the highly diversified Standard & Poor's 500 as a safe place in which to plow long-term investments. For most of the '90s, Americans were hectored to invest their money in S&P 500 index funds. Champions of the S&P 500 boasted incessantly about how S&P index funds crushed most mutual funds and stock pickers, all while charging lower management fees. But in the past two years, the safe S&P 500 has proved to be even more dangerous than the rest of the market. While the Dow is off 26.6 percent from its 2000 peak, the S&P 500 is off a whopping 40.6 percent.

The index is one of the more unlikely villains of the bubble. Despite perceptions, the index is not a passive investment vehicle. Instead, S&P is constantly choosing new stocks and booting old ones. And in the past few years, S&P's modus operandi—which receives surprisingly little scrutiny—led it, essentially, to recommend that investors buy highly speculative companies at or near their tops.

Standard & Poor's traces its roots to 1860, when Henry Varnum Poor, author of the definitive History of Railroads and Canals in the United States, started supplying financial data to investors. His company began to rate bonds in 1916 and merged with Standard Statistics in 1941 to form S&P. Since 1966, it has been part of the McGraw Hill empire, which also includes Business Week.

S&P has compiled an index of 500 leading companies in critical industries around the world since 1957. (Today, it includes only U.S. companies.) And while it typically doesn't get as much press as the Nasdaq or the Dow, the S&P 500 is far more important than either. Because of its breadth and diversification, the S&P 500 is the crucial benchmark for professional investors. Investments by insurance companies, pension funds, college savings funds run by states, and public employee pension funds are either invested in the S&P 500 companies or mimic its makeup closely. "The S&P 500 is used by 97 percent of U.S. money managers and pension plan sponsors," S&P's Web site proudly notes. "More than $1 trillion is indexed to the S&P 500." (That sum is almost certainly lower now.) About 8 percent of the shares of every S&P 500 stock are held by index funds. As a result, S&P's eight-person Index Committee, which selects the companies that enter and leave the S&P 500, is a far more influential stock picker than Warren Buffett or Fidelity manager Peter Lynch.

When a company merges with another index company, or is acquired by a foreign concern, or files for Chapter 11, the S&P committee automatically deletes it. And some companies simply wither away to the point where the committee—which remains anonymous to forestall lobbying—determines them to be too insignificant to merit inclusion.

Between 1990 and 1994, the committee made an average of about 13 changes each year. But with the surge of merger and acquisition activity in the late 1990s, the need for deletions rose. Between 1996 and 2000, the committee changed an average of 40 companies each year. In 2000, a record 58 changes occurred.

The Index Committee, which meets regularly to evaluate potential targets for inclusion, is guided by several long-standing criteria. Companies added are supposed to be representative of the American economy. They should have market capitalizations of about $4 billion or more and should have the largest market values in their sectors. They must also show four consecutive quarters of profits. The committee also uses new additions to ensure that the index remains representative of a highly dynamic economy. If a health-care company leaves, it is generally replaced by a health-care company. But if a company in a declining industry leaves—say a steel manufacturer—the committee might choose to replace it with a company in a rapidly growing industry, like software or telecommunications.

It's easy to see how the standards, which had generally served the index well, were affected by the bubble. Historically, company and industry market capitalizations have been highly correlated with their commensurate roles in the American economy. But that relationship went wildly out of whack in the late 1990s, as companies with relatively small revenues—Yahoo!,, Qualcomm, etc.—became worth far more than giant companies like General Motors and Sears. Suddenly needing to fill a large number of openings, the committee turned to these initiates.

By and large, dot-coms didn't make the S&P 500, largely because they couldn't report profits. But in 1998 and 1999, telecommunications, software, and fiber-optic companies started to trickle in; in 2000, that trickle became a flood.

AOL was arguably the first New Economy stock granted entree into the S&P 500. It entered at the close of 1998, replacing Venator, the parent company of Foot Locker. Network Appliances entered on June 24, 1999, followed soon after by Qualcomm on July 21, Global Crossing on Sept. 28, and Yahoo! on Dec. 7. The tech-tilted makeover accelerated throughout 2000.

The problem was not that these companies were added—it was clear that they represented an important part of the economy—but when they were added. S&P essentially took many of these speculative companies at or near their tops. When Yahoo! came in, it traded at an astronomical 228 (it's now at 13); Qualcomm traded at 159.75 when it was initiated into the club, and now it trades at 27.

S&P also contributed to the frothiness surrounding these stocks. When S&P announced an addition, it became clear that every public fund that uses the S&P 500 benchmark would have to buy that stock on the date of its inclusion. Guess what that did to the fortunate stocks?

On the day Yahoo! joined the S&P 500, it rose 67 points. And in the week between the announcement and the actual inclusion, Yahoo! rose 136 points, or 64 percent. According to a 2000 study by Salomon Smith Barney, stocks selected for inclusion outperformed the S&P 500 by 7.7 percent in the period between the announcement and the inclusion. The net effect: S&P 500 mutual funds—that is, you—effectively bought these new stocks at artificially inflated prices.

Some of the moves the committee made in 2000 turned out to be enormously bad for S&P investors, adding volatile, incredibly overpriced stocks to the index. On Jan. 28, 2000, Consolidated Natural Gas was replaced by Conexant—then an $88 stock, now a $2 stock. On March 31, auto-parts company Pep Boys was replaced by Veritas Software. On May 4, out went Reynolds Metals and CBS, in came Sapient (a $102 stock) and Siebel Systems. On July 26, JDS Uniphase subbed in for Rite Aid. And on Nov. 3, PaineWebber was swapped for Broadvision. Of the 58 stocks entering the index in 2000, 24 were Nasdaq stocks.

Joining the S&P 500 conferred a greater legitimacy on the companies and brought in a whole new class of institutional buyers who, by virtue of their mandate to follow the S&P 500, had to own the newly selected stocks. By virtue of their mandate to follow the S&P 500, they also had to hold them all the way down.

Throughout 2000 and 2001 many of the multibillion-dollar new initiates plummeted and were unceremoniously ejected from the index. Sapient, for example, was booted out after less than two years, having lost 98.4 percent of its value. Broadvision, worth $23 billion at its peak (it's now worth just $98 million), got axed after just 10 months. Conexant got disconnected last June, 30 months after its inclusion.

Investors who plowed funds into the S&P 500 thinking they were getting a conservative barometer have been sorely disappointed. Sure, the S&P 500's performance hasn't been as abysmal as the Nasdaq's—off 74 percent from its 2000 peak. But because the S&P 500 dictates the investments of millions of investors, its decline has been far more destructive.

Big Boom, Weak Profits

Revised figures show Corporate America's earnings were a lot skimpier in the last expansion and were already well into their slide by 2000

Trustworthy numbers are hard to come by these days. Corporations such as AOL Time Warner (AOL ), Qwest Communications (Q ), and WorldCom are under investigation for accounting problems. The reputation of the accounting profession is in shambles. And investigators in Congress and the New York State Attorney General's office have turned up e-mails confirming the long-held suspicion that analysts are pressured to write favorable reports about the companies they follow.

The one beacon of honesty left seems to be the government statistical agencies -- and that's what makes the latest report from the Bureau of Economic Analysis so important. The gross domestic product report, released on July 31, showed that last year's downturn was deeper and longer than first believed. The economy shrank for the first three quarters of the year, rather than the single quarter that the numbers originally showed.

That removes any doubt that the U.S. experienced a true recession in 2001. Moreover, the recovery so far in 2002 has been weaker than expected. First-quarter GDP growth, first thought to be 6.1%, has been revised down to 5.0%, while the second quarter clocked in at only 1.1%, less than half the 2.3% economists had expected.

REAL PRODUCTIVITY GAINS. But more important, the report revises the economic data for 1999, 2000, and 2001, giving a far clearer sense of what really happened during the New Economy boom and bust. The good news is that despite the downward revisions, the productivity gains of the New Economy were real. Since 1995, productivity rose at a 2.5% annual pace, according to BusinessWeek's analysis of the BEA revisions. These numbers might change a bit when the Bureau of Labor Statistics releases its official productivity stats on Aug. 9. While slightly lower than the previous 2.6% rate, that's still a big jump over the 1.5% rate that prevailed from 1980 to 1995.

The bad news: Corporate profits were much weaker than first believed. They've been revised down a total of $143 billion, or 6%, for the three years from 1999 to 2001. While the revisions were concentrated in telecom, utilities, and business services, the problem went well beyond a few bad apples such as Enron Corp. and WorldCom Inc.

Profits, rather than peaking in 2000 as everyone thought, actually hit their high point in the third quarter of 1997, and have been bumping lower since, especially outside the financial sector. Instead of going towards profits, the benefits of faster productivity growth flowed out the door to workers and managers as higher wages and lucrative stock options.

PRESSURE TO CUT. That means the stock market was even more irrationally exuberant in 1999 and 2000 than anyone realized, skyrocketing in value even as profits tailed off. This has big implications for the future. The new data from the BEA suggests companies are going to have to go through a prolonged period of rebuilding earnings to make up for the deep profit decline.

In a world where demand is weak and it's tough to raise prices, that can only mean one thing: continued intense pressure on companies to hold down labor costs by laying off workers, reducing wage increases, and restricting the use of stock options. Indeed, companies such as Avaya, Providian Financial, and Alcoa have announced job cuts in recent weeks.

In 2000, the notion that Corporate America was in the midst of a profits recession would have seemed like heresy. Companies were reporting respectable increases in earnings per share, with the BusinessWeek profits scoreboard showing a 17% gain in the second quarter of 2000 over a year earlier. Federal Reserve Chairman Alan Greenspan lauded the profit performance of U.S. corporations. Even the government's initial estimate pegged corporate profits at a record $964 billion in the second quarter of 2000, a rise of 15% over a year earlier. That made the sharp rise in stocks at the time seem at least plausible, if not fully rational.

TAX DATA KNOWS ALL. But over time, the government statisticians refined their profit estimates, mainly using information from tax returns submitted to the Internal Revenue Service. The IRS data has several advantages.

First, manipulating tax return data is harder than distorting earnings statements, since there is no such thing as a pro forma tax return. Second, the tax data for profits, unlike the financial reports for investors, treat the cost of exercised stock options as an expense. Finally, tax return data includes all companies, from money-losing startups to the biggest multinationals.

With each successive revision, corporate profits have dropped. The declines for nonfinancial corporations were especially dramatic. In March, 2001, the BEA originally reported profits for 2000 of $631 billion. Then in June, it revised the number down to $550 billion. The latest release shows only $462 billion, a number well below the overall profits figure for the preceding several years. Profits for 2000 now appear to have fallen 11% below the revised 1999 total of $518 billion, and 17% below overall 1997 profits of $556 billion--the year they peaked.

WEAKNESS REVEALED. It may well be that the bad news is not over, either for 2000 or 2001. As companies such as WorldCom officially restate their profits, they will refile back tax returns, which will eventually show up in the government figures. And the BEA's profit numbers for 2001 are vulnerable to further revisions as more complete tax data become available.

The profits revisions show just how weak many companies became in recent years. But how did so many fall into such bad shape? A lot of startups ran up big losses during the tech frenzy of 1999 and 2000. Not surprisingly, the industries with the biggest downward revisions in profits were business services -- most of the dot-com startups -- and new telecoms. Webvan had $438 million in operating losses in 2000, PSINet lost $735 million, and Global Crossing lost a whopping $1.4 billion. Remember It lost nearly $100 million in 2000 before closing down.

Moreover, the BEA also subtracts the value of exercised stock options, which can be enormous. For example, Kenneth Lay and Jeffrey Skilling of Enron exercised stock options worth $185 million in 2000 -- an expense that shows up as part of the government's overall profit data but not in reported earnings. In telecom, top executives took home at least $500 million from exercised stock options and other long-term compensation in 2000 alone, and perhaps much more.

RISING WAGES. Finally, companies were simply paying a lot of money to managers and workers. Of course, part of this was the outsize compensation packages executives got. But the biggest cost was the rising outlay for ordinary workers. During the boom years, companies were hiring people at a frantic pace and paying them more and more.

Surprisingly, the wage increases continued even into the recession. From 1997-2000, real wages rose by 5%. And since the end of 2000, real wages have risen by another 3%. All told, from the first quarter of 1997 to the first quarter of 2002, compensation to workers and executives, including exercised stock options, rose by $1.4 trillion. By comparison, corporate profits were flat.

The recession in New Economy profits helps explain why there was so much accounting chicanery during the boom years. Companies were under pressure to show earnings growth, even while their real profits were declining. The hidden weakness also explains the devastation in the stock market over the last couple of years. In effect, stock prices had been soaring for three years, from 1997-2000, while earnings had actually been falling. As a result, it took a wrenching bear market to get stock values back into line with profits again.

NO MAGIC ELIXIR. But the readjustment won't likely stop there. Profits at nonfinancial corporations are still only 8% of corporate output, way below the 11% in 1998. To get profit margins back up to a normal level, companies will have to hold labor compensation flat for at least another year. That likely means cutbacks in health benefits, smaller wage increases, and fewer jobs.

Still, there is no sign in the revision that the central achievement of the New Economy -- faster productivity growth -- is disappearing. Indeed, the latest numbers strengthen the case that output per worker is still rising at a full percentage point faster than it did in the previous 15 years.

But the new numbers also show that productivity growth is not a magic elixir. Just as the U.S. economy experienced high productivity growth with flat or falling profits, the pendulum may swing back the other way, and we may be entering a period of high productivity growth combined with a weak labor market.