Astute investors seek opportunities both long and short, but an accounting rule that most fail to follow closely could be creating risk, and potentially, reward, for those who understand its impact.
The term is “goodwill,” which sounds positive but really means that some asset the company has — typically the market value of a second company it acquired at an earlier time — is clearly worth less money than before.
Remember the Time Warner/AOL debacle. The magazine giant eventually had to recognize that it overpaid for the online service, resulting in a one-time goodwill charge that nevertheless made headlines in 2002 as the largest quarterly loss to date in history — $99 billion.
So, watch out for companies whose goodwill exceeds market cap. Your broker can help you find them, but a recent analysis from North Square Capital shows that car and truck parts maker Valeo’s goodwill is now 554 percent higher than its market cap; Telecom Italia is at 219 percent; and recently merged market news service Thomson Reuters is at 119 percent. (These are selected examples, not personal recommendations.)
Accounting practices require goodwill to be tested for impairment on a yearly basis; with falling stock prices, goodwill will need to be deducted from earnings.
Therefore, earnings and equity prices have to decline in order to reflect assets shrunken by those one-time accounting charges.
Be careful, though, there is no effect of the writedowns on the cash flow, but the impact is real as writedowns may also increase leverage ratios and limit borrowing.
It can be expected that the effect of the upcoming writedowns will be negative in the short term, that is, during the next six months.
Most of companies in this position have high goodwill numbers because of past takeovers, especially the ones completed at the top of the boom market.
Some examples of the effect goodwill can have on stocks:
On Jan. 19, shares in the Royal Bank of Scotland collapsed as the British government raised its stake and the bank reported Britain’s largest ever corporate loss after an impairment charge on its takeover of ABN Amro.
Regions Financial lost a quarter of its value on Jan. 20 after taking a $6 billion goodwill charge on its $10.5 billion purchase of AmSouth Bancorp
Don’t be surprised to see losses in upcoming earnings of companies in this position. Last year’s goodwill is not tenable given the current share prices.
For those with speculative instincts I think that these stocks could be short candidates. This should not be considered as advice but only as an alert. Risk takers must take their decisions on their own.
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