To most people on Wall Street, nothing is more important than earnings season. Four times a year, these releases can be the catalysts that cause giant institutions to deploy billions into, or out of, a particular stock or security. At the same time, these reports may provide the "rationale" for some investment analyst to issue a buy or sell recommendation (causing the investment giants to deploy . etc.).
The whole thing mystifies me, to be honest. You'd think that by now, after all the scandals we have seen involving the likes of Enron, WorldCom, and many others, investors would take the regular pronouncements of corporate executives and their quarterly results with a little more than a grain of salt.
Through a glass darkly
This is not to insinuate that they are all crooks or dissemblers, but generally, corporate executives operate in the micro-environment of their business and their industry. And although they may possess great skill in that domain, their acumen when it comes to forecasting basic economic conditions, to which all businesses are subject, is less sharp than that of any average economist, which is not saying much at all.
In early 2003, I was on a TV show with Jack Welch and several other analysts. Few would argue, I'm sure, that Mr. Welch wasn't one of the greatest CEOs of all time, or at least in the past 50 years. The value he created for shareholders when he ran General Electric (NYSE:GE) was enormous. Yet when asked about the economy back then, Mr. Welch responded by saying he felt things were terrible and saw no sign of any upturn whatsoever.
With the benefit of 20/20 hindsight, we now know that the economy was already improving when Mr. Welch uttered those words, but he, along with many other active CEOs at the time (and a fair share of economists), was dismal. Investors who paid attention to the gloomy forecasts missed out on a 2,200-point advance in the Dow and similar strong gains in the other averages. Moreover, by the time the doubters had their "proof" that things were getting better, the market had already peaked.
I've seen the above example repeated over and over again in my career, and my advice to you is, when corporate execs start talking about how robust their business is, it's probably time to lighten up; and when they tell you how difficult their operating environment has become, you might want to consider adding to your holdings of that particular stock. (Of course, I am talking about high-quality companies, which is all I get involved in.)
There's another reason to be wary of CEO pronouncements, and it's a bit more insidious in nature. Sometimes they don't always provide us with the complete picture. Sadly, that statement probably doesn't shock anyone anymore because we've seen a rash of scandals in the past four years: Enron, WorldCom, Adelphia, Tyco, etc. Some of the perpetrators get caught, some don't.
For whom the bell .
Let me give you an example where the recent actions of company insiders speak far louder than their words. The company I am talking about is Toll Brothers (NYSE:TOL), which until recently was one of the market's strongest performers. It was considered the "Tiffany of homebuilders" because its customer base was comprised of the rich and the affluent and Toll built the mansions for them to live in. It was thought to be impervious to business cycles, or at least far more so than other homebuilders who built for the masses.
For awhile, that certainly appeared to be true. The stock rose more than four-fold from 2003 through the end of 2004, driven aloft by the seemingly unstoppable momentum in the housing market. Yet some economists as far back as 2004 were already starting to talk about a "housing bubble." Ian Morris, an economist with HSBC Securities, told BusinessWeek that he thought "home prices nationally would slide 5 percent to 10 percent over the coming five years."
However, forecasts like that were nowhere to be found at Toll Brothers. In a statement accompanying the Nov. 1, 2004, release of record full-year results, chairman Robert Toll said, "As long as the population continues to rise and affluent households continue to grow much faster than the population in general, and as long as government keeps making it difficult to entitle building lots, demand for luxury homes will continue to exceed supply."
Perhaps. Anyway, who was going to question Bob Toll? He was the preeminent homebuilder operating in the biggest real estate boom this country had seen in more than 30 years. He cited Harvard studies and even then-Fed Chairman Alan Greenspan's view that there was no bubble. Why, then, were the company's president and members of the board, including Toll's own brother Bruce, selling hundreds of thousands of shares?
If few economists believed there was a housing bubble in 2004, many started to be convinced in 2005. In February of that year, Christopher Thornberg, a senior economist at the UCLA Anderson Forecast, said, "We have evidence the market is cooling." And Dean Baker, co-director of the Center for Economic and Policy Research in Washington, said, "A lot will see substantial losses in home value as a result of that bubble, which will be ending soon."
Once again, when asked about the possibility of a downturn in housing, Robert Toll had this to say:
"I don't see any reason for it not to continue to be a good market. The doomsayers are predicting that there will be an implosion that will come from the recognition that the market is just floating on air and not sustainable and that it's going to wreak havoc on the economy. I think that's a lot of bull. I think housing price escalation will continue."
And once again insiders let loose with a barrage of selling, this time led by Bob Toll himself. In February 2005 he filed to sell 1.5 million shares of his stock, and as soon as that paperwork was submitted, he unloaded 777,500 for a total of $68 million. Following in his footsteps were the company's president, executive vice president, and several directors. These sales occurred at or near record highs at the time.
By May 2005, the problems in the housing market were mounting. Inventories were growing, and the Fed was approaching the one-year anniversary of its rate hike campaign with little indication that it was going to stop. Mortgage rates were moving higher. Still, the Toll Brothers chairman sounded unperturbed. On May 10 he offered these reassuring words to investors:
"Demand for luxury homes remains strong, and we continue to enjoy solid pricing power."
Soon after Bob Toll made those comments, his brother sold another 250,000 shares at a price of $91.72 per share.
Fast-forward to today. Toll Brothers' stock is trading at $26 (split-adjusted) per share. The company's net income has declined 16 percent, even though Bob Toll predicted it would be 20 percent higher this year. Now Mr. Toll's assessment of conditions has suddenly turned more cautious. Little more than a week ago he made these statements:
"It appears that the current housing slowdown, which we first saw in September '05, is somewhat unique . It seems to be the result of an oversupply of inventory and a decline in confidence. Speculative buyers who spurred demand in '04 and '05 are now sellers; builders who built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction."
Moreover, he referred to a "continuing malaise" that was "undermining consumer confidence and keeping buyers on the sidelines." Long gone is the haughty talk of a housing slowdown just being "a lot of bull."
In all fairness to Bob Toll and the insiders at Toll Brothers, they shouldn't be castigated for not getting their economic forecast right. I told you; it's hard. It happens to economists all the time and it happens to the rest of us at least that often. However, what the insiders at Toll Brothers did was consistently unload huge amounts of stock while telling investors all along that everything would be great.
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Fool contributor Mike Norman is the founder and publisher of the Economic Contrarian Update and a Fox News business contributor. He is also a radio show host at BizRadio Network. Mike does not own shares in any of the companies mentioned in the article. The Fool has an ironclad disclosure policy.
