Skepticism, Value Stocks and American Express

The giant financial-services firm's earnings reporting raises Bronchick's eyebrows.
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I guess last week's column on the history of

financial booms and busts struck a nerve: Thanks for all the email, and apologies to anyone I couldn't get back to. I guess I'm not used to being popular!

And just as an avalanche of hostile mail in

early April on a similar topic clearly signaled I was on the right track, the deluge of "right on" mail last week inevitably preceded a minirally in a number of the berated issues.

C'est la vie

, as they say.

But some of the questions suggested that not everyone understands what I'm trying to do in writing this column, so let me restate what I call my pertinent issues.

First off, I'd like to take a moment to clear up a common misperception: I am not habitually bearish in the sense that, say,

James Grant

is. I just happen to have developed a skepticism during the past 16 years in the investment business, and it has proven awfully hard to shake. Value managers are paid to be skeptical; growth managers are paid to believe. And, as I've noted in previous columns, there are numerous reasons to be skeptical in the current environment.

In spite of my overall sense that there are a lot of things really wrong here, we are mostly invested in our large-cap accounts and fully invested in our small-cap accounts. And that may lead some to say: "Aha! A perfect example of being fully invested to keep up with the

Standard & Poor's

and

Dow Joneses

: behavior that many institutional portfolio managers display in contradiction to their own investment disciplines." (This is also known as the "Yes, I hate the market, but don't worry, I'll get out just before all the other guys" theory.)

I look at it somewhat differently. As a firm, we get about five good Big Macro Ideas a year, and we usually get about one right. That's why it really pays us to stick to our core discipline. If we find something we like at a price we like, we step up to the plate regardless of the headline du jour.

Since we manage $1.2 billion, and have a fairly concentrated approach, we can come up with 30-odd appropriate names under most circumstances. Today is no exception, thanks to the mile-wide gulch between the institutional favorites and many rank-and-file companies. So that explains why my columns might harp a little hard sometimes on what I still in my gut feel is a grossly overextended market -- yet I may still have five good (

a priori

, of course) ideas to share nonetheless.

I also try to use the column as an idea generator to get people to think about things that are not so obvious, without trying to plug specific names every week. Nothing on this Web site -- or anywhere else, for that matter -- should be taken as an invitation to stop thinking; as in "great, I'll buy some" -- without conducting further due diligence on your own. And frankly, it has been helpful to me as an investor to put some of my undecideds onto

TheStreet.com's

front page -- and I have gotten some terrific feedback from some obviously very bright and focused

TSC

investors.

Which brings me to revisit the subject of two former columns:

Ace Limited

(ACL)

and

Fairfax Holdings (FFH:Toronto), both of which got clobbered recently. I do not have a position in the former and have a minor position (even more minor now thanks to price depreciation) in the latter. Both of these columns are perfect examples of my intent: Here's something that looks really interesting on the face of it; here's why; and so lets all take a closer look.

As for Ace and Fairfax, both have suffered from a truly miserable insurance environment that is hampering efforts to integrate and produce results from recent and large acquisitions. Both stocks appear extremely cheap, and so continue to appear on my promising-candidates list.

In fact, I would be stepping in if I wasn't already stuffed to the brim with some other "not working out so well either" names in the group. And as noted in the Fairfax piece, its insurance group is not

Berkshire Hathaway's

(BRK.A) - Get Report

-- as Berkshire is laboring under the same conditions, and yet is down less than a third of the other two.

Lastly, I also try to present a window into what people actually do on my side of the business on a day-to-day basis. And on that note, I occasionally wish I wrote more than weekly (Forget about it!) when I get scooped on something that so clearly deserves writing about. The most recent example of this was in this week's

Barron's

, which told the tale of a recent

American Express

(AXP) - Get Report

meeting for institutional shareholders. At this meeting, a hedge-fund manager questioned whether American Express would have made consensus earnings estimates without the help of a gain on the sale of credit-card receivables, since the company is spending heavily on its Internet ventures. As for our firm, we had just spent about two hours on this issue and thought it made a terrific column -- but embarrassingly, the ink-and-wood-pulp crowd beat us.

Yet the gain isn't the only thing troubling us. A recent

Financial Accounting Standards Board

rule change on how to account for software spending forces a firm like American Express, which in 1998 had simply expensed $200 million-ish in spending, to now capitalize it over three to five years. In other words, in 1999, American Express is able to take out an additional $150 million of real expenses out of the income statement, and "spend" it on things like more marketing and Internet initiatives.

All of this is spelled out to shareholders if you bother reading the annual report and 10-K, so I am not implying that the company is doing anything particularly weaselly. But the question remains: If American Express thinks it will earn a significant return on its investment in marketing new cards and in building an Internet presence, shouldn't it be spending the money even if reported earnings are hit by a nickel? American Express' strategy has shifted from building spending per card member to acquisition of new card members, requiring more marketing. Are its managers suggesting that they would not have made this shift if the accounting rules hadn't changed and/or securitization gains were not there?

American Express has become beloved because it always hits its numbers, mostly through terrific execution, but also through savvy management of the interplay of revenue growth, marketing and additions to loss reserves. Some might call this earnings management, and like all suspicion of earnings management, the complaints tend to be pretty muffled --

if

you do it well over a long period of time, as I suspect is the case with American Express.

But the fact is that while reported earnings might hit targets, American Express' free cash flow won't grow as fast in 1999, apples to apples, since the cash outlay on software and marketing is going up despite its absence on the income statement. This is not troublesome on its own, as the company should be spending the money. What's troublesome is that American Express and a number of analysts appear to be nodding and winking at each other to maintain shareholder-friendly reported earnings. This raises a classic question: What's really wagging the dog here? As a long-term shareholder, that's a question I'd rather not be pondering.

And uneasily, I am sure this is becoming as common in corporate accounting as getting splattered by air-conditioner run-off in New York this summer.

Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At time of publication, RCB was long Fairfax Holdings, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.