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Revaluations of the fair value adjustments

By Admire Mavolwane

IF one tunes in to international news channels or picks up a copy of the notable publications like The Economist, The Spectator or T

he Wall Street Journal
, he/she is bound to be confronted with coverage of the gummed up overseas money markets.

The first victim of the tightening of inter-bank market funding has turned out to be the United Kingdom’s fifth largest mortgage lender, Northern Rock.

The institution suffered a run on deposits two weeks ago which only stopped after the Bank of England had indicated that it would use taxpayers’ funds to guarantee deposits that were held by the mortgage lender.

Northern Rock’s rocky patch is the result of the long running saga of sub-primes, securitisation, collateralised debt instruments and other financial innovations that have left the markets unsure of who is exposed and to what the extent.

The secondary fear is that financial crises, like buses, come in convoys, so after Northern Rock who is next?

For many Zimbabweans, although the scars are almost healed, the situation reminds them of 2004.

All the seemingly brainy types of securitizations and structured products have not eliminated the fundamental mismatch in the banking sector, which is borrowing short and lending long.

This remodeling — disguised as financial innovation — does not eradicate it. The same risk just emerges in a different form.

The same could be said about the new form of ingenuity that the Zimbabwean corporate world is now showing.

A good number of companies both listed and non-listed, have joined in the stock market game with a lot of zeal.

Not a bad idea, after all, we are all only trying to preserve the little value that is left.

Traditionally, pension funds, insurance companies and asset management companies have been the most influential participants in the stock market.

These institutions train and employ analysts and fund managers who read literature on investment analysis, portfolio structuring and all the details of investing.

Then, these specialists, in trying to put theory into practice, devise “sophisticated” valuation techniques like earnings forecasts, P/E ratios, charts, market capitalizations, discounted cash flows and all the jazzy stuff.

The same whizzes were also responsible for the birth of the Old Mutual Implied Rate (OMIR) and other high sounding terms like currency hedges, in frequent use today. As such it is assumed that traditional players on the ZSE, as defined earlier, invest logically based on some sometimes obscure formula.

The thrust of the investment philosophy is obviously to achieve returns above accepted benchmarks.

The question is what investment formula or methodology does the particular corporate use remembering that it is not core business and neither is return an issue.

Preservation of value is paramount. These guys are thus known to buy at all costs, based just on names and not on fundamentals.

Could it then be said that these cowboys are responsible for some of the questionable price trends in the market which are not in sync with accepted valuations?

Fair and fine, but the increased activity of new players on the market presents traditional investors with a dilemma.

Take, for instance, Circle, which in the six months to June 2007 had operating profits of a mere $39,5 billion, and a revaluation gain on quoted investments of $187 billion.

The same obtains with Econet with the fair value adjustment on quoted shares of $2,2 trillion overshadowing the operating profit of $210 billion.

All the companies in the insurance sector are in a similar position with attributable profits being credited to superlative investment income performance.

Banking groups have also joined the bandwagon with most deriving their profits from investing activities on the stock, foreign exchange and property markets.

So when investing in these companies, what are investors buying into?

In essence a pension fund and/or insurance portfolio is buying into another stock market investment portfolio.

A situation akin to the popular funds of funds!

The problem which arises therein is that when Econet publishes its results the share price in turn re-rates to reflect the revaluation of its share portfolio which probably comprises any of Circle, Kingdom, FML, Nicoz, Bindura, among others.

For FML and Nicoz, for example, the value of Econet shares in their respective portfolios goes up, and the gain is booked in the income statement.

Circle’s portfolio could possibly be holding Econet, and when the cement manufacturer releases it financials, these will reflect the revaluation of the Econet counter.

The same could be said of Kingdom.

Thus the revaluation of Econet’s portfolio — which will be reflected through Econet’s share price -— will feed into the revaluations of portfolios at FML, Bindura, Circle, CFI, Fidelity, Zimnat etc.

Thus revaluations are now feeding into more revaluations.

Eerily for many these so called fair value adjustments are slowly and dangerously assuming a life of their own.

Consequently, the stock market runs the serious risk of becoming a deck of cards.

One positive share price initiates a series of portfolio gains in similar fashion to the sub-primes debacle, which started off as simple loans before mutating into so called collaterised debt instruments and other derivative products.

But once the collapse begun, initiated by the credits defaults, the whole set-up came down on the financial system.

One’s gut is bound to tighten when one thinks of the likely events when the tables turn on the ZSE and share prices start collapsing.

Another consequence of ‘fair value adjustments’ is that the bottom line and operating cash flows are losing significance in the valuation of companies.

In fact, without further analysis, attributable earnings growth rates and the resultant P/Es are misleading.

But for a market used to P/Es, the fact remains that Econet’s interim results reflect $12 994/share. No attention is paid to the fact that that operating earnings per share before minorities and taxation were a mere $1.34.

The powers that be at the ZSE ought to seriously consider compelling companies to calculate and publish an adjusted operating profit and adjusted operating earnings per share, as Old Mutual does.

The adjusted profit would represent the directors’ view of the underlying performance of the company and would exclude fair value adjustments of shares, biological assets and properties, goodwill impairments, profit/losses on sale of subsidiaries, and fortuitous income like exchange gains or losses.

Then, at least, the disclosure level would allow even the layman to ascribe proper values to shares and presumably make more informed decisions.

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