Friday, September 02, 2005

When are Extraordinary Items Extraordinary? 3 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
By now most would be aware that Katrina is not the name of some new starlet but rather a rather tempestous hurricane that has taken the US coastal areas by storm, literally. It has devastated the US state of New Orleans, probably killed thousands and has left the world's refining capacity in a tight bind by sweeping away twenty oil rigs.

Last year it was Hurricane Ivan which caused major US refineries to shut down production. This year it is Katrina. Next year what will it be? It sure looks like hurricanes in the US in September-October are not an extraordinary event anymore. If you were considering the fundamentals for say, a US refinery, would you then consider its provisions for say, its shutting down due to the hurricane, as an extraordinary occurrence that should be factored out when calculating PE? Surely not, if there is a strong likelihood it is going to recur year after year.

Let's think back to a few other events that have had a habit of repeating themselves. Livestock-related viruses/illnesses in Asia & in particular China -- pig flu, avian flu, lead poisoning from fish; chronic power shortage in the cities and factories during summer in China; regular fogging of Malaysia (and sometimes Singapore) during the June-August period; terrorist attacks over the world; all these have been considered extraordinary events at some time recently and some have since been factored in as key risks that companies in the relevant sectors would have to face; others might still be viewed as extraordinary events.

Extending this to investing, I have realised that we should be careful when reading financial statements and be wary and even cynical when we come across "extraordinary" charges, usually classified as provisions. These might be due to the company selling off certain subsidiaries at a loss (ie. below book value), incurring certain bad debts that have to be written off (provisions for doubtful receivables), or incurring writeoffs due to inventory obsolescence. If the company has been selling off subsidiaries routinely at a loss, then surely it says something about the judgment of the management? If high receivables provisions have to be made (typically the way to judge is by comparing it with revenue base) then it says something about the credit-worthiness of the customers. And if inventory has to be written off, it suggests an inability to dispose of the company's goods which might point to longer-term problems with the brand. And of course, what's to stop a company from exaggerating its revenue and then taking charges on its receivables to achieve a net result of an image of a growing company albeit affected in the short term by certain temporal concerns. That is what Lucent did; investors ignored these provisions and focused only on the growing topline during the dot-com boom; they paid the price for it later.

The long and short of it is that for market players, and indeed more so for long-term investors, recognising when extraordinary events are indeed likely to be solely unique to that year, and when they are not really "extraordinary" and might indeed morph into a trend, is a very important process to think through.




Anonymous Anonymous said...

"...has left the world's refining capacity in a tight bind by sweeping away twenty oil rigs."

i would like to state that the shutting down of oil rigs(which produces crude oil) would relieve the over-utilisation of oil refineries(which produces refined oil), instead of adding to the supply gut of crude oil.
there are shortages of refined oil, not crude. the fact that price of crude oil is sky-high baffles me.

anyways, this correction has nothing to do with the crux of the article.

9/02/2005 11:11 PM  
Blogger DanielXX said...

Hi Quest,
You're rght, my mistake. The oil rigs drill for crude oil. Anyway, the refineries have been forced to shut down, so Katrina's impact is on refining capacity as well.

As for the price of crude oil, surely if the demand for refined oil products is high, the demand for crude oil will be high (and hence high oil prices)? Whether refining capacity is tight or not will only have an impact on refining margins, not the price of crude oil. On the supply side, light sweet crude oil is apparently tight, because spare capacity from Saudi Arabia is mainly the heavy sour variety, which is less sought after.

9/03/2005 3:49 AM  

I like to look over a balance sheet before I buy a stock.

12/11/2012 3:54 PM  

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