When are Extraordinary Items Extraordinary? 3 comments

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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.