Reducing Risk: Making Sound Investments In A Volatile Stock Market

FAYETTEVILLE, Ark. - Investors looking to make sound investments in an increasingly volatile stock market may want to heed the advice of University of Arkansas researcher Tommy Carnes: multiple occurrences of write-downs for restructuring, discontinued operations and other special events bode ill for a company’s future financial performance.

Carnes conducted his research with Ervin Black of Brigham Young University and Vernon Richardson of the University of Kansas. Their study appears in the autumn issue of Review of Quantitative Finance and Accounting.

The researchers looked at nonrecurring events, such as discontinued operations or special items like corporate restructuring. Although these are usually rare or one-time events, some companies show multiple occurrences of these events.

While single occurrences usually have a positive effect on market value, multiple occurrences have a negative effect. In addition, firms with multiple write-downs were found to be four times more likely to go into liquidation or bankruptcy within the next five years, according to Carnes.

The study looked at 33,616 single occurrences and 6,164 multiple occurrences. In a single occurrence the company has not had another write-down in the previous five years. Multiple occurrences are defined as three or more instances in a six-year period.

By looking for multiple occurrences of nonrecurring items, investors can have an additional clue as to the actual financial condition of a company. These occurrences may also signal a drop in the company’s stock prices.

"We found that when there are multiple occurrences of such events, the most recent occurrence has a significant effect on stock price in the year in which it occurs," said Carnes. "The most current event of a series of nonrecurring items has a negative effect upon stock price, whether it has had a positive or negative effect on net income."

The study considered two possible explanations for negative stock price reactions to multiple write-downs: the firms are already in financial trouble and this is just an additional indication of it or the firms are making repeated attempts to manage earnings.

"The results indicate that multiple write-downs are being used by some firms to compensate for overstated earnings in previous period," said Carnes. "This supports the Securities and Exchange Commission concern that earnings are being manipulated through the use of nonrecurring items."

Carnes explained that the SEC is concerned that many earnings statements do not accurately reflect the company’s financial position. In 1998, SEC chairman Arthur Levitt said earnings management had become "a game among market participants," with a subsequent reduction in the quality of financial reporting.

He cites the experience of the company Waste Management as an example. It went back four years to restate its earnings, taking a $3.5 billion write-off. The firm had earned almost 40 percent less from 1992 to 1996 that it had originally reported.

Market analysts usually don’t factor nonrecurring items into their assessment of a firm’s earnings. However, multiple occurrences may be a strong indicator of a company’s financial health, since these firms tend to increase current period discretionary accruals. In effect, they "borrow" future earnings.

"Firms that take multiple write-downs are likely to be those that expected higher future earnings," Carnes explained. "However, management eventually realizes that the expected level of future earnings will not occur. Management’s response is to take an accounting write-down in order to 'catch up’ - and in many cases, the write-down is not large enough to compensate fully for the accumulated effects of the accruals, forcing management to take additional write-downs."