Five Lessons From Xerox
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Xerox once epitomized the large multinational corporation typically found in Foolish Four or Beating the S&P portfolios. But something went terribly wrong. Today we examine five myths that often surround such companies. Stay tuned to the end for a challenging puzzler!
By Ethan Haskel (TMF Cormend)
October 25, 2000
The recent implosion of Xerox <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: XRX)") else Response.Write("(NYSE: XRX)") end if %> has been about as pleasant for shareholders as a massive copier jam two minutes before the Big Presentation. The ugly particulars of Xerox's woes won't be detailed here. Readers are referred to articles at the Fool and elsewherefor their pre-Halloween blood and gore. What we've witnessed in the last year-and-a-half is the downward spiral of a once-majestic corporate leader to a company now fighting to stave off financial collapse.
Xerox's plight should be of no small concern for Foolish Four or Beating the S&P (BSP) investors. It was only last year that the company was a member of the elite BSP 30, a group of corporate giants selected partially for their presumed stability. For a while, "The Document Company" was included in many a BSP portfolio, given its relatively high yield and low stock price.
But something went terribly wrong with Xerox, as made clear by yesterday's disastrous quarterly earnings report. As with any unexpected disaster, from the Titanic to the space shuttle Challenger, there are always lessons to be learned -- lessons especially pertinent for those investing in large, established companies. Xerox, once deemed a prototype of such a rock-solid company, demonstrates five common myths of investing.
Myth 1: The stock price of a huge company may decline, but it will not crash.
One look at Xerox's price chart will dispel this myth forever. From July of 1999 to its low one week ago, the company's stock price declined from over $60 to under $7, a loss of nearly 90%. That's enough to make Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> seem like a stock for cautious widows and orphans! And Xerox isn't alone. The charts of past and present Dow giants Goodyear Tire <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GT)") else Response.Write("(NYSE: GT)") end if %>, Union Carbide <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UK)") else Response.Write("(NYSE: UK)") end if %>, International Paper <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IP)") else Response.Write("(NYSE: IP)") end if %>, and Eastman Kodak <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EK)") else Response.Write("(NYSE: EK)") end if %> all look nearly as ugly.
Myth 2: A high dividend yield will prevent a large decline in stock price.
When Xerox was flying high -- a short 18 months ago -- its dividend yield was 1.3%, roughly the equivalent of the S&P 500 as a whole. When Xerox's share price nose-dived from $60 to the $22 level found at the start of this year, the yield increased to 3.7%. Earlier this summer, the stock price fell further (to $15), with the yield climbing to a whopping 5.4%.
Many investing professionals reason that this large yield puts a safety net on future stock price drops, believing that at such a high yield, any further drop in stock price is unlikely. The reasoning is that at such high yields, institutions looking for income stocks will jump in and buy the stock mainly for its generous dividend. This type of buying may play some role in maintaining a stock's price. But if a company's earnings and prospects turn really sour, the stock price will always drop further. In fact, Xerox's stock price did drop yet again, from $15 to under $10, yielding well over 8% recently. One primary reason that the Foolish Four drops the stock with the highest RP ratio and BSP drops the very lowest-priced stock, is to try to avoid such meltdowns.
Myth 3: Huge companies will remain huge forever; sticking with them perpetually is usually best.
Just 10 years ago, the elite Dow 30 included companies such as Woolworth -- renamed Venator <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: Z)") else Response.Write("(NYSE: Z)") end if %> -- USX, Union Carbide, and Bethlehem Steel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %>. In Gulliver's world, such former Brobdingnagians have shrunk to relative Lilliputians. All these companies now sport market caps of $4 billion or less. There is no such thing as a corporate American Manifest Destiny, where large companies inevitably conquer the world. Staying too long on a sinking ship often courts disaster.
BSP recognizes that all huge companies don't necessarily stay huge forever, and thus the BSP 30 list changes annually to reflect new corporate realities. Xerox was not included in the new BSP 30 list in March since its lower market capitalization made it ineligible. Flailing Dow companies are jettisoned as well, although not nearly as frequently as those in BSP. As we've seen, recent Dow outcasts haven't performed very well.
That's not to say that we should abandon either Foolish Four or BSP stocks that crash once they've already been included in our portfolio. These companies often are experiencing short-term problems that are correctable. As far as I'm aware, there's no variation on these strategies that has shown that dumping them in midstream is better than leaving them until the next renewal date.
Myth 4: A stock split almost always bodes well for a stock's future price.
Xerox split its stock 2-for-1 in February 1999, and it was downhill from there. Fools have learned that stock splits add no real value to the price of a company even though when a fast-growing company splits its stock and continues to grow, the split can create an illusion of value. When a company isn't growing robustly for fundamental reasons, the illusion fades fast. In fact, I've shown previously that Foolish Four or BSP companies that split their stocks within the previous year perform miserably: More than 90% of these companies subsequently underperform the S&P 500.
When such a stock becomes eligible for Foolish Four or BSP because of the (artificially) lower stock price, it's a far different situation than when its price simply drops naturally. Because of the compelling data (compelling enough to me, at least), the BSP strategy doesn't buy an otherwise eligible BSP stock if it has split its stock price within the past year. Application of this rule not only would have saved investors a lot of grief with Xerox, but would also have spared some misery for holders of the Foolish Four's AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %> and BSP's Chase Manhattan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CMB)") else Response.Write("(NYSE: CMB)") end if %>.
Myth 5: A dividend cut almost always bodes poorly for a stock's future price.
About two weeks ago, Xerox announced it was cutting its dividend by 75% as part of a restructuring move. When a company cuts its dividend, it's almost always in real trouble. It makes sense then that the stock price of companies that cut their dividends should inevitably fall further, right? Wrong.
A few months ago, I looked at the fate of all 40 Dow companies that cut their dividend since 1961. On average, these companies performed very poorly in the year they made their cut. That's not surprising, since dividend cuts are usually only made when a company is in tough financial straits. But for the year following the calendar year of the dividend cut, the average Dow dividend-cutter performs about the same as the market indexes. Foolish Four stocks that cut their dividend, in contrast to the average Dow dividend-cutter, did very well in the year after the cut -- on average doubling the return of the S&P 500.
Technically, Xerox is currently neither a Foolish Four nor a BSP stock, so we can't make any generalizations about the meaning of Xerox's recent cut. But just because a beaten-up company announces a dividend cut, doesn't necessarily mean its future stock price is doomed. A dividend cut often indicates that the company finally recognizes its deep problems and is willing to take the necessary steps to correct them. Often the poor outlook is already factored into the stock price, and there's nowhere to go but up as company restructuring occurs.
Former Foolish Four company International Business Machines <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> and former BSP company Chrysler -- now DaimlerChrysler <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DCX)") else Response.Write("(NYSE: DCX)") end if %> -- are two noteworthy companies that admirably reversed their fortunes. Others, such as former BSP company Kmart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KM)") else Response.Write("(NYSE: KM)") end if %> -- which went into a tailspin after a stock split in 1993 -- haven't. Whether Xerox will be able to rebound from here is anybody's guess; I'll leave the speculation to others.
Now, for a little fun. Speaking of Xerox, what do the following companies have in common: Xerox, PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %>, Enron <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ENE)") else Response.Write("(NYSE: ENE)") end if %>, Johnson & Johnson <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JNJ)") else Response.Write("(NYSE: JNJ)") end if %>, and Minnesota Mining and Manufacturing <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MMM)") else Response.Write("(NYSE: MMM)") end if %>? Check back next week for the answer.
Beating the S&P year-to-date returns
(as of 10-24-00):
Bank One <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ONE)") else Response.Write("(NYSE: ONE)") end if %> +10.5%
PepsiCo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PEP)") else Response.Write("(NYSE: PEP)") end if %> +32.0%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -8.6%*
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> -8.3%
Fannie Mae <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FNM)") else Response.Write("(NYSE: FNM)") end if %> +19.9%
Beating the S&P +9.1%
Standard & Poor's 500 Index -4.8%
*Includes Visteon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VC)") else Response.Write("(NYSE: VC)") end if %> spin-off
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +23.5%
S&P 500 +16.5%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $183,100
S&P 500 $81,400
