MARKET COMMENT
WorldCom: The Consequences For Joe Public

By Bruce Jackson (TMFGoogly)
June 27, 2002

The $3.8 billion accounting fraud committed at US telecoms giant WorldCom (Nasdaq: WCOM) has shaken the Western World. Not just the financial world, but the whole Western World, as witnessed by President George W Bush's vow to "hold people accountable" for the bookkeeping scandal at the company. Politicians normally don't get involved in the day to day machinations of the stock market, but this is such big news that George Dubbya felt compelled to comment.

There's no doubting this is BIG news. The news knocked share prices across the globe. But, the $64,000 question remains - "What does it all mean to me?".

Consequence One - Bankruptcy For WorldCom

WorldCom is likely to go bankrupt. The fear of bankruptcy will likely see many of WorldCom's existing customers desert it. It's often a vicious and rapid downward spiral.

Before this scandal broke, they were already struggling under over $30 billion of debt. Yes, $30 billion. When you consider their total sales for 2001 were $35 billion, it's hard to imagine how they could have been allowed to accumulate so much debt. But, up until a couple of years ago, we were living in unreal (dot-com, TMT bubble) times. If you own shares in WorldCom, you've done your dough.

Consequence Two - Debt Write-Offs For Banks

WorldCom going into bankruptcy will hit some of the banks that have lent money to the ailing company. But, none of them are significantly exposed, and should WorldCom default on its debts, it is certainly not going to bring down any one bank. Bad debts are one of the occupational hazards of being a bank. They are not welcome, but likewise not unexpected. Bank share prices have been hit, but they don't deserve to be hit too hard. 

Consequence Three - Stock Market Valuations

Stock markets across the globe were hammered on the news of WorldCom's accounting fraud. Why? A loss of confidence in reported company profits.

Why does that affect the stock market? Companies are usually valued on a multiple of their reported profits. If a company made £10m profit last year and the stock market determines that the company should be valued at 15 times those profits, it's market capitalisation would be £150m. Now, if that same company's profits were fraudulently over-stated, and they were in fact only £7m, the company may only be valued at 10 times profits, giving it a market capitalisation of £70m, over 50% lower than its previous valuation. It's no wonder stock markets fell when the WorldCom story broke. It's a consequence.

Consequence Four - Corporate Confidence Dented, Economic Recovery Delayed

A scandal of this magnitude erodes corporate confidence yet further. It was already pretty fragile, especially in the TMT sectors (Telecoms, Media, Technology) but this has increased cautiousness. There will be further spending cut backs as many of the heavily indebted telecoms companies attempt to conserve as much cash as possible. Marketing budgets will remain depressed, as that is very much seen as discretionary spending.

Many economic pundits had been predicting a recovery in spending in the latter part of this year. In one fell swoop that economic recovery has been put on hold. That means corporate profits, in general, will remain depressed, and depressed profits could lead to a further depression of the stock market.

Consequence Five - A Potential Buying Opportunity

The WorldCom fraud is a disgrace. It is the epitome of corporate greed, and symbolic of the excesses of the recent past. Many stock market investors are 'up in arms', and rightly so.

But, by far the majority of companies, and their auditors, are 100% honest. For them, a reported profit is a real profit. They are generating cash. Some of them are growing quite steadily thank you very much. Yet their stock market valuations have crashed as the stock market itself has crashed. The experienced stock picker should be able to find some bargains amongst the ruins.

For the time-poor stock market investor, a lower stock market, should be welcomed. If they are continuing to invest regularly into the stock market, courtesy of a vehicle like an index tracking fund, today they will be buying more units than they were a month ago. If they are not intending on selling anytime in the next 5 or 10 years, that's got to be a good thing.

The Bottom Line

There most definitely are consequences from the WorldCom fraud. There may well be further consequences, some of which I've not identified. But, we've had accounting scandals in the past (although not on this scale) and we'll have them in the future. The stock market has recovered in the past, and will recover again in the future, as will corporate and investor confidence.

Finally, don't forget that the best time to invest in the stock market is at the time of maximum pessimism. We may not be there now, but there's no doubting the mood is pretty pessimistic right now. That should get you thinking.

Further reading: Lessons From WorldCom  | Fear Not A Falling Market | All About Index Trackers