Some value managers - including Putnam Investments, Boston, and Hotchkis & Wiley Capital Management, Los Angeles - are reworking their stock valuation models because of the pension liability crisis facing corporate America.
Putnam adjusted its discounted cash model last year to factor in pension liabilities, said Debby Kuenstner, chief investment officer of the global value equity group. Since the third quarter, managers have been able to screen the value stock universe for companies expected to be hit with pension contributions and to reduce those holdings, she said. She wouldn't name any companies.
Hotchkis & Wiley beefed up its dividend discount model last summer to reflect the impact of underfunding on balance sheets and earnings, said Gail Bardin, portfolio manager. The firm had always adjusted earnings to remove pension surpluses from the calculation, but the new balance sheet calculations "highlight analysts' attention on companies with pension problems and put our minds at rest about the other companies," Ms. Bardin said.
Ms. Bardin said analysts didn't find any time bombs in the firm's value portfolios, but "to be ahead of any problems," they run all stocks in the Standard & Poor's 500 index through the model weekly.
"You have to spend time and be careful to back out core underfunding from earnings and adjust the valuation based on these new liabilities," said Bob Costomiris, a large-cap and small-cap value manager at Strong Capital Management Inc., Menomonee Falls, Wis. He said he used to look for companies with attractively overfunded pension plans because his strategy treats pension surpluses as assets. Now, he noted, "the game is just the opposite."
Catherine Zaharis, a midcap value portfolio manager at Principal Global Investors, Des Moines, Iowa, said: "Our biggest concern is the impact of pension underfunding on earnings. We're very aware that in past years between 20% and 30% of earnings came from pension surpluses. What we are seeing now are more companies with lowered earnings estimates because of pension impacts. Negative surprises like that concern us."
Ms. Kuenstner recently briefed Putnam's less experienced staff about pension underfunding. "The younger analysts had to be reminded that pensions are important because they don't show up on the balance sheet and they (analysts) weren't used to looking for pension assets or liabilities."
Or, as Thomas McKissick, a value portfolio manager at TCW Investment Management, Los Angeles, puts it: "We haven't had to think about this for 20 years."
What's more, pension underfunding will become an even larger factor in picking value stocks if equity markets don't improve or interest rates don't increase this year.
Ms. Kuenstner expects an urgent wake-up call by the end of this year, when "the market will realize that pensions are hurting the free cash flow of many companies, and that will start impacting stock prices."
Analysts at Victory Capital Management Inc., Cleveland, predict plan sponsors will have to adopt lower assumed return rates of 6% to 6.5% over the next five years, said Richard Turgeon, director of research. If interest rates drop, the discount rate assumption will have to be lowered as well, and the present value of the liabilities will be increased.
"One portfolio manager on our team (recently) told me that underfunding was `yesterday's news,' but he's wrong. Over the next five years, companies will get mid-single-digit returns combined with a lower discount rate. That means they will have lower returns with increasing liabilities. These are real costs to companies," Mr. Turgeon said.
Carlene Murphy Ziegler, who manages small-cap growth stocks at Artisan Partners LP, Milwaukee, agreed. "(Investors) aren't paying enough attention to what return assumptions and discount rate assumptions companies are using to calculate pension fund liabilities" and have not begun to absorb the impact of underfunding.
"But when companies don't report earnings at all, or eroded earnings (later this year), those stocks will be punished. And they haven't been punished yet," Ms. Ziegler said.
She expects a small-cap rally, however, because U.S. companies will not be equally affected by the need to increase their pension contributions. Most small-cap and midcap companies, as well as technology companies and newer companies, offer defined contribution plans, Ms. Ziegler said, making them more attractive investments.
Not all value managers are worried, though.
"Pension underfunding is something to think about, but not something we worry about. Pension underfunding is a minor consideration at this point," said Neil Eigen, chief investment officer for value stocks at J.&W. Seligman & Co. Inc., New York.
U.S. companies with major underfunding problems tend to be old-economy companies with mature workforces - such as airlines and automakers - that are few in number and well known, Mr. Eigen said. Because corporations can smooth out pension funding over several years, the impact on most other companies will be minimal, although the use of cash for pension contributions could affect a company's ability to grow, he said.
"If you are using free cash flow to pay down the pension obligation, you aren't investing in the company. There is absolutely no return on this investment," Mr. Eigen said.
Mr. Eigen said he can make a case for stock market improvement this year that would erase the pension deficits of many companies. But if the markets don't cooperate in 2003, even Mr. Eigen said he would have to think seriously about the impact on free cash flow.