Nortel woes continue
Understand managers' justifications

Yet another bomb has been dropped in the ongoing accounting woes at Brampton-based Nortel Networks. This latest letdown comes nearly four years after the first leg dropped, courtesy of former CEO John Roth. More than 120 investment funds count Nortel among their top holdings. This is an opportunity to better understand how managers make decisions and scrutinize their investment processes.

The bomb

While Nortel's delay in filing its 2003 audited financial statements has always been blamed on expense accounting issues, the latest revelation is an eye-opener. It was revealed that more than US$3 billion in revenue was misstated. Worse, they also confirmed that US$250 million is being "permanently reversed", implying it should never have been counted as revenue in the first place.

This is striking news for a couple of reasons. First, given the damaged trust caused by Nortel's previous 'revelations', you'd think they'd be a bit more careful about making certain claims related to their financials. Second, at the beginning of this month at a Morgan Stanley technology conference, current CEO Bill Owens emphatically stated that, "pure and simple, we will have the results out by mid-November". That's obviously not going to happen.

An excerpt from a November 12 Globe and Mail article illustrates the painful complexity of cleaning up Nortel's books. In part, the article says:

'Nortel has been working on the restatement for about eight months and said it has more than 200 outside consultants and advisers helping 650 of its own financial staff review and verify hundreds of thousands of documents. During the process, the board has met more than 30 times and the audit committee more than 40 times.

But the complexity of the situation extends beyond the financial documents themselves, [John Gavin, president of SEC Insight Inc., an independent research firm] said.

"The new CEO has to figure out who he can trust and there may still be people in there who have an incentive to hide things and cover their own tracks. It makes the forensic accounting exercise inherently challenging," he said. "You may have former employees who know where the bodies are, so to speak, and aren't saying a word on the advice of counsel."'

The next question is which fund managers still hold this stock and why?

Investment fund exposure

According to Morningstar Canada's Paltrak software (as of September 30), Nortel is found in the top holdings of 123 mutual, segregated, and pooled funds. Multiple versions of a particular fund make up about half of those, while just 35 are actively managed. While this is still a significant amount, it is significantly less than the more than 500 funds that held Nortel in their top-15 in May when I wrote this article.

Since managers run multiple funds, I'd estimate that Nortel was only among the top holdings of no more than twenty fund managers. Of the three funds profiled in May, just one - Fidelity True North - still held the high profile stock as of the end of September in its top-15.

Interestingly, Fidelity True North's Nortel weighting of 3 percent at the end of September is nearly 50% higher than the 2.1 percent weighting it occupied in the S&P/TSX Composite Index. Even for benchmark-sensitive managers like Fidelity, that's a significant bet.

However, the dubious honour of 'big Nortel bets' goes to Mavrix Fund Management's 'Growth' and 'Canadian Strategic Equity' funds, with weightings of 6 and 5 percent, respectively in this infamous stock.

I wonder, however, how any larger-than-benchmark weighting is justified given all of the issues that existed before this latest news - namely the suspicious firing of high level executives, the delays in filing its financials, and the complexity of its accounting problems if it takes so many people so long to sort things out.

A matter of style

Seemingly, there are two types of managers holding Nortel today. First, there are the index-huggers. These are managers that will hold stocks just because they occupy positions in widely followed benchmarks. Such managers reason that they should be careful not to step too far away from the benchmark against which they are compared. Pension managers - like PH&N - fall into this camp.

The second type of manager loves volatility because they try to generate income by selling options against existing stock positions. With such a strategy, the more volatile the stock, the better - and they don't come much more volatile (and liquid) than Nortel.

Growth and momentum managers are no longer interested in the stock. Nortel hasn't (yet) reported a profit since the last millennium and has had a falling share price since last winter. And value managers may only be interested after another 50 percent has been sliced from Nortel's share price.

Gaining insight

It's easy to sit in my position and second-guess managers. But what I'm really doing is using hindsight - and this stock - in an attempt to better understand manager style and philosophy. While no manager should be evaluated on the basis of any one or two stocks, such isolated cases can certainly be used to gain greater insight into the way investors' money is being managed. And it could make or break one's opinion of a particular manager.

So, by all means, ask your fund companies and managers why they still hold Nortel - if in fact they do - and why. And demand more than a canned response written by the marketing department. You deserve it for placing your trust in them.