On Tuesday, June 30, Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), a leading oil-and-gas company, announced it would take an asset write-off — slashing its asset values on the balance sheet — of between $15 billion and $22 billion in the second quarter. The same amount, of course, will hit Shell’s quarterly earnings. The massive write-off, said Shell, is a result of its assessment of the coronavirus pandemic impact on its business and asset values, particularly the integrated gas unit. Investors’ reaction was swift — Shell’s stock price dropped almost 3% for the day.

This is not an isolated event. We are now witnessing an avalanche of asset write-offs by oil companies (BP (BP), announcing earlier this month a $13 billion to $17.5 billion write-off, and Chevron (CVX), an $11 billion write-off in December 2019). Asset write-offs in other industries, reflecting worsening of the business environment, are also announced, though less frequently than in oil and gas.

What is the relevance of such asset write-offs, often of staggering amounts, to investors? Is it a signal to dump the stock, as some Shell investors did on June 30?

Let’s examine first the effects of an asset write-off: It decreases asset values on the balance sheet and, correspondingly, reported earnings. However, it does not affect the all-important cash flows, because a write-off is essentially no more than an accounting entry. And it has a generally small negative effect on reported leverage (debt/equity ratio), since a write-off reduces balance sheet equity (book value), typically by 5%-10%. Of the above, the direct adverse effect of an asset write-off on earnings sounds most serious.

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So why did investors shrug off the large oil companies’ write-offs? After dropping 2.8% on June 30, Shell’s stock price gained much of this loss in the following two days. BP’s announcement on June 15 of up to a $17.5 billion asset write-off had no effect on its stock price, neither on that day nor the next. Chevron’s announcement, Dec. 10, 2019, of an $11 billion write-off, caused a slight price increase on that day (to $114.84), and a further increase two days later (to $115.74). It doesn’t seem that giant asset write-offs spook investors. Large-scale research on the asset write-off issue is sparse and largely outdated — likely because researchers too realized it’s a nonevent. Some studies showed a small negative price reaction to write-off announcements, particularly when it came to goodwill, while other studies showed a small positive reaction. Overall, it seems to be a washout.

How can this be? Huge hits to earnings leave investors blasé?

Two reasons.

Both the write-off amount and its timing are highly questionable and sometimes manipulated. An asset value is determined by the future cash flows, or savings, it will generate. But how reliable are such cash flow predictions, particularly in the current environment? Not highly. So determining an asset write-off (loss of value) is essentially a guesswork. (I am not referring here, of course, to assets, like securities, which are traded in active markets.)

Worse yet, evidence shows that the timing of asset write-offs is often manipulated by managers to alleviate investors’ reaction (like writing off during a crisis when investors already expect large losses). So, given the questionable amount and timing of write-offs, it’s no wonder investors’ reaction is often muted. Asset write-offs essentially reflect a worsening of business conditions, now and in the foreseeable future. But in most cases investors already know this well before managers announce a write-off. Who hasn’t heard for months about the troubling state of the oil-and-gas industry with no clear direction in sight? So, the bad business news is often baked in to the stock price long before it’s confirmed by an asset write-off. The write-off is old news.

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One more point: The current furor over Exxon (XOM) avoiding a massive write-off of its assets is intriguing. Complaints were filed with the SEC and DOJ and lawsuits are threatened against Exxon. Based on its peers’ experience with write-offs I suspect that, when Exxon finally yields and writes off some assets, it will be a dud in the market within a few days.

So what should you do when a company announces an asset write-off? I would do nothing, unless the write-off runs counter to my positive perceptions of the company. In this case, managers’ negative views conveyed by the write-off warrants a reconsideration of mine.

Disclosure: I am/we are long XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Via SeekingAlpha.com