A Short Course in Cooking the Books
With Bernard Ebbers (WorldCom) in the slammer, and Ken Lay and Jeffrey Skilling (Enron) most likely hot on his heels, if you think we can now invest with more safety and security, think again. Mark Tier explores…
I much prefer a stock to go down, not up, right after I’ve bought it.
You might think that’s weird. But my attitude is very simple: I only buy stocks that fit my investment criteria – stocks I have sound reasons to expect will rise in value over time. And I only pay what I consider to be a bargain price.
So if a stock I like goes down, it’s an even better bargain. And if there’s something I like better than a bargain, it’s a better one.
This is, of course, the opposite of the kinds of companies Wall Street analysts usually like. They want companies that consistently report higher earnings, predictably and consistently, quarter after quarter. So when one of their companies misses its target, even by a fraction of a cent, the stock gets hammered.
Overstating Earnings and Understating Earnings: Give the People What They Want
From this perspective, is it fair that WorldCom chief Bernard Ebbers is the only one going to jail (via the poorhouse)? And Ken Lay and Jeffrey Skilling (Enron) are the only people who are on trial?
After all, for several years they gave Wall Street – and, presumably, investors – exactly what they wanted. Predictably, consistently, and most importantly, every quarter.
For this achievement they were lauded. They were “heroes of Wall Street” until they fell – or should I say, crashed – from favor.
And where were those so-called watchdogs, the “Guardians” of investor interests back then?
Well, Wall Street analysts and brokers, those self-appointed prognosticators of investment value, were falling over themselves to see who could blow their trumpets loudest for Enron, WorldCom and their ilk.
And unlike the U.S. Army – which in those old Western movies always appeared over the hill just in time to rescue the beleaguered heroine from a fate worse than death at the hands of the Indians – the SEC (as usual, I might add) roared into town with its guns blazing, its lawyers firing writs and its enforcers slapping miscreants in handcuffs long after the horse had bolted…I mean, the money had flown the coop.
So now, courtesy of the SEC, Ebbers is going to jail, with Lay and Skilling quite likely hot on his heels.
Once again, the SEC has succeeded in its mission of protecting investors.
Or has it?
If you were unfortunate enough to be a shareholder of WorldCom or Enron, you might feel a sense of revenge at seeing these CEOs sent to jail – but it won’t do your wallet any good.
Fact is if you want to protect your money, as an investor you’re on your own.
Overstating Earnings and Understating Earnings: Legal Ways to Over- or Understate Earnings
There’s no need to follow Ebbers, Lay and Skilling and go outside the law to “manipulate” earnings. There are lots of areas where there’s plenty of legal discretion to over- (or under-) state earnings. A few examples:
Subscription revenue: Publishers love it when a subscriber takes advantage of those big discounts sometimes offered for renewing your magazine subscription five years in advance. They can book the promotion cost today, while the revenue is amortized over five years. A great tax shelter.
Years ago, AOL got into trouble for doing the reverse: to pump up earnings, they booked the full revenue for such long-term subscriptions as this year’s income. Great for the management whose stacks of stock options soared in value.
Pension plans: Simply increase the expected return on the money in your company’s pension plan by 1%, and you can release a nice chunk of money from the pension plan and add it to the bottom line.
In a world of low interest rates, the generous average assumption of 6%-8% annual return on money in American companies’ pension funds means that most plans are woefully underfunded.
No matter…so long as you, as manager, act within the legal limits of discretion.
“Non-performing” loan reserves: If you’re a banker or in the business of making loans, what portion of your loans should you hold as reserves against bad debts? Within reason, the choice is yours. The more you put in the reserve, the lower will be this year’s profits. Of course, if your reserves are too low, you’ll have to take a big loss…sometime in the future.
And with any luck, you won’t be around when that happens.
Insurance: Insurance companies take in premiums today and pay out claims later – often decades later. To fund those future claims, you must establish reserves so you can pay the claims.
How much should those reverses be? That depends on what returns you expect on the investments you can make with the premium money before you have to pay out any claims…and how big those claims are likely to be.
As in the banking business, the lower your reserves, the more premium income you can book as profits today.
As insurance can have a very “long tail” (some asbestos claims still being adjudicated decades after the policies were issued) there’s probably more room in the insurance business than anywhere else to use “creative assumptions” to “massage the numbers.”
Indeed, Warren Buffett has gone so far as to say that you can practically report any result you want to from quarter to quarter.
There’s just one problem: if you use all these completely legal shenanigans to inflate current earnings, you incur an addition cost.
The higher your profits today, the bigger your current tax bill.
That doesn’t matter too much if you’ve persuaded analysts and investors to focus on pseudo-measures of profit performance like EBITDA (earnings before interest, taxes, depreciation and amortization). Then your earnings can look great…even if they won’t cover your annual interest bill!
Overstating Earnings and Understating Earnings: One More Tool
That’s just one more tool you can use dazzle Wall Street, ramp up your stock price, and cash in your options at an inflated price – all, ultimately, at shareholders’ expense.
You see, every dollar that a company pays out in tax is one less dollar for shareholders, and one less dollar it can invest to make shareholders more money in the future.
So if your aim is to increase shareholder value in the long term, you’ll be as conservative as you can legally be in maximizing reserves against potential future losses…and minimizing today’s earnings (and taxes).
More importantly, when the next recession sends those competitors who under-reserved out of business, you’ll be around to pick up the pieces…and increase your market share.
This is, of course, exactly the business model of one of the world’s best-managed insurance companies: Warren Buffett’s Berkshire Hathaway.
Buffett is as conservative as you can get when it comes to money, so you can bet he’s pushing those loss reserves to the limit, so making Berkshire Hathaway – as a friend of mine described it – “a giant tax shelter.” Completely, 100% legally!
And it’s also what makes a great investment: a company whose management is focused on maximizing shareholder value in the long-term – even if it doesn’t bring them any friends on Wall Street in the short term.
Remember: that the SEC will only protect you by putting shady CEOs in jail after your money has long gone to “money heaven.” If you’re investing for the long-term, your money will be much safer if you take the time and trouble to invest only in companies whose management puts shareholders’ interests first. And (among other things) takes every legal avenue available to reduce taxes and other expenses now so they can make much more money for you in the future.
Be aware: such companies are unlikely to be current Wall Street favorites, as the last thing they’re trying to do is ramp up the stock price next quarter. But if you’ve done your homework, and the stock falls after you’ve bought it, like me, you’ll find yourself very happy to buy even more.
Of course, if you’re speculatively inclined – and can spot the next Enron or WorldCom as they’re on the way up – you can ride the momentum to a small fortune.
So long as you bank your profits before they disappear!
for The Daily Reckoning
August 17, 2005
PS. If you want to understand the intricacies of the insurance business, Warren Buffett is the best teacher. And his latest Letter to Shareholders (http://berkshirehathaway.com/letters/2004ltr.pdf ) is a good introduction.
Mark Tier founded and edited (until 1991) the investment newsletter World Money Analyst, and is also the author of Understanding Inflation, The Nature of Market Cycles, and How To Get A Second Passport. His articles have appeared all around the world, in publications varied as Time, Reason and Business Traveler.
Seven years ago he adopted them himself, sold all his business interests and now lives solely from the returns on his investments.
Nothing much is happening in the financial markets. Gold is over $450 and headed for $500. The dollar is down below $1.23 per euro and headed for $1.50. The Dow lost more than 100 points yesterday and is headed below 10,000. But don’t ask us when!
In the meantime, we continue our outline of ‘America’s Empire of Debt,’ which we began last week, in a speech in Vancouver.
How did America become an empire? We don’t recall the question ever coming up. There was never a debate on the subject. There was never a national referendum. No presidential candidate ever suggested it. Nobody ever said, “Hey, let’s be an empire!” People do not choose to have an empire; it chooses them. Then, gradually and unconsciously, their thoughts, beliefs and institutions are refashioned to the imperial agenda.
While there has been no discussion of whether or not America should be an empire, there has been much public clucking on the specific points of the imperial agenda. Should we attack Iran or Iraq? Should we have national identity cards? Should we suspend The Bill of Rights in order to combat terrorists more effectively?
Many people wondered, including your editor, what was the point of the war against Iraq. The country had no part in terrorist attacks. Au contraire, Saddam’s Iraq was a bulwark of secular pragmatism in an area unsettled by religious fanaticism. It was the religious fanatics who posed a danger, said the papers, not the ruthless dictators who suppressed them. Others wondered if an attack on Iraq would make the world safer…or more dangerous. Or if the United States had committed enough troops to get the job done.
But the big question had already been settled without ever having been raised. Why should Americans care what happened in the Middle East? Or anywhere else? Did the Swiss wonder what kind of government Iraq should have? Did the Swiss try to make the rest of the world more like Switzerland…or allow themselves the vain fantasy of imagining that the everyone on the planet secretly yearned to be more like the Swiss themselves?
While no one noticed, the imperial weed put down roots deep in the soil of North America. By the early 21st century, hardly anything else grew; it had completely crowded out the delicate flowers planted by the Founding Fathers. The debate surrounding the invasion of Iraq was an imperial debate – about means and methods, not about right and wrong. No one from either major political party bothered to suggest that the United States had no business nosing around in other peoples’ business. By then, no business nowhere was too small or too remote not to be of interest. From its military bases all over the globe, and its sensors orbiting the planet, the American imperium watched everyone, everywhere…all the time. In the year 2005, no sparrow falls anywhere in the world without triggering a monitoring device in the Pentagon.
This marks what may be the peak of a trend that began more than 100 years ago. Just about the turn of the century, the United States became the world’s largest economy – and its fastest growing one. Near the same time, Theodore Roosevelt began riding rough over small, poor nations. America’s fat proto-imperialist rarely saw a fight he didn’t want to get into. It was at his urging (he had threatened to raise his own army to do the job) that Wilson announced his readiness to join the war in Europe in 1917. Wilson said he was doing it to “make the world safe for democracy.” This is the stated goal of nearly all U.S. foreign policy ever since – to improve the planet. Of course, almost all empire builders think they are improving the planet. Even Alexander the Great thought he was doing it a favor by spreading Greek culture.
But when Wilson sent troops to Europe, people wondered then what the real point was. America had no interest in the war and no particular reason to favor one side over the other. But there too, they missed the point. America was becoming an empire fast. Empires are almost always at war – for their role is to “make the world safe.”
President Truman clarified the imperial modus operandus when he went to war in Korea with no declaration of war. He didn’t even tell Congress until after the army was engaged and Americans were dying. Then, President Johnson followed up with another war in a far-off place that made no difference to Americans – Vietnam. What was the point? The Swiss army was nowhere to be found. And where were the Belgians? Even the French had given up on Vietnam a decade before. But half a million American soldiers went to Vietnam. And for what? Just another war on the periphery of the empire. None of these engagements made any sense for a humble nation that minded its own business. None would have made any sense for America until the first Roosevelt administration. But once the nation had become an empire – with a homeland and wide-ranging interests beyond it – almost all wars seemed appropriate.
Another landmark in the history of the American empire came just two days and 34 years ago. That was the day that Richard Nixon severed the link between the imperial currency and gold. Thitherto, empire or no, the United States had to settle its debts like other nations – in a currency it couldn’t manufacture. Henceforth, the way was clear for a vast increase in empire spending…and debt.
And thus we arrive at the real problem for the American empire. It has by far the strongest military in the world. It has no serious challengers beyond its borders. Hence, it had to become its own worst enemy. All empires must pass away. All must find a way to destroy themselves. America found debt.
More news, from our team at The Rude Awakening:
Sven Lorenz, reporting from the U.K…
“With oil prices soaring and supply depleting it is no surprise to some that we are building nuclear power plants around the world at a ferocious rate.”
Bill Bonner, back in Ouzilly…
*** “At home, I’m never right,” said Steve Sarnoff to the crowd at the Agora Wealth Symposium last week.
“The only place I’m ever right is in the market.”
He could say that again. Through the years, Steve has completely reinvented an 18th century trading tool, called Japanese candlestick charting.
The great investing expert Richard Russell, founder of the Dow Theory Letters, has called this mild-mannered vegetarian from California, “The master of candlesticks.”
This could explain why you could have heard a pin drop while he was making his speech – people knew that they shouldn’t miss a word of advice Steve was giving.
*** Empires are thought by many to be good things. They expand the area in which trade can take place. In modern parlance, they allow for increased ‘globalization.’ Generally, globalization is good for everyone. It permits people to specialize in what they do best, producing more and better things at lower costs. But it is more beneficial to some than to others. And currently, the Asians are getting the most out of it. There are three billion people in Asia. And almost every one of them is willing to work for a fraction of the average American wage. Not only that, they tend to save their money, rather than spend it. The savings rate in China, for example, is said to be nearly 25%. In America, it is near zero.
Globalization and artificially low interest rates in America have allowed Asian industries to flourish. But for every dollar earned by an Asian exporter, 6 cents in debt was added to America’s heavy balance sheet.
More to come…