The Aleph Blog » 2013 » January » 18

Archive for January 18th, 2013

Penny Wise, Pound Foolish

Friday, January 18th, 2013

Some of the dumbest things I have seen in my life inside corporations revolve around incompetent managers, who don’t have the foggiest idea how to grow value organically, and use a variety of shortcuts or cheats to give an illusion of creating value by doing nothing.  I have given a few examples in these two articles:

Here are some more examples:

Some acquirers tend to despise the employees of firms that they acquire, and assume there is a lot of fat to be cut.  So it was that a client that I managed assets for that was acquired by a British company.  A few months after the acquisition the client firm announced that they were firing half of the accountants, and all of the accountants dealing with investing.  I went to the management of the firm that was a new client of ours and expressed my concerns, saying that they would lose all customization and control of results by outsourcing investment accounting — it could never be as responsive as retaining “in-house” staff.  Also, firing half of the remaining accountants would lose a lot of local knowledge where systems are deficient and need “hand holding’ with regular adjusting entries to make sure the accounting was correct.

In this example, the investment accountants were actually quite good, though their leader did not present well.  I had a good relationship with him and his staff, and helped them find new jobs, much as I hated to see them go.  I did the same for some of the other accountants that were let go, since I interacted with some of them as well.  It almost seemed like the new client wanted to eliminate all of the accountants with special long-term knowledge of the business, and retain the cheaper ones with less institutional knowledge/tenure.

As it was, my dealings with the new heads of financial reporting left me scratching my head, wondering why the new guys were a “trade up.”  They seemed to understand the issues less well than those they replaced, but were advertised to be really bright.  Okay, lost on me.

I relayed my concerns to my bosses, and they said, “Not much we can do.  We have the same ultimate parent company, but they’re not geared toward taking feedback at what would be such a micro level for them.  Let’s just watch and see what happens — if it is as bad as you think, it should materialize in six months or so.”

As it was, my bosses were right, and so was I.  For the first six months after the accounting change, profits were astounding.  The new management team was patting itself on the back, certain that their decisions were leading to greatly improved profitability.  (As an aside, I remember sitting through interminable meetings where new accounting software was being introduced. The old stuff was not good enough.)

Then came the year end audit, and new internal auditor plus new external auditors questioned accruals produced by the new outsourced investment accountants.  I was asked what the right approach was for accruing income on some obscure fixed income security.  Belying their cheap cost, the new investment accountants did not make the correcting entries into the system that the old accountants had, leading to a massive over-reporting of income.  Far from being more profitable than the past, it was far less profitable, despite all of the firings in accounting.

This was the first comeuppance of many for an untalented management team that eventually all got fired, as well as the ultimate CEO of the firm that trusted them, and invested a lot of money into that subsidiary.

Warnings to the wise: always analyze your profit margins in a competitive industry, and if results seem too good to be true, don’t accept them, push back and look at all of the squishier accrual items to see if there is an error.  Bad management teams accept good results without question, and criticize bad results always.  Good management teams criticize unusual results, whether good or bad, but bias income to the low side of fair, allowing small positive surprises to emerge.

Then there was the time where an insurance company that I worked for bought out a smaller company, and the hidden price of the deal was that the new CEO would be the CEO of the acquired company in a year.  Bad move.  The guy was an accountant, and his only means of “adding value” were cutting employees, and skimping on squishy accrual items.  While he was CEO, I kept track of how mach GAAP income outpaced my adjusted Statutory income, which should have been close to GAAP.

The CEO had a fragile personality as he did this, emphasizing that the team he had assembled (loyal, but less competent) was highly ethical.  As it was, the CFO tried to find ways to convert capital gains into regular income for GAAP but not tax purposes, which maximized ROE, which was the largest contributor to management bonuses.  They were even the first ones to try an unusual derivative marketed by Morgan Stanley — bull/bear notes, as they were called. It was a bond that would split in two after a certain trigger, leading to two bonds — one with a premium income that would be held, and one with a discount income that would be sold for a capital loss.

Sadly, the company had a hard time evaluating the offer, until they approached me.  (Here is where ability conflicts with ethics.)  The chief actuary (via the Peter Principle, but true of all of that management team) showed me the derivative, and I said, “Oh, that’s easy.”  I told him I would have results by the next morning, and it was 4PM already.  I took it home, worked on it through the evening, and the next day presented the result.

I told him that the math worked mostly, but that if the US Treasury applied anti-abuse rules, it would be invalidated.  I also told him that I didn’t think the transaction was ethical, because restructuring merely to avoid tax, and change the GAAP statement impact had no economic substance.

He ignored my warnings, and so I found myself a week later presenting before all of the leading managers of the company the details of the transaction to be.  (Before that, I talked to the instigator of the idea at Morgan Stanley, and showed him errors in his spreadsheet.  Do not assume that investment banks are infallible.  Also, don’t assume that actuaries or any quants are infallible.  They are human too, and subject to their own biases.  People often shout the word “science” when they are the most weak.)

I told them that I thought the idea was not ethical, but that it would do what was promised.  They were happy with that.  I was already known to be opinionated, though my results were very good.  That poisoned me with senior management which prized loyalty over truthfulness.

Two months later, I was working with a new firm, and the boss came to me and said, have you ever heard of bull/bear notes?  I roared with laughter, and puzzled, he looked at me and I said, “Heard of them?  I corrected their models!”

It should have been a warning sign because our client (the same as mentioned in the first story prior to the acquisition) was willing to consider such garbage in order to increase operating income.  Good managements don’t go for gimmicks.  Going for gimmicks means you aren’t focused on real organic growth.

So, we started in on a new transaction.  The rep from Morgan Stanley was surprised to talk to me again.  Very easy to do, because I knew the model as well as he did, or maybe better, much as I did not like it.

I went through the same schtick with the new client, but they were determined to do it no matter what.  I still remember being in a dim conference room with my boss, when FASB’s EITF [Emerging Issues Task Force] disallowed the transaction going forward, and required all of those that had done it do disclose the results in a footnote.  (Only one company had done it, my prior employer.)

-==-=–=-=-=-==-=–==-=-

The company that actually executed the bull/bear note eventually sold itself to another firm.  While I was working as a buy-side insurance company investment analyst, I got to meet the CFO of the company that bought them.  I said to him, “Would you like me to tell you the history of how this came to be?”  With a grim face he told me no.  It was a thing of pain, but he did not want to know the truth.  He kinda knew it already, and simply absorbed the loss.

With Epictetus, I can tell you that the truth will set you free.  Lies always constrain.  With Jesus, I can say, “You will know the truth, and the truth will set you free.”  This is far more personal, and useful, because Jesus himself lives to teach and protect his own. He is the Truth.

To all, I say, be wary of management teams that control results overly — this seems to be more common in finance, where results are harder to judge.  Finance is all accruals, which makes results ephemeral.

But good managers of financials are conservative.  That is the thing to look for in financials.  If my two examples above are not enough, it is not wise to buy financials that offer growth, because it often stems from scams, not real growth.

I have seen my share of fakers in this life in financial company management.  Be wary when you invest in financials; there is a reason why they are separate from industrials and utilities.  They are less reliable, particularly in time of stress.

So, to investors that care about what they invest in:

  • Analyze acquisitions — most aren’t good
  • Scrutinize accounting — most of the devils lie in accrual entries
  • Analyze management, if you can — understand their ethics, or lack thereof

I’ve written too long, but consider what I have said for your own good.  It will help you.

Hit the “Defer” Button, Thanks…

Friday, January 18th, 2013

Long-time readers know that I am a fan of Michael Pettis.  I learned a ton from his book, “The Volatility Machine.”  (I have the top review of his first book at Amazon.)

I am quoting from his recent email, “What I will watch in 2013.”

Quoting what I can legally do from his recent e-mail, Michael Pettis says (my emphases are in bold italic):

We ended 2012 in a burst of optimism for Europe, with everyone cheering Mario Draghi for having “saved” the euro, but I am deeply skeptical. As far as I can tell nothing substantial has changed, and if countries like Spain are a little more able today to roll over their debts than they had been during the summer, so what?

It is interesting that policymakers are so pleased by an end (temporarily, I assume) to the financing crisis. One of the regular features of sovereign debt crises, and one amply revealed in Beth Simmons book on the 1930s crisis in Europe, Who Adjusts?, is that one of the complicating factors in a crisis is the tendency of policymakers (along with workers, creditors, small businesses, and middle class savers) to change their behavior in response to a crisis by taking steps that protect them from the consequences of the crisis but that also make the crisis worse. Policymakers do this by shortening their time horizons and managing from crisis to crisis, rather than by sorting out the underlying problems. The fact that Spanish policymakers are so relieved by their ability to
access near-term financing may be a case in point. It is easy to see why the worry so much about getting through the next bond auction, but at the end of the day this is not Spain’s real problem.

….

One way or the other, in other words, the world will rebalance. But there are worse ways and better ways it can do so. Large trade surpluses can decline, for example, because exports fall, or they can decline because imports rise. Large trade deficits can contract under conditions of high unemployment, but they can also contract under conditions of low unemployment. Low savings rates can rise with declining household income or with rising household income. Repressed consumption rates can reverse through collapsing growth or through surging consumption. Excessive debt can be resolved by default or by growth.

Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there.  International cooperation, of course, will reduce the pain.

For this reason I have no doubt that over the next few years we will see the imbalances I have identified over the years in this newsletter reverse themselves, but whether they reverse in more orderly or less orderly ways will depend on policy decisions. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation.

When there is too much debt, and things aren’t going wrong it could be an unusual perching on a mesa.  The room to adjust is limited, and the cliffs are steep.  China, as much as the US, has a tangled financial system. Too much much lending from banks to nonbanks.  Too much lending to Party Members.  Too much creation of Wealth Management Products, which threaten the legitimacy of financial capitalism inside China.  I would rather be in the US than China if I were an average person — the protections in the US are much better.

As it is, central bank bureaucrats can lower interest rates for the banks, but it does not really cure the bad debt problem, because after a bout over overlending, there will be some that could not repay even if interest were reduced to zero.  In one sense, that is the reality behind the zero bound.  After a bull market in credit, the bear market will involve some companies/people who borrowed so much that the principal cannot be repaid even at zero interest.

The action of central banks at the zero bound may allow those that are well-off to become better-off and increase their well-being.  But monetary policy cannot help those that can’t refinance.

This is why I believe that the biggest issue in restoring prosperity globally, is finding ways to have creditors and stressed debtors settle for less than par on debts owed.  Move back to more of an equity culture from what has become a debt culture.  A key aspect of that would be making interest paid non-tax-deductible for corporations, housing, etc., while making dividend payments similar to REITs, while not requiring payouts equal to 90% of taxable income.  Maybe a floor of 50% would work, with the simplifying idea that companies get taxed on their GAAP income — no separate tax income base.  Would certainly reduce the games that get played.

Anyway, those are my opinions.  The world yearns for debt relief, but governments and central banks argue with that, and in the short-run try to paper over gaps with additional short-term debt that they think they can roll over forever. They just keep trying to hit the “defer” button, avoiding any significant reforms, in an effort to preserve the “status quo.”

My fear is that at some point, some significant player will follow a discordant approach which changes the terms of the tenuous equilibrium, leading to global inflation (monetize the debts for real; do not sterilize) or insist on fair payments at par (adopt a gold or other commodity-based currency standard).  I think the former is more likely than the latter, but who can say?  It is possible to end up with a bipolar world where both exist, or we could muddle along with the present “race to the bottom” for some time.  “Crabs in a basket,” and no one ever gets out, always pulling each other down.

Time to hit publish.  I am indebted to Michael Pettis, but do not write as well as he does.  Get on his mailing list if you can.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin