Category: Accounting

At the Fordham Conference: Time for a New Antitrust? False Assumptions

At the Fordham Conference: Time for a New Antitrust? False Assumptions

Posted on by David Merkel

Carl Felsenfeld: Do we know what the problem is?? What are we trying to solve?? Antitrust does not deal with Citigroup/Travelers, it should deal with Bank of America/Fleet, Wells Fargo/Norwest.? But it didn’t deal with those bank acquisitions.? The regulators were out to lunch.

Jesse Markham: Antitrust can only do so much. It also does not do so well where size is due to organic growth.? (DM: like Google or Microsoft.)

Zephyr Teachout: Antitrust should be based on size.? The DOJ is less subject to regulatory capture, and more inclined to prosecute.

Paul Kaplan: These ideas are against current trends in antitrust.? Perhaps a more rigorous application of the Sherman Act would be more effective.? Organic growth to a large size is still a problem, but how do you avoid punishing success?

(DM: just met Colin Barr of Fortune.? Nice to put a face to the name after all these years.)

Discussant: Canada disallowed securitization for the most part, and stopped more mergers with their banks.

False Assumptions

William Black — Control Fraud & Systematically Dangerous Institutions -Accounting values can be fudged.? RBC as well.? Difficult to detect Control Fraud.? Originating bad loans allows a bank to grow rapidly.? Need forensic accountants.

(DM: look for fast growth — quality, quantity, price. Look for new products.)

Lawrence Baxter — When Big Becomes a Problem.? – Worked ten years at a major bank that went through? a ton of mergers.? The self-regulations with each bank having its own risk model doesn’t work.? The regulators don’t understand them, and spend time learning what is going on.

(DM: fascinating that no one has talked about why the US bailed out holding companies, rather than letting them fail, and merely backing up the operating subsidiaries.? Also, few have fingered the Fed’s monetary policy.)

Shawn Bayern — False Assumptions in Law and Economics — Innovation in the banking is not always a positive.? Bonuses to executives skew incentives.? (DM: it is a form of asset/liability management.)

Russell Pearce — discussant — Business is self-interested, and short-term greedy.? Profit-making is maximized, not even long-term greedy (DM: maximizing the net present value of profits).? (DM: incent using long dated restricted common stock — trouble is, it doesn’t incent as well as cash.)

Mark Gimein — discussant — 3 questions a) What of a big rogue banker?? The market is good at absorbing single failures.? (DM: but not multiple failures.)? b) who should do the regulation?? Tough to get bright men who are tough who won’t go to work for the banks, or buy into the banks logic. c) Control Fraud is hard to prevent; human nature is that way.? No systematic approach to dealing with fraud.

Detecting Fraud — check for adverse selection, honest businessmen won’t do business that way.? Also, it never make sense for a secured lender to accept inflated appraisals.

(DM: Look for gain-on-sale accounting.? Analyze management culture for short-termism.? Remember you can never get pricing, volume and quality at the same time.? Financial companies are in a mature industry, so beware sompanies that grow fast.? Be aware of long dated accruals.)

Discussant — are we worse off today than in the robber baron era? Not necessarily.

Holmes bad man theory — the law exists to constrain bad men.

I gave a 3-minute rant on how insurers are better regulated than banks.? I’ll write more about that tonight in a piece that articulates my views on banking reform.

Book Review: Quality of Earnings

Book Review: Quality of Earnings

Posted on by David Merkel

I think earnings quality is one of the great neglected concepts of investing.? Why do many growth investors blow up on seemingly promising companies?? The answer is often that the investors did not review earnings quality.? Why do value investors fall into value traps?? The answer is often that the investors did not review earnings quality.

I have reviewed a number of books, and written many articles about earnings quality? Because so much of the investment world is blind here, the idea still has punch.

Thornton O’Glove hits at the subject in a traditional way — accrual accounting entries are always more suspect than cash entries.? He focuses on:

  • Being skeptical — don’t trust management, analysts, auditors.
  • Look for inconsistencies in disclosure.? Who tells a happy story broadly, bet is serious in regulatory filings?
  • Who plays games with one-time events?? What companies push the limits in determining what is a one-time event?
  • How do companies play with their accruals in order to report income?
  • Is taxable income significantly out of whack with GAAP income?

The book was written in the Mid-1980s, before it was easy to review SEC filings.? That has changed, but few really review filings today, even though it is easy to do so.

This is a good book, and you can learn a lot from it, but many of the references are dated, as in the classic version of “The Intelligent Investor.”? I mean, I recognize most of the examples, but many readers will say, “Huh, I’ve never heard of that company!”

Do you want to improve your investing?? Look to earnings quality.

Who could benefit from the book?? Any investor could benefit from the book, particularly those that analyze fundamentals.

If you want to buy the book, you can buy it here: Quality of Earnings

Full disclosure:? I bought this book.? I review books old and new.? This old book still has value, and I recommend it.? It will require more effort than most investors are willing to put forth, but I believe it will yield value to those who work with it.? This is simple stuff, but it is work, and there is always a barrier to entry around work.

Also, anyone entering Amazon through my site and buying anything — I get a small commission, but you don’t pay anything more.? I love it when both my readers and I win.

Cram and Jam

Cram and Jam

Posted on by David Merkel

Insurance is probably the most complex industry as far as accounting goes.? Why?? When you sell the policy, you have a vague? idea of what the costs will be, and when those cash flows will occur.

That leaves room for a wide variety of games as far as the accounting goes.? Because hitting operating return on equity targets is often the “be all” and “end all” of management reporting, one of the holy grails was taking capital losses and turning them into operating income.? Net result on income is zero, but it looks like you are making a lot of returns off of operations.

At one company that I worked for, the new CEO want to great pains to declare how ethical the new CFO was.? I murmured to my boss, “Not ethical, but clever.”? He gave me a smile.? She had pulled that very trick, and if one reconciled the Statutory and GAAP accounting, the chicanery was obvious.

At AIG, my managers were quite concerned about what went above the line and below the line.? If an accounting item didn’t figure into net income my managers didn’t care about it, even if it diminished shareholders equity.

As an investor, this made me skeptical about income statements.? But if you don’t have an income statement, what do you do to estimate profitability?

Well, you could look at the change in tangible net worth due to common shareholders, and add back dividends, including the value of spinoffs, and net money spent on buybacks.? That is what a shareholder earns, in book value terms.? Back when I was an analyst of the insurance industry, there were companies run by value investors that would present their returns that way showing the the growth in fully converted book value over time.? In a sense , Berkshire Hathaway does that as well, but it doesn’t pay a dividend, so it is simply the increase in book value.

In the short run the market is influenced by net income due to common shareholders.? But there is a difference between the two measures of income, and I call the difference “cram.”? Cram is the amount of extra income reported through the income statements that does not makes its way through the balance sheet.

That said, I have another measure that I nickname “jam.”? Jam is the amount of money gained/lost from buying back stock.? In general, when companies buy back stock they dilute value for investors.? Better to retain and reinvest.

How do I know this?? I have been working on an accounting quality model, which is still a work in progress.? An aside, I have had my share of calls from consultants who tell me they have an earnings quality model that covers the whole market.? When they call me I ask them how they analyze financial companies.? I get the intelligent equivalent of a shrug.? The reason is that accruals on the financial statements of industrials and utilities are quite similar, but for financials, they are quite different.

Here are some of the results of my model on the S&P 100:

The data covers the last 4 3/4 fiscal years.? Why did I use fiscal years? Because data capture with companies is most complete at fiscal year ends, when they file their 10Ks.

What did I find?? In general, most companies lose money off of buybacks, whether it is 24% of cumulative net income, or 32% of final tangible net worth.? Individual company performance varies a great deal.? More surprising to me was that cram on average was only 1% of cumulative net income.? Maybe GAAP isn’t so bad on average after all.? But averages conceal a lot of variation — I would not want to own companies that lose a lot of money off of buybacks, or those that inflate net income versus growth in tangible book.

If buybacks ceased, companies might have a lot of slack assets on hand.? I know that companies keep themselves slim to avoid takeovers,? A large amount of slack assets invites others to come in and buy the assets to manage them.? Still, it seems that most buybacks waste the money of shareholders.? This seems to be another example of the agency problem, wheremanagers take an action that benefits them, but harms shareholders.

I would be negative on both cram and jam.? Good companies don’t report earnings in excess of what shareholders obtain, and they don’t buy back stock except when it is cheap.

Full disclosure: long ALL COP CVX ORCL PEP

Book Review: Warren Buffett on Business

Book Review: Warren Buffett on Business

Posted on by David Merkel

In the Fall of 2005, I was at the Annual Meeting of the Casualty Actuarial Society in exotic Baltimore, Maryland.? The Keynote address was by Roger Lowenstein who did a talk on two topics.? Warren Buffett the great investor, and the looming problems from the demographic crisis.

At the end of what was arguably a good talk, he asked for questions.? No one raised their hands.? After a pause, he asked for questions again, and I raised my hand.? I commented that he should have given his talk to the Life actuaries — they are the ones concerned about longevity and health costs, and if he really wanted to do a favor for casualty actuaries, don’t talk about Buffett the investor — talk about Buffett the P&C insurance CEO.

He commented that he was asked to speak about the topic by the CAS.? I like Lowenstein, so if you are reading this Roger, my apologies for making the comment.

Warren Buffett on Business is one step closer to the book I would like to see — I would like to see a book on Buffett as an insurance CEO.? Buffett is a great insurance CEO, and deserves a lot of credit in that capacity.? (Warren, I doubt you are reading this, but if you would like me to write that book, please e-mail me.)

But Berkshire Hathaway is an insurance/industrial hybrid, unique among companies.? Warren Buffett on Business ignores Buffett the investor to take up issues that are just as significant: Buffett the business owner and manager.

The words in the book are Buffett’s.? The man who organized the book took Buffett’s words over the last 25-30 years, and organized them into categories regarding management issues.? The topics include:

  • Berky acts like a partnership even though it is a corporation.
  • Corporate Culture and Governance
  • Competent Managers and Honest Communication
  • GEICO and Gen Re acquisitions (personally I think Buffett got hosed moving to terminate financial contracts? at Gen Re rapidly.? There is a rule of thumb that says negotiations on illiquid contracts should be undertaken slowly, unless the other side is panicking.)
  • Assessing and Managing Risk
  • Compensating Management
  • Time Management
  • Crisis Management
  • Acquisitions — Buffett gets to own a wide number of unique corporations, because the one selling out wants the culture preserved, and if the price is right Buffett will do that.
  • Ethics in Business
  • And more…

Both in the chapters and in the appendices, the words of Buffett shine forth as a way to manage corporations for the best long term results, even if things don’t work so well in the short run.

Quibbles

Much as I like the words of Buffett, I prefer a second voice adding analysis.? Let the words of Buffett star, but let someone else add color and history, because Buffett’s own words are not complete enough.

Also, an analysis of how Buffett managed the insurance lines of his enterprise would be welcome.? Even for those looking exclusively at investment issues, the insurance enterprises offered Buffett the balance sheet he needed to buy assets that could take a while to work out.

Who would benefit from this book: Any manager of any company would benefit from this book.? Buffett lovers, if you have read the last 25-30 years of annual reports from Buffett, and notable things he has said outside of that, you likely do not need this, unless you have specific questions on management that you want answered by Buffett, and you can’t remember what he said in the past.

For most of the rest of us, this will still be a valuable book.? If you want to buy this book, you can buy it here: Warren Buffett on Business: Principles from the Sage of Omaha

Full Disclosure:? I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Miscellaneous Notes

Miscellaneous Notes

Posted on by David Merkel

When I wrote for RealMoney, I would sometimes do Columnist Conversation [CC] posts that would be entitled “Miscellaneous Notes,” or “Odds and Ends,” etc.? Occasionally my editor would chide me saying that I should be able to come up with better titles.? I don’t know; I have a wide vista of interests in investing.? It is hard to make me focus on a single issue for a long period of time.

So here are some miscellaneous notes.? It is my website, after all.

1) A recent comment on the piece On Vanilla Products😕 David, doesn’t Vanguard and Fidelity offer a low fee VA product using in house funds?? At some point I another low fee insurace offering was out there (under 50bps+fund fees) for no fee planners, but cannot remember the name for the life of me.? I think they worked with Rydex to grab traders assets.

I agree it’s a great way to retain sticky assets.

A dear friend of mine told me that Jackson National was offering such a product.? No jealousy from me; any product that I think should exist makes me grateful when it comes into existence.

2) A reader commented on the the piece, Recent Portfolio Actions: It sounds as if you’re more bearish now than in 2003.? Why?? It is doubtful that the Fed will remove liquidity any time soon.? While there may be headwinds in terms of value, the consumer, and real estate, the appetite for junk bonds keeps growing.? As long as that’s the case, the likely-to-become-insolvent crowd will be able to meet short-term payments, and asset bubbles could continue to grow.

That’s a very good question, and it is one that makes me wonder in the present environment.? The comparison should not be 2003, but 2001-2003.? It is rare for the fixed income market to have a V-shaped recovery.? More often than not, the recovery is a W, or a pair of Ws.

Also, in 2003, when I looked at the credit troubles remaining, there were few of them.? in 2009, there are a lot of them, in residential housing, in commercial real estate, in junk bonds, etc.? I don’t care about the current speculative wave; bear market rallies are sharp and severe.? Big as it is, I believe that we have experienced a humongous bear market rally.

3) Because I am a fan of James Grant, that does not mean that I have praise for him on his recent WSJ op-ed.? If you had said this 6-10 months ago, when I recommended buying junk bonds, I would be impressed.? But most of the rally has already happened, and bear markets often have multiple bottoms.? This bear market has only had one bottom, and there are many more defaults to come in this recession.

4) One reader said to me regarding this piece: David, I know what you mean.?? But I’m curious in this context about the role of absolute valuation strategies in what you recommend.?? Is it a) no role (relative valuation rules!), b) plays a role, but only within the 10% stretch band, c) matters, but one can always find a portfolio’s worth of low absolute valuation stuff (if one doesn’t worry about the implied adverse selection bias that when everything else is pricey, the cheap stuff is much more likely to be cheap for a good reason), or d) something else?

I don’t have a good answer here.? I use a blend of absolute and relative valuation criteria.? I would like to use absolute valuation all of the time, but that does not give enough opportunities.? I live in an era where the competition is much higher than it was for Ben Graham, or Warren Buffett, when he was starting his partnership.

I will say this, though: absolute valuation can be an excuse for investors that are not willing to do the digging necessary to unearth more complex values.

That said, I like to buy companies below 2x book, and below 14x earnings.? Multiplying them, as Graham did, most of my companies trade below 22.5x book times earnings.? That helps protect against companies that manipulate earnings or the balance sheet, if one relies on a joint criterion.? Behind that, I review the cash flow statement.? Clever companies can fuddle two of the three main statements; no one can fuddle all three.? Accounting fraud usually can be seen from the cash flow statement being less positive than the income statement.

Ten Points on Commercial Real Estate Lending

Ten Points on Commercial Real Estate Lending

Posted on by David Merkel

Before I begin this evening, I would like to give a big praise to Calculated Risk.? CR and his readers do a great job of highlighting stories in economics and real estate; I get a lot of data from that blog.? Some articles cited this evening have sprung from links on a CR post; my non-citing of CR is not a lack of respect for what CR does.

1)? We are at the beginning of seeing large commercial properties slide into default where equity sponsors have concluded that there is no use throwing good money after bad.? Recourse typically does not exist on commercial loans, aside from the smallest loans.

The last article is interesting to me, in that the ability of the US Postal Service to walk away from leases is greater than I previously thought.? It is also interesting to contemplate the economics of a collapsing postal service.? Will the postal service charge a differential rate to serve rural areas?? It would align revenues with costs, but politically I can’t imagine it is feasible given the US Senate.

2)? Of course, those defaults have large negative implications for large and small banks, as well as CMBS and Commercial REITs.

The difficulty for banks is different because they do not hold their Commercial Real Estate [CRE] loans at fair value.? So long as the loan is performing, it can be held at par.? The accounting does not require anticipating failure, no matter how likely on average that failure would be.

The banks have writeoffs to take which the CMBS market is already anticipating.? Absent a larger rally in CMBS, there will be significant writeoffs at the banks eventually.

For a broader look at the troubles the banks face, look at this article: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On.

3)? When the price of properties are down 36% from the peak, it implies that most recent lending, 2006 and beyond, is under water, and 2005 is iffy.

4) $165 Billion in Commercial Loans are Due in ?09.? Banks will extend the loans, whereas CMBS special servicers will foreclose on some and extend others — the balance sheet of a CMB Securitization is not as flexible as that of a bank.

5) “What evil lurks in the heart of Commercial Real Estate loans?? The Shadow Supply knows.”? Whether it is condos in Manhattan, or apartments in the same, the problem of underemployed real estate weighs on the market, waiting for a moment to sell, and making the recovery that much longer.

6)? Goldman Sachs is the key component of the oligarchy that controls the US Government and sucks the blood of the American taxpayer for profit. ;)? Now they are planning to repeat their clever pillage of residential housing in the commercial sector.

Look, GS is clever, and they will make money they can.? I never supported any of the bailouts, but if the government sets the rules inadequately, and GS finds holes to profit off of, where does the blame go, but to the government who set loose rules.

7)? Goldman also sees hard times ahead for Commercial REITs, as I do.? Prices are too high relative to NAVs.? There will be significant loan defaults.? Shall I mention that Deutsche Bank agrees?

8) At such a time, as is normal, underwriting standards rise, and loan volumes decline.? It adds insult to injury, but banks have to protect their balance sheets.

9) This is also affecting pension plans, which are large investors in commercial real estate, both equity and mortgages.

10)? And looking at the architectural billings index, any turn in commercial real estate will not be soon.

I will be considerably more bullish when these problems are half solved.? Until then, I am still a bear on financials.

Nine Notes on Residential Real Estate

Nine Notes on Residential Real Estate

Posted on by David Merkel

I don’t really have one unified article type when I write here.? Sometimes I have a really strong conviction about something, and then it flows.? At other times, I gather data, do an analysis, and come up with a way of motivating it.? Then there are the Seven, Eight, Ten, Twelve, Fifteen, Twenty Points/Notes/Comments articles.? Tonight’s piece is one of those.

(An aside — the numbers stem from a comment from an editor of a Canadian business publication — he told me that certain numbers grab people’s attention more.? True?? Not sure.? I do know that one of my editors at RealMoney felt that some of my quirky titles lost readership.? Even today, my editor at SA freely revises my titles, sometimes making something an emphasis that I had not intended.? Whatever; she titles better than me.? What intrigues me is that other sites sometimes pick up her title, not mine, even when they link directly to my blog.)

I don’t do linkfests.? I don’t do them not because they are not valuable, but because others do them better then me, like Abnormal Returns.? So, I do something different.? As I troll the web each day, I tag articles for future comment.? I then wait until I have a critical mass of articles on a given topic, and then I publish one of the “XX Points” articles.? This enables a greater range of facets on a given issue.? I also allows me to give more of an integrated explanation of how I think it all fits together.? Now, the price is that some of the articles are dated.? I think they are fresh enough to highlight trends.

Enough explaining.? On to tonight’s topic, real estate and its effect on the real and financial economies.

1)? Principal forgiveness — it is what underwater homeowners want, and what they are unlikely to get.? Principal forgiveness means that a loss has to be taken by someone now.? Adjust the rate, adjust the term, adjust the amortization — it is all tinkering, even if it lowers the payment slightly, because the owner is still inverted on his mortgage.

Ideas like lowering the principal, but giving the bank a large chunk of the price appreciation at sale, or say 30 years out, would be cute, but still, the bank (or juniormost MBS certificate holder, who usually directs the servicer) would take a loss now.

So, I’m not surprised when I read articles like these:

Governments have power, but it is very difficult to fight the economics of the situation.? One further note, as is mentioned by a few of the above articles, is that the most profitable situation for the lenders/servicers, is that the property teeters on the edge of solvency, not only paying the mortgage slowly, but pays additional fees in the process.

2)? Will there be a second foreclosure wave?? Maybe.? First American CoreLogic argues that it will be the existing wave continuing.? I tend to agree with CoreLogic for the following reason: when you have enough of the mortgaged homes of the country underwater, it is difficult to slow the rate of foreclosure, because foreclosures happen to properties that underwater where one of the following occurs:

  • Death
  • Divorce
  • Unemployment
  • Disability
  • Disaster
  • Strategic default (buy a nicer home cheaper, and stop paying off this overpriced garbage)
  • Debt reset/recast

3)? The GSEs, despite the rally, are still in lousy shape.?? Fannie lost $14.8 Billion, and tapped the Treasury for liquidity.? Freddie earned less than $1 billion, but only because they revalued assets $5 billion higher.? Their regulator believes that they won’t be able to repay all aid that the US has granted them.? My verdict: the common of each company is an eventual zero.? Stay away.? Thrillseekers that like zero shorts, don’t do it; the odds are good for a zero, but the payoff is asymmetric.

4)? What percentage of homeowners are or will be upside-down or underwater?

I favor the estimates of First American CoreLogic.? First, they have great data.? Second, my view is that properties with greater than 90% LTVs are likely upside-down in a sale due to closing costs.? The inflection point in mortgagee behavior occurs between 90-100% LTVs, not at 100%+.

That’s why we are in such deep trouble.? With 32% of all mortgages inverted, there will be many more foreclosures, and prices should still head downward, even on the low end.

5)? But maybe things aren’t so bad, at least on the low end.

6)? All that said, the high end isn’t seeing much action, and prices continue to sag.? There aren’t many move-up buyers.

7)? What characterizes the underwater borrower?? Cash-out refinancing, and home equity loans.? The home as an ATM always relied on the “greater fool” theory implicitly — that there would always be a greater fool willing to buy out the home at a greater price than the new amount of leverage.? On the home equity loans — banks are doing all that they can to avoid recognizing losses.? With home equity loans, losses are usually total.? The only thing that surprises me here is that it has taken this long to get to realizing the losses.

8 ) So you want appraisers to be honest, but not yet?? Appraisers, auditors, etc. — third party evaluators are conflicted — he who pays the piper calls the tune, and no one is willing to have the buyer pay for the appraisal.? So now the appraisers try to be honest and business can’t get done?!? Those who hire appraisers, make up your minds; do you want a few short term deals, or do you want reliable long term business?

9)? On the dark side, many option ARMs will default before the payments recast.? That means the recast wave will be more gradual, but it won’t be any less troublesom in aggregate.

That’s all for this evening.? Absent something else pressing, I will write about commercial real estate on Monday night.

Earnings, Analyst Estimates, and Estimating Future Prospects

Earnings, Analyst Estimates, and Estimating Future Prospects

Posted on by David Merkel

This has been an interesting earnings season.? Many companies have been beating earnings estimates once certain one-time items are excluded.? This has led to criticism by market commentators alleging that earnings estimates and/or adjusted earnings are not a reliable guide for individual stocks or the market as a whole.? There’s some truth there, but let me try to give a more nuanced view.

What are we really trying to estimate?

Earnings estimates do not primarily exist for the purpose of estimating the next few quarters’ or years’ earnings.? They exist for estimating the future path of free cash flows.? Wait, what is free cash flow?? Free cash flow is the amount of money that you can take away from a business at the end of an accounting period and leave the company as well off as it was at the beginning of the accounting period.? How does that compare to earnings?? Typically, non-cash charges like depreciation and amortization get added back to earnings, and maintenance capital expenditures get deducted — what remains is free cash flow, which can be used for dividends, buybacks, and investments to build the business.? Free cash flow is similar to what I will call “run rate” earnings, though there are some differences.

In that sense, analysts are trying to estimate “run rate” earnings when they adjust for “one time” events.? Absent these abnormal occurrences which won’t happen next quarter, what would the earnings have been?? Surprises above and below the consensus estimates of the analysts provide information to investors.? Positive surprises indicate that the future run rate for earnings might be higher, and vice-versa for negative surprises.

I say “might be,” rather than “will be,” because of randomness in profitability, or, an inability to truly figure out all of the abnormalities and timing differences in a given quarter.? Typically, several positive earnings surprises must take place before estimates of the run rate begin to rise.? One is normal randomness, two is happenstance, three is a pattern, four is a change in trend.

Guiding up, guiding down

Of course, corporate management can make life easier by giving earnings guidance to analysts, and then guiding the estimates up or down as they see best.? They can also break out their estimates of operating or adjusted earnings in order that analysts can decide for themselves which adjustments are “one time,” and which aren’t.? (In my opinion, Allstate does a particularly good job with this, as does Assurant.)

But changing guidance is powerful, particularly for companies with a reputation for UPOD (underpromise, overdeliver), as opposed to companies with a reputation for OPUD (overpromise, underdeliver).? When analyzing guidance changes, one must adjust for prior earnings surprises to figure out whether th raise in guidance reflects only past successes, or forecasts greater successes in the future.

That’s a lot of “one time” events!? Why do so many of them raise operating earnings?? Shouldn’t the difference net to zero over a long enough timespan?

Alas, once we start adjusting earnings to create operating earnings, we enter a new world with a new accounting basis that superficially resembles “run rate earnings” but with a fault.? Almost every quarter has its parade of “one time” events.? On average, the adjustments raise operating earnings over ordinary GAAP earnings.? Managements are more incented to find the positive adjustments to earnings in the short run.? Obvious negative adjustments get accounted for, but non-obvious ones don’t get searched for.

But clever investors eventually adjust for this.? Here’s a way to do it.? Analyze a long period of time, say five years, or the CEO tenure, whichever is shorter.? Look at the growth in book value, and add back dividends.? Compare that to cumulative diluted earnings over the same time period.? If cumulative diluted earnings are higher, then earnings are inflated.? Here’s another way: if you have a long enough data series, add up operating and diluted earnings over a long period of time, say five years, or the CEO tenure, whichever is shorter.? If operating earnings are significantly larger, there is a company that is using operating earnings to make itself look more profitable than it actually is.

If nothing else, over a long enough period of time, this is a means of measuring the honesty of management teams where it comes to financial reporting.? In my book, honest/conservative management teams deserve higher multiples than less scrupulous management teams.? These measures document the games that management teams play in order to make their results look better than they should appear.

How are we doing versus the expectations of the market?

The investment game is one where profitability performance versus expectations determines price performance.? Prices don’t ordinarily react to backward-looking data, unless there is a big one-time charge that adds a lot to book value, or takes a lot away, perhaps impairing the future prospects of the firm.? Prices do react to the signals given through earnings relative to expectations, as it leads investors to update their views of potential future run rate earnings, or, free cash flow.

Can we make a lot of money off of this effect?

Not so much any more.? There are many investors following earnings momentum, earnings surprises, analyst estimate revisions, and price momentum, that the average investor can’t make a lot of money off of this effect.? But ordinarily it does help an investor understand what is going on when stock prices move after earnings are released.? Expectations of the future change, and that drives current stock prices.

Full disclosure: long ALL AIZ

A Call For Accounting Integrity

A Call For Accounting Integrity

Posted on by David Merkel

This post is not one where I go through one of my “pet issues” in accounting (e.g. fair value accounting, goodwill accounting, pension accounting, or employee stock option accounting).? Rather, I am writing to encourage all finance bloggers, and those that read me to write Mary Schapiro at the SEC, and encourage her to appoint Jack Ciesielski to be Chief Accountant at the SEC.

Why do I write this?? I only track the blogs of two accountants, Jack Ciesielski, and Tom Selling.? Tom has written a post supporting Jack for the position of Chief Accountant for the SEC.? Here is a confirmation of the possibility in this Bloomberg article.

I first met Jack Ciesielski in 1997 at a lunch for the Philadelphia Financial Analysts.? I immediately appreciated his acumen.? After that, when I moved down to Baltimore, I got to know him better at the Baltimore Security Analyst Society (Now Baltimore CFA Society) meetings.? I have learned a lot from him.

Now, I have nothing to deprecate the other fellow being considered, the acting Chief Accountant.? He may be a wonderful choice for the position, but Jack is a CFA Charterholder, so he understands the concerns of investors.? Further, his newsletter has pointed out flaws in accounting methodologies for over a decade.? Jack is not merely a critic, but he understands where US GAAP and IFRS accounting are weak.? He has not “gone along to get along,” but has offered helpful criticism on accounting standards.

To my fellow bloggers out there, please link to this post, and ask your readers to petition the SEC Chairman to appoint Jack Ciesielski.? They can do so here.? To my readers, please also petition the Chairman of the SEC, and ask her to appoint Jack.? It doesn’t have to be anything fancy, just that you know that Jack has supported accounting integrity for many years.? If there is any doubt look in the deep past on his blog, where his musings went to everyone, not just clients.

I will write my own missive to Ms. Schapiro tomorrow.? If it is any good, I will post it here.

Book Review: Mr. Market Miscalculates

Book Review: Mr. Market Miscalculates

Posted on by David Merkel

Since the first time I read him, I have been a fan of James Grant.? He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.? Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.? When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”? For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.? This book followed the same format, reprinting the best of old columns, with modest commentary.? In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?? Isn’t that a waste of time? That depends.? Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?? Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?? Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.? Being too early means you eventually get disregarded.? The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.? That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.? You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,? but your costs don’t go up.?? Also, thanks to Axios Press for the free review copy.? I read the whole thing, and enjoyed it all.

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