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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Income statements feed into each other is not something investors often doIll stop. The article cited case after case. More generally, the researchers found that within two weeks of a cover appearance, over a third of the honorees suffered injuries, slumps, or other misfortunes. Theories abound on the cause of the cover jinx, many having to do with players or teams choking under the added performance pressure. A much better explanation is that no explanation is needed. Its what you would expect. People often attribute meaning to phenomena governed only by a regression to the mean, the mathematical tendency for an extreme value of an at least partially chance-dependent quantity to be followed by a value closer to the average. Sports and business are certainly chancy enterprises and thus subject to regression. So is genetics to an extent, and so very tall parents can be expected to have offspring who are tall, but probably not as tall as they are. A similar tendency holds for the children of very short parents. If I were a professional darts player and threw one hundred darts at a target (or a list of companies in a newspapers business section) during a tournament and managed to hit the bulls-eye (or a rising stock) a record-breaking eighty-three times, the next time I threw one hundred darts, I probably wouldnt do nearly as well. If featured on a magazine cover (Sports Illustrated or Barrons) for the eighty-three hits, Id probably be adjudged a casualty of the jinx too. Regression to the mean is widespread. The sequel to a great CD is usually not as good as the original. The same can be said of the novel after the best-seller, the proverbial sophomore slump, Tom Peterss excellent companies faring relatively badly after a few good years, and, perhaps, the fates of Bernie Ebbers of WorldCom, John Rigas of Adelphia, Ken Lay of Enron, Gary Winnick of Global Crossing, Jean-Marie Messier of Vivendi (to throw in a European), Joseph Nacchio of Qwest, and Dennis Kozlowski of Tyco-all CEOs of large companies who received adulatory coverage before their recent plunges from grace. (Satirewire.com refers to these publicity-fleeing, company-draining executives as the CEOnistas.) There is a more optimistic side to regression. I suggest that Sports Illustrated consider featuring an established player who has had a particularly bad couple of months on its back cover. Then they could run feature stories on the boost associated with such appearances. Barrons could do the same thing with its back cover. An expectation of a regression to the mean is not the whole story, of course, but there are dozens of studies suggesting that value investing, generally over a three-to-five year period, does result in better rates of return than, say, growth investing. Its important to remember, however, that the size of the effect varies with the study (not surprisingly, some studies find zero or a negative effect), transaction costs can eat up some or all of it, and competing investors tend to shrink it over time. In chapter 6 Ill consider the notion of risk in general, but there is a particular sort of risk that may be relevant to value stocks. Invoking the truism that higher risks bring greater returns even in an efficient market, some have argued that value companies are risky because theyre so colorless and easily ignored that their stock prices must be lower to compensate! Using risky in this way is risky, however, since it seems to explain too much and hence nothing at all. Accounting Practices, WorldComs Problems Even if value investing made better sense than investing in broad-gauged index funds (and that is certainly not proved) a big problem remains. Many investors lack a clear understanding of the narrow meanings of the denominators in the P/E, P/B, and P/D ratios, and an uncritical use of these ratios can be costly. People are easily bamboozled about numbers and money even in everyday circumstances. Consider the well-known story of the three men attending a convention at a hotel. They rent a booth for $30, and after they go to their booth, the manager realizes that it costs only $25 and that hes overcharged them. He gives $5 to the bellhop and directs him to give it back to the three men. Not knowing how to divide the $5 evenly, the bellhop decides to give $1 to each of the three men and pockets the remaining $2 for himself. Later that night the bellhop realizes that the men each paid $9 ($10 minus the $1 they received from him). Thus, since the $27 the men paid (3 x $9 = $27) plus the $2 that he took for himself sums to $29, the bellhop wonders what happened to the missing dollar. What did happen to it? The answer, of course, is that there is no missing dollar. You can see this more easily if we assume that the manager originally made a bigger mistake, realizing after charging the men $30 that the booth costs only $20 and that hes overcharged them $10. He gives $10 to the bellhop and directs him to give it back to the three men. Not knowing how to divide the $10 evenly, the bellhop decides to give $3 to each of the three men and pockets the remaining $1 for himself. Later that night the bellhop realizes that the men each paid $7 ($10 minus the $3 they received from him). Thus, since the $21 the men paid (3 x $7 = $21) plus the $1 he took for himself sums to $22, the bellhop wonders what happened to the missing $8. In this case theres less temptation to think that theres any reason the sum should be $30. If people are baffled by these disappearances, and many are, what makes us so confident that they understand the accounting intricacies on the basis of which they may be planning to invest their hard-earned (or even easily earned) dollars? As the recent accounting scandals make clear, even a good understanding of these notions is sometimes of little help in deciphering the condition of a companys finances. Making sense of accounting documents and seeing how balance sheets, cash flow statements, and income statements feed into each other is not something investors often do. They rely instead on analysts and auditors, and this is why conflating the latter roles with those of investment bankers and consultants causes such concern. If an accounting firm auditing a company also serves as a consultant to the company, there is a troubling conflict of interest. (A similar crossing of professional lines that is more upsetting to me has been curtailed by Eliot Spitzer, New York attorney general. One typical instance involved Jack Grubman, arguably the most influential analyst of telecommunications companies such as WorldCom, who was incestually entangled in the investments and underwriting of the very companies he was supposed to be dispassionately analyzing.) A students personal tutor who is paid to improve his or her performance should not also be responsible for grading the students exams. Nor should an athletes personal coach be the referee in a game in which the athlete competes. The situation may not be exactly the same since, as accounting firms have argued, different departments are involved in auditing and consulting. Nevertheless, there is at least the appearance of impropriety, and often enough the reality too. Such improprieties come in many flavors. Enrons accounting feints and misdirections involving off-shore entities and complicated derivatives trading were at least subtle and almost elegant. WorldComs moves, by contrast, were so simple and blunt that Arthur Andersens seeming blindness is jaw dropping. Somehow Andersens auditors failed to note that WorldCom had classified $3.8 billion in corporate expenses as capital investments. Since expenses are charged against profits as they are incurred, while capital investments are spread out over many years, this accounting mistake allowed WorldCom to report profits instead of losses for at least two years and probably longer. After this revelation, investigators learned that earnings were increased another $3.3 billion by some combination of the same ruse and the shifting of funds from exaggerated one-time charges against earnings (bad debts and the like) back into earnings as the need arose, creating, in effect, a huge slush fund. Finally (almost finally?) in November 2002 the SEC charged WorldCom with inflating earnings by an additional $2 billion, bringing the total financial misstatements to over $9 billion! (Many comparisons with this sum are possible; one is that $9 billion is more than twice the gross domestic product of Somalia.) WorldComs accounting fraud first came to light in June 2002, long after I had invested a lot of money in the company and passively watched as its value shriveled to almost nothing. Bernie Ebbers and company had not merely made $1 disappear as in the puzzle above, but had presided over the vanishing of approximately $190 billion, the value of WorldComs market capitalization in 1999-$64 a share times 3 billion shares. For this and many other reasons it might be argued that both the multi-trillion-dollar boom of the 90s and the comparably sized bust of the early 00s were largely driven by telecommunications. (With such gargantuan numbers its important to remember the fundamental laws of financial estimation: A trillion dollars plus or minus a few dozen billion is still a trillion, just as a billion dollars plus or minus a few dozen million is still a billion.) I was a victim, but the primary victimizer, Im sorry to say, was not WorldCom management but myself. Putting so much money into one stock, failing to place stop-loss orders or to buy insurance puts, and investing on margin (puts and margin will be discussed in chapter 6) were foolhardy and certainly not based by the companys fundamentals. Besides, these fundamentals and other warning signs should have been visible even through the accounting smoke screen. The primary indication of trouble was the developing glut in the telecommunications industry. Several commentators have observed that the industrys trajectory over the last decade resembled that of the railroad industry after the Civil War. The opening of the West, governmental inducements, and new technology led the railroads to build thousands of miles of unneeded track. They borrowed heavily, each company attempting to be the dominant player; their revenue couldnt keep pace with the rising debt; and the resulting collapse brought on an economic depression in 1873. Substitute fiber-optic cable for railroad tracks, the opening of global markets for the opening of the West, the Internet for the intercontinental railroad network, and governmental inducements for governmental inducements, and there you have it. Millions of miles of unused fiber-optic cable costing billions of dollars were laid to capture the insufficiently burgeoning demand for online music and pet stores. In a nutshell: Debts increased, competition grew keener, revenue declined, and bankruptcies loomed. Happily, however, no depression, at least as of this writing. In retrospect, its clear that the situation was untenable and that WorldComs accounting tricks and deceptions (as well as Global Crossings and others) merely papered over what would soon have come to light anyway: These companies were losing a lot of money. Still, anyone can be forgiven for not recognizing the problem of overcapacity or for not seeing through the hype and fraudulent accounting. (Far less blameless, if I may self-flagellate again, were my dumb investing practices, for which WorldCom management and accountants certainly werent responsible.) The real source of most peoples dismay and apprehension, I suspect, derives less from accountants malfeasance than from the markets continuing to flounder. If it were rising, interest in the various accounting reforms that have been proposed and enacted would rival the publics keen fascination with partial differential equations or Cantors continuum hypothesis. Reforms can only accomplish so much. There are countless ways for accountants to dissemble, many of which shade into legitimate moves, and this highlights a different tension running through the accounting profession. The precision and objectivity of its bookkeeping fit uncomfortably alongside the vagueness and subjectivity of many of its practices. Every day accountants must make judgments and determinations that are debatable-about the way to value inventory, the burdens of pensions and health care, the quantification of goodwill, the cost of warranties, or the classification of expenses-but once made, these judgments result in numbers, exact to the nearest penny, that seem indubitable. The situation is analogous to that in applied mathematics where the appropriateness of a mathematical model is always vulnerable to criticism. Is this model the right one for this situation? Are these assumptions warranted? Once the assumptions are made and the model is adopted, however, the numbers and organizational clarity that result have an irresistible appeal. Responding to this appeal two hundred years ago, the German poet Goethe rapturously described accounting this way: Double entry bookkeeping is one of the most beautiful discoveries of the human spirit. Focusing only on the bookkeeping and the numerical output, however, and refusing to examine the legitimacy of the assumptions made, can be disastrous, both in mathematics and accounting. Recall the tribe of bear hunters who became extinct once they became expert in the complex calculations of vector analysis. Before they encountered mathematics, the tribesmen killed, with their bows and arrows, all the bears they could eat. After mastering vector analysis, they starved. Whenever they spotted a bear to the northeast, for example, they would fire, as vector analysis suggested, one arrow to the north and one to the east. Even more important than the appropriateness of accounting rules and models is the transparency of these practices. It makes compelling sense, for example, for companies to count the stock options given to executives and employees as expenses. Very few do so, but as long as everyone knows this, the damage is not as great as it could be. Everyone knows whats going on and can adapt to it. If an accounting practice is transparent, then an outside auditor who is independent and trusted can, when necessary, issue a statement analogous to the warning made by the independent and trusted matriarch from chapter 1. By making a bit of information common knowledge, an auditor (or the SEC) can alert everyone involved to a violation and stimulate remedial action. If the auditor is not independent or not trusted (as Harvey Pitt, the recently departed chairman of the SEC, was not), then he is simply another player and viola tions, although perhaps widely and mutually known, will not become commonly known (everyone knowing that everyone else knows it and knowing that everyone else knows they know it and so on), and no action will result. In a similar way, family secrets take on a different character and have some hope of being resolved when they become common knowledge rather than merely mutual knowledge. Family and corporate secrets (such as WorldComs misclassification of expenses) are often widely known, just not talked about. Transparency, trust, independence, and authority are all needed to make the accounting system work. They are all in great demand, but sometimes in short supply. |
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