cooking the books + screwing the shareholders

  1. 1,037 Posts.
    Cooking the Books + Screwing the Shareholders.

    Cooking the Books — and Screwing the Shareholders
    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.

    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.
    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

    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 favour.
    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 US 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.
    [Volume 1 Issue 6]
    Fact is if you want to protect your money, as an investor you’re on your own.

    A Short Course in “Cooking the Books”...
    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 5 years in advance.
    They can book the promotion cost today, while the revenue is amortized over 5 years. A great tax

    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

    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 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.....and Screwing the Shareholders

    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.
    [GT Financial Traders Chronicle]
    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!

    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!
    PS. If you want to understand the intricacies of the insurance business Warren Buffett is the
    best teacher. And his latest Letter to Shareholders is a good introduction
    - Mark Tier

    Author of “Winning Investment Habits of Warren Buffet and George Soros”
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