METHODS FOR WEALTH ENHANCEMENT

Among the popular methods for pursuing such opportunities for wealth enhancement, aside from the big bath technique studied by Zeckhauser, are:

·        Maximizing growth expectations.

·        Downplaying contingencies.

MAXIMIZING GROWTH EXPECTATIONS

Imagine a corporation that is currently reporting annual net earnings of $20 million. Assume that five years from now, when its growth has leveled off somewhat, the corporation will be valued at 15 times earnings. Further assume that the company will pay no dividends over the next five years and that investors in growth stocks currently seek returns of 25% (before considering capital gains taxes).

Based on these assumptions, plus one additional number, the analyst can place an aggregate value on the corporation’s outstanding shares. The final required input is the expected growth rate of earnings. Suppose the corporation’s earnings have been growing at a 30% annual rate and appear likely to continue increasing at the same rate over the next five years. At the end of that period, earnings (rounded) will be $74 million annually. Applying a multiple of 15 times to that figure produces a valuation at the end of the fifth year of $1.114 billion. Investors seeking a 25% rate of return will pay $365 million today for that future value.

These figures are likely to be pleasing to a founder/chief executive officer who owns, for sake of illustration, 20% of the outstanding shares. The successful entrepreneur is worth $73 million on paper, quite possibly up from zero just a few years ago. At the same time, the newly minted multimillionaire is a captive of the market’s expectations.

Suppose investors conclude for some reason that the corporation’s potential for increasing its earnings has declined from 30% to 25% per annum. That is still well above average for Corporate America. Nevertheless, the value of corporation’s shares will decline from $365 million to $300 million, keeping previous assumptions intact.

Overnight, the long-struggling founder will see the value of his personal stake plummet by $13 million. Financial analysts may shed few tears for him. After all, he is still worth $60 million on paper. If they were in his shoes, however, how many would accept a $13 million loss with perfect equanimity? Most would be sorely tempted, at the least, to avoid incurring a financial reverse of comparable magnitude via every means available to them under GAAP.

That all-too-human response is the one typically exhibited by owner managers confronted with falling growth expectations. Many, perhaps, most, have no intention to deceive. It is simply that the entrepreneur is by nature a self-assured optimist. A successful entrepreneur, moreover, has had this optimism vindicated. Having taken his company from nothing to $20 million of earnings against overwhelming odds, he believes he can lick whatever short-term problems have arisen. He is confident that he can get the business back onto a 30% growth curve, and perhaps he is right. One thing is certain—if he were not the sort who believed he could beat the odds one more time, he would never have built a company worth $300 million.

Financial analysts need to assess the facts more objectively. They must recognize that the corporation’s predicament is not unique, but on the contrary, quite common. Almost invariably, senior managers try to dispel the impression of decelerating growth, since that perception can be so costly to them. Simple mathematics, however, tends to make false prophets of corporations that extrapolate high growth rates indefinitely into the future. Moreover, once growth begins to level off, restoring it to the historical rate requires overcoming several powerful limitations.

Limits to Continued Growth

Saturation Sales of a hot new consumer product can grow at astronomical rates for a time. Eventually, however, everybody who cares to will own one (or two, or some other finite number that the consumer believes is enough).

At that point, potential sales will be limited to replacement sales plus growth in population, that is, the increase in the number of potential purchasers.

Entry of Competition Rare is the company with a product or service that cannot either be copied or encroached on by a “knockoff” sufficiently similar to tap the same demand, yet different enough to fall outside the bounds of patent and trademark protection.

Increasing Base A corporation that sells 10 million units in Year I can register a 40% increase by selling just 4 million additional units in Year 2. If growth continues at the same rate, however, the corporation will have to generate 59 million new unit sales to achieve a 40% gain in Year 10. In absolute terms, it is arithmetically possible for volume to increase indefinitely.

On the other hand, a growth rate far in excess of the gross domestic product’s annual increase is nearly impossible to sustain over any extended period. By definition, a product that experiences higher-than-GDP growth captures a larger percentage of GDP each year. As the numbers get larger, it becomes increasingly difficult to switch consumers’ spending patterns to accommodate continued high growth of a particular product.

Market Share Constraints For a time, a corporation may overcome the limits of growth in its market and the economy as a whole by expanding its sales at the expense of competitors. Even when growth is achieved by market share gains rather than by expanding the overall demand for a product, however, the firm must eventually bump up against a ceiling on further growth at a constant rate. For example, suppose a producer with a 10% share of market is currently growing at 25% a year while total demand for the product is expanding at only 5% annually. By Year 14, this super growth company will require a 115% market share to maintain its rate of increase. (Long before confronting this mathematical impossibility, the corporation’s growth will likely be curtailed by the antitrust authorities.)

Basic economics and compound-interest tables, then, assure the analyst that all growth stories come to an end, a cruel fate that must eventually be reflected in stock prices. Financial reports, however, frequently tell a different tale. It defies common sense yet almost has to be told, given the stakes.

Users of financial statements should acquaint themselves with the most frequently heard corporate versions of “Jack and the Beanstalk,” in which earnings—in contradiction to a popular saw—do grow to the sky.

Commonly Heard Rationalizations for Declining Growth

“Our Year-over-Year Comparisons Were Distorted” Recognizing the sensitivity of investors to any slowdown in growth, companies faced with earnings deceleration commonly resort to certain standard arguments to persuade investors that the true, underlying profit trend is still rising at its historical. Freak weather conditions may be blamed for supposedly anomalous, below-trendline earnings. Alternatively, the company may allege that shipments were delayed (never canceled, merely delayed) becauseof temporary production problems caused, ironically, by the company’s explosive growth. (What appeared to be a negative for the stock price, in other words, was actually a positive. Orders were coming in faster than the company could fill them—a high-class problem indeed.) Widely publicized macroeconomic events such as the Y2K problem18 receive more than their fair share of blame for earnings shortfalls. However plausible these explanations may sound, analysts should remember that in many past instances, short-term supposed aberrations have turned out to be advance signals of earnings slowdowns.

“New Products Will Get Growth Back on Track” Sometimes, a corporation’s claim that its obviously mature product lines will resume their former growth path becomes untenable. In such instances, it is a good idea for management to have a new product or two to show off. Even if the products are still in development, some investors who strongly wish to believe in the corporation will remain steadfast in their faith that earnings will continue growing at the historical rate. (Such hopes probably rise as a function of owning stock on margin at a cost well above the current market.) A hardheaded analyst, though, will wait to be convinced, bearing in mind that new  products have a high failure rate.

“We’re Diversifying Away from Mature Markets” If a growth-minded company’s entire industry has reached a point of slowdown, it may have little choice but to redeploy its earnings into faster-growing businesses. Hunger for growth, along with the quest for cyclical balance, is a prime motivation for the corporate strategy of diversification.

Diversification reached its zenith of popularity during the “conglomerate” movement of the 1960s. Up until that time, relatively little evidence had accumulated regarding the actual feasibility of achieving high earnings growth through acquisitions of companies in a wide variety of growth industries.

Many corporations subsequently found that their diversification strategies worked better on paper than in practice. One problem was that they had to pay extremely high price-earnings multiples for growth companies that other conglomerates also coveted. Unless earnings growth accelerated dramatically under the new corporate ownership, the acquirer’s return on investment was fated to be mediocre. This constraint was particularly problematic for managers who had no particular expertise in the businesses they were acquiring. Still worse was the predicament of a corporation that paid a big premium for an also-ran in a “hot” industry. Regrettably, the number of industry leaders available for acquisition was by definition limited.

By the 1980s, the stock market had rendered its verdict. The price earnings multiples of widely diversified corporations carried a “conglomerate discount.” One practical problem was the difficulty security analysts encountered in trying to keep tabs on companies straddling many different industries. Instead of making 2 + 2 equal 5, as they had promised, the conglomerates’ managers presided over corporate empires that traded at cheaper prices than their constituent companies would have sold for in aggregate had they been listed separately.

Despite this experience, there are periodic attempts to revive the notion of diversification as a means of maintaining high earnings growth indefinitely into the future. In one variant, management makes lofty claims about the potential for “cross-selling” one division’s services to the customers of another. It is not clear, though, why paying premium acquisition prices to assemble the two businesses under the same corporate roof should prove more profitable than having one independent company pay a fee to use the other’s mailing list. Battle-hardened analysts wonder whether such corporate strategies rely as much on the vagaries of mergers-and-acquisitions accounting as they do on bona fide synergy.

All in all, users of financial statements should adopt a “show-me” attitudetoward a story of renewed growth through diversification. It is often nothing more than a variant of the myth of above-average growth forever.

Multi-industry corporations bump up against the same arithmetic that limits earnings growth for “focused” companies.

DOWNPLAYING CONTINGENCIES

A second way to mold disclosure to suit the issuer’s interests is by downplaying extremely significant contingent liabilities. Thanks to the advent of class action suits, the entire net worth of even a multi-billion-dollar corporation may be at risk in litigation involving environmental hazards or product liability. Understandably, an issuer of financial statements would prefer that securities analysts focus their attention elsewhere.

At one time, analysts tended to shunt aside claims that ostensibly threatened major corporations with bankruptcy. They observed that massive lawsuits were often settled for small fractions of the original claims. Furthermore, the outcome of a lawsuit often hinged on facts that emerged only when the case finally came to trial (which by definition never happened if the suit was settled out of court). Considering also the susceptibility of juries to emotional appeals, securities analysts of bygone days found it extremely difficult to incorporate legal risks into earnings forecasts that relied primarily on micro- and macroeconomic variables. At most, a contingency that had the potential of wiping out a corporation’s equity became a qualitative factor in determining the multiple assigned to a company’s earnings.

Manville Corporation’s 1982 bankruptcy marked a watershed in the way analysts have viewed legal contingencies. To their credit, specialists in the building-products sector had been asking detailed questions about Manville’s exposure to asbestos-related personal injury suits for a long time before the company filed. Many investors nevertheless seemed to regard the corporation’s August 26, 1982, filing under Chapter 11 of the Bankruptcy Code as a sudden calamity. Manville’s stock plunged by 35% on the day following its filing.

In part, the surprise element was a function of disclosure. The corporation’s last quarterly report to the Securities and Exchange Commission prior to its bankruptcy had implied a total cost of settling asbestos-related claims of about $350 million. That was less than half of Manville’s $830 million of shareholders’ equity. On August 26, by contrast, Manville estimated the potential damages at no less than $2 billion.

For analysts of financial statements, the Manville episode demonstrated the plausibility of a scenario previously thought inconceivable. A bankruptcy at an otherwise financially sound company, brought on solely by legal claims, had become a nightmarish reality. Intensifying the shock was that the problem had lain dormant for many years. Manville’s bankruptcy resulted from claims for diseases contracted decades earlier through contact with the company’s products. The long-tailed nature of asbestos liabilities was underscored by a series of bankruptcy filings over succeeding years.

Prominent examples, each involving a billion dollars or more of assets, included Walter Industries (1989), National Gypsum (1990), USG Corporation (1993 and again in 2001), Owens Corning (2000), and Armstrong World Industries (2000).

Bankruptcies connected with asbestos exposure, silicone gel breast implants, and assorted environmental hazards (see Chapter 13) have heightened analysts’ awareness of legal risks. Even so, analysts still miss the forest for the trees in some instances, concentrating on the minutiae of financial ratios of corporations facing similarly large contingent liabilities. They can still be lulled by companies’ matter-of-fact responses to questions about the gigantic claims asserted against them.

Thinking about it from the issuer’s standpoint, one can imagine several reasons why the investor-relations officer’s account of a major legal contingency is likely to be considerably less dire than the economic reality. To begin with, the corporation’s managers have a clear interest in downplaying risks that threaten the value of their stock and options. Furthermore, as parties to a highly contentious lawsuit, the executives find themselves in a conflict.

It would be difficult for them to testify persuasively in their company’s defense while simultaneously acknowledging to investors that the plaintiffs’ claims have merit and might, in fact, prevail. (Indeed, any such public admission could compromise the corporation’s case. Candid disclosure therefore may not be a viable option.) Finally, it would hardly represent aberrant behavior if, on a subconscious level, management were to deny the real possibility of a company-wrecking judgment. It must be psychologically very difficult for managers to acknowledge that their company may go bust for reasons seemingly outside their control. Filing for bankruptcy may prove to be the only course available to the corporation, notwithstanding an excellent record of earnings growth and a conservative balance sheet.

For all these reasons, analysts must take particular care to rely on their independent judgment when a potentially devastating contingent liability looms larger than their conscientiously calculated financial ratios. It is not a matter of sitting in judgment on management’s honor and forthrightness. If corporate executives remain in denial about the magnitude of the problem, they are not deliberately misleading analysts by presenting an overly optimistic picture. Moreover, the managers may not provide a reliable assessment even if they soberly face the facts. In all likelihood, they have never worked for a company with a comparable problem. They consequently have little basis for estimating the likelihood that the worst-case scenario will be fulfilled. Analysts who have seen other corporations in similar predicaments have more perspective on the matter, as well as greater objectivity. Instead of relying entirely on the company’s periodic updates on a huge class action suit, analysts should also speak to representatives of the plaintiffs’ side. Their views, while by no means unbiased, will expose logical weaknesses in management’s assertions that the liability claims will never stand up in court.

THE IMPORTANCE OF BEING SKEPTICAL

By now, the reader presumably understands why this chapter is entitled “The Adversarial Nature of Financial Reporting.” The issuer of financial statements has been portrayed in an unflattering light, invariably choosing the accounting option that will tend to prop up its stock price, rather than generously assisting the analyst in deriving an accurate picture of its financial condition. Analysts have been warned not to partake of the optimism that drives all great business enterprises, but instead to maintain an attitude of skepticism bordering on distrust. Some readers may feel they are not cut out to be financial analysts if the job consists of constant naysaying, of posing embarrassing questions, and of being a perennial thorn in the side of companies that want to win friends among investors, customers, and suppliers.

Although pursuing relentless antagonism can indeed be an unpleasant way to go through life, the stance that this book recommends toward issuers of financial statements implies no such acrimony. Rather, analysts should view the issuers as adversaries in the same manner that they temporarily demonize their opponents in a friendly pickup basketball game. On the court, the competition can be intense, which only adds to the fun. Afterward, everyone can have a fine time going out together for pizza and beer. In short, financial analysts and investor-relations officers can view their work with the detachment of litigators who engage in every legal form of shin-kicking out of sheer desire to win the case, not because the litigants’ claims necessarily have intrinsic merit.

Too often, financial writers describe the give-and-take of financial reporting and analysis in a highly moralistic tone. Typically, the author exposes a tricky presentation of the numbers and reproaches the company for greed and chicanery. Viewing the production of financial statements as an epic struggle between good and evil may suit a crusading journalist, but financial analysts need not join the ethics police to do their job well.

An alternative is to learn to understand the gamesmanship of financial reporting, perhaps even to appreciate on some level the cleverness of issuers who constantly devise new stratagems for leading investors off the track.

Outright fraud cannot be countenanced, but disclosure that shades economic realities without violating the law requires truly impressive ingenuity.

By regarding the interaction between issuers and users of financial statements as a game, rather than a morality play, analysts will find it easier to view the action from the opposite side. Just as a chess master anticipates an opponent’s future moves, analysts should consider which gambits they themselves would use if they were in the issuer’s seat. “Oh no!” some readers must be thinking at this point. “First the authors tell me that I must not simply plug numbers into a standardized spreadsheet.

Now I have to engage in role-playing exercises to guess what tricks will be embedded in the statements before they even come out. I thought this book was supposed to make my job easier, not more complicated.”

In reality, this book’s goal is to make the reader a better analyst. If that goal could be achieved by providing shortcuts, the authors would not hesitate to do so. Financial reporting occurs in an institutional context that obliges conscientious analysts to go many steps beyond conventional calculation of financial ratios. Without the extra vigilance advocated in these pages, the user of financial statements will become mired in a system that provides excessively simple answers to complex questions, squelches individuals who insolently refuse to accept reported financial data at face value, and inadvisably gives issuers the benefit of the doubt.

These systematic biases are inherent in selling stocks. Within the universe of investors are many large, sophisticated financial institutions that utilize the best available techniques of analysis to select securities for their portfolios. Also among the buyers of stocks are individuals who, not being trained in financial statement analysis, are poorly equipped to evaluate annual and quarterly earnings reports. Both types of investors are important sources of financing for industry, and both benefit over the long term from the returns that accrue to capital in a market economy. The two groups cannot be sold stocks in the same way, however.

What generally sells best to individual investors is a “story.” Sometimes the story involves a new product with seemingly unlimited sales potential.

Another kind of story portrays the recommended stock as a play on some current economic trend, such as declining interest rates or a step-up in defense spending. Some stories lie in the realm of rumor, particularly those that relate to possible corporate takeovers. The chief characteristics of most stories are the promise of spectacular gains, superficially sound logic, and a paucity of quantitative verification.

No great harm is done when an analyst’s stock purchase recommendation, backed up by a thorough study of the issuer’s financial statements, is translated into soft, qualitative terms for laypersons’ benefit. Not infrequently, though, a story originates among stockbrokers or even in the executive offices of the issuer itself. In such an instance, the zeal with which the story is disseminated may depend more on its narrative appeal than on the solidity of the supporting analysis.

Individual investors’ fondness for stories undercuts the impetus for serious financial analysis, but the environment created by institutional investors is not ideal, either. Although the best investment organizations conduct rigorous and imaginative research, many others operate in the mechanical fashion derided earlier in this chapter. They reduce financial statement analysis to the bare bones of forecasting earnings per share, from which they derive a price-earnings multiple. In effect, the less conscientious investment managers assume that as long as a stock stacks up well by this single measure, it represents an attractive investment. Much Wall Street research, regrettably, caters to these institutions’ tunnel vision, sacrificing analytical comprehensiveness to the operational objective of maintaining up-to-the minute earnings estimates on vast numbers of companies.

Investment firms, moreover, are not the only workplaces in which serious analysts of financial statements may find their style crimped. The credit departments of manufacturers and wholesalers have their own set of institutional hazards.

Consider, to begin with, the very term “credit approval process.” As the name implies, the vendor’s bias is toward extending rather than refusing credit. Up to a point, this is as it should be. In Exhibit 1.3, “neutral” Cutoff Point A, where half of all applicants are approved and half are refused, represents an unnecessarily high credit standard. Any company employing it would turn away many potential customers who posed almost no threat of delinquency. Even Cutoff Point B, which allows more business to be written but produces no credit losses, is less than optimal. Credit managers who seek to maximize profits aim for Cutoff Point C. It represents a level of credit extension at which losses on receivables occur but are slightly more than offset by the profits derived from incremental customers.

To achieve this optimal result, a credit analyst must approve a certain number of accounts that will eventually fail to pay. In effect, the analyst is required to make “mistakes” that could be avoided by rigorously obeying the conclusions derived from the study of applicants’ financial statements.

The company makes up the cost of such mistakes by avoiding mistakes of the opposite type (rejecting potential customers who will not fail to pay). Trading off one type of error for another is thoroughly rational and consistent with sound analysis, so long as the objective is truly to maximize profits. There is always a danger, however, that the company will instead maximize sales at the expense of profits. That is, the credit manager may bias the system even further. Such a problem is bound to arise if the company’s salespeople are paid on commission and their compensation is not tightly linked to the collection experience of their customers. The rational response to that sort of incentive system is to pressure credit analysts to approve applicants whose financial statements cry out for rejection.

A similar tension between the desire to book revenues and the need to make sound credit decisions exists in commercial lending. At a bank or a finance company, an analyst of financial statements may be confronted by special pleading on behalf of a loyal, long-established client that is under allegedly temporary strain. Alternatively, the lending officer may argue that a loan request ought to be approved, despite substandard financial ratios, on the grounds that the applicant is a young, struggling company with the potential to grow into a major client. Requests for exceptions to established credit policies are likely to increase in both number and fervor during periods of slack demand for loans.

When considering pleas of mitigating circumstances, the credit analyst should certainly take into account pertinent qualitative factors that the financial statements fail to capture. At the same time, the analyst must bear in mind that qualitative credit considerations come in two flavors, favorable and unfavorable. It is also imperative to remember that the cold, hard statistics show that companies in the “temporarily” impaired and start-up categories have a higher-than-average propensity to default on their debt.

Every high-risk company seeking a loan can make a plausible soft case for overriding the financial ratios. In aggregate, though, a large percentage of such borrowers will fail, proving that many of their seemingly valid qualitative arguments were specious. This unsentimental truth was driven home by a massive 1989–1991 wave of defaults on high-yield bonds that had been marketed on the strength of supposedly valuable assets not reflected on the issuers’ balance sheets. Bond investors had been told that the bold dreams and ambitions of management would suffice to keep the companies solvent.

Another large default wave in 2001 involved early-stage telecommunications ventures for which there was scarcely any financial data from which to calculate ratios. The rationale advanced for lending to these nascent companies was the supposedly limitless demand for services made possible by miraculous new technology.

To be sure, defaults also occur among companies that satisfy established quantitative standards. The difference is that analysts can test financial ratios against a historical record to determine their reliability as predictors of bankruptcy. No comparable testing is feasible for the highly idiosyncratic, qualitative factors that weakly capitalized companies cite when applying for loans. Analysts are therefore on more solid ground when they rely primarily on the numbers than when they try to discriminate among companies’ soft arguments.