Dumbing down
02 Oct 2003
Being smart is not necessarily the best way to protect yourself from troublesome accounting.
EPS, Dividends, etc. are all well and good. But we can't do much with them if the numbers aren't being honestly reported and if management isn't sincerely trying to run the business for the benefit of all shareholders.
Actually, there are two variations of the theme. One is outright fraud. Individuals who are involved in generating the numbers are lying. That, of course, is illegal. The other variation is something often referred to as "financial engineering." This is very legal. It refers to making full use of reporting techniques allowed by law in order to present the company in a way that management deems favorable. The key here is that what financial engineers do is absolutely, completely, and positively legal, and often they are admired by their peers, and by analysts, for their innovative use of the reporting tools available to them.
Fraud is the obvious thing. No analysis of the reported numbers can protect you from becoming a victim of dishonesty. Our only protection is a diversified portfolio to cushion the impact of fraud in one of the holdings.
Believe it or not, financial engineering may be a worse problem. Because it's legal, and praised in some circles, more companies are willing to do it. As noted, financial engineers do not lie. Instead, they tell you the truth about questions you really ought not be asking, and distracting you from issues that may be more important.
The simplest form of financial engineering is the increasingly extensive use of pro forma accounting, in which lots of unpleasant adjustments are omitted.
The pro forma numbers focus investors away from issues that are vital to them as they view the company in a different capacity.
It gets worse. Because financial engineering can get complicated, if you have trouble figuring out what's happening, your initial human reaction will be to feel a sense of shame that you don't know how to analyze the company. Hence you are likely to go passively along with the crowd because you don't want to admit, even to yourself, that you're letting an opportunity slip by because you aren't sufficiently competent to understand it.
Don't ever let anyone make you feel embarrassed about not understanding a set of financial statements! If someone does try to make you feel like an idiot because you don't get it, there is, indeed, one idiot in the conversation, but rest assured that it's not you!
Here's a defense that may prove more effective in protecting you against trouble. If you feel dumb, smile, because in truth, you may be the one who is getting it right. And if you feel smart, consider dialing down your IQ for a while. See if you can understand the situation based only on accounting for simpletons. If not, pass the stock by and look for something else.
Seriously folks: don't let anyone distract you from the basics: (i) Revenue is money that other people give to the business; (ii) Expenses are money the business gives to other people; and (iii) You want more of the former than the latter. Check the financial releases and see if they make sense under those basic concepts.
That's pretty much all you need to do. If you find this insufficient for a particular company, pass it by.