click here to return to the Calico Cat homepage

Wall Street and the illusion of profits

According to Wednesday’s Wall Street Journal, federal investigators are probing alleged accounting fraud at Coca-Cola Co. They are focusing on an email sent from company headquarters in 1999 directing Coke’s unit in Japan to look for ways to make up for a $35 million profit shortfall.

The Japanese unit was supposed to make up the shortfall by having its bottling companies purchase extra concentrate before the end of the quarter, which would have the effect of stealing profits from the future in order to make the present numbers look good. (Wouldn't an increase in Coca Cola's profits cause a corresponding decrease in profits of the bottling companies? No, because the concentrate is carried on their books as an asset. A net increase in accounting profits is created out of nothing.)

My first reaction to this news was to ask, “so what else is new?” Isn’t it standard operating procedure to play with the accounting figures to make the earnings look good? Don’t all public companies play these kinds of games?

Nearly a decade ago when I worked in the accounting department of a private software company with about $15 million in annual sales, there were strong incentives to use accounting to increase profits as much as possible. The company didn’t have to impress Wall Street, but it was trying hard to impress its venture capitalists and position the company to be sold. Every “expense” that could possibly be capitalized was. Revenue was recognized in advance of actually performing the work required in the contracts when it should have properly been recognized after the work was completed.

A few years ago I worked for a public company that sold medical devices. The company had around $90 million in annual sales. During one month in the summer I heard rumors about how bad sales were during the quarter. Because I had access to the company’s sales database, I did some research and sure enough, I discovered that there was a noticeable drop in sales. I predicted that the company would report a loss of between three and four cents a share for the quarter. (Each penny per share represented about $200,000.)

The earnings were finally released, and to my surprise, we reported a one penny per share profit! The press release proudly trumpeted yet another profitable quarter, further proof of the company’s dramatic turnaround. I have no idea where that penny of profits came from. I am pretty sure that there were some accounting shenanigans pulled to create the illusion of a penny of profit where none actually existed.

Wall Street investors are extremely impressed by steady earnings. They hate it when a company earns a dollar a share one quarter, then loses 50 cents the next. They’d rather see a company earn 24 cents one quarter and 26 cents the next. Then they proclaim, “look the company is growing!” and they joyfully bid up the stock price because the two cents increase in profits makes it a growth company. The companies know how Wall Street behaves, and they endeavor to give Wall Street what it wants.

But how realistic is it for a company to have steady growth? This is why the father of value investing, Benjamin Graham, was extremely distrustful of growth stories. Read his book Security Analysis: The Classic 1934 Edition, and you will see that even though it was written in 1934, it reads as if he’s writing about the bubble investors of the late 1990s. (The 1934 edition is far better than the horrible 1987 edition that wasn’t written by Graham at all.)

This is why I don’t invest in companies based on growth stories, or even give much credence to earnings at all! The price/earnings (PE) ratio is the first financial indicator that novice investors understand. Most never graduate to trying to understand what’s in the balance sheet. So earnings tend to be overvalued, and earnings growth is much more overvalued than earnings alone. The people who lost the most money in the stock market crash of 2000 were those invested in the growth companies.

Occasionally I’ll find a stock with a low PE ratio that’s a good buy, maybe because it’s a boring company, or because it’s not the top company in its field (the horror of being number two!), or maybe it had a bad year or a bad quarter. But low PE companies are hard to find, an indication that the stock market is still overvalued. I’ve made the most money investing in companies that have no consistent earnings, but that have assets which are unappreciated by Wall Street.

UPDATE

For investing advice, visit my Contrarian Investing Blog.

posted Saturday, July 24, 2004