There is plenty of blame to go around for the apparent accounting frauds that led to Enron Corporation filing for relief under Chapter 11 of the U.S. Bankruptcy Code. In assessing blame, though, it would be a shame if conventional security analysts, conventional money managers and conventional finance academics were left out of the mix. Whatever their other talents — and these people tend to have many other talents — analysts, money managers and finance professors seem notoriously unqualified to be intelligent, responsible users of GAAP who actually understand the uses and limitations of financial statements.
The 1960’s were a period of great ferment in finance. Two divergent trends took hold. One affected bottom-up fundamentalists, and one affected conventional top-down security analysts and money managers.
The Securities Acts Amendments of 1964 sparked a disclosure revolution that is still ongoing. Today, for trained, bottom-up fundamentalists, GAAP has never been better, more informative or more reliable, the Enrons of this world notwithstanding.
Starting in the 1960’s and continuing to date, Modern Capital Theory (MCT) has increasingly dominated conventional security analysis and conventional money management. MCT is based on views that there exists an efficient market where the market knows more than any individual, or group, of investors; where day-to-day stock market price fluctuations are highly material; where there is a primacy of the income account with a consequent denigration of the importance of examining balance sheets and financial positions; where generally recognized growth is worth premium prices in the stock market; and where the GAAP earnings or cash flow number, as reported, is deemed to be far more important than what can be learned from studying and interpreting all of the other GAAP numbers available for a corporate analysis.
In MCT, an investor guards against market risk through diversification and asset allocation. In bottom-up fundamentalism, certainly as practiced by Third Avenue Funds, investment risk is guarded against by obtaining detailed knowledge about companies and the securities they issue and by being acutely price conscious when acquiring securities.
Enron-type promotions fare much better in the MCT environment than in a bottom-up fundamentalist environment.
In the old days when I was growing up as a security analyst, there was a pervasive principle of GAAP which stated, in effect, that financial statements were to be prepared under the assumption that the users of GAAP were intelligent, informed persons who expected financial statements, taken as a whole, to be objective benchmarks which the user could then employ in an analysis. After the 1960’s, this approach was increasingly discarded, as MCT took hold as the approach of choice for outside, passive, minority investors. Today, it is expected in security analysis that GAAP tell the truth (rather than provide objective benchmarks) to the average investor about those particular numbers deemed most important to the average investor, i.e., those numbers most likely to have an immediate impact on stock market prices. The particular numbers deemed important under the present paradigm are quarterly earnings per share from normalized operations, or quarterly cash flow per share from normalized operations. If these quarterly flow numbers have been growing rapidly, the common stock is seen as a “growth stock,” likely to sell at a premium price in stock markets populated by outside, passive, minority investors. The average investor focuses on what the operating earnings numbers are rather than what all the numbers mean simply because the earnings numbers, as reported, are likely to have a major, immediate, influence on stock market prices for a common stock.
Enron took advantage of this average investor approach. It apparently tried to maximize reported earnings per share from operations by booking as income the present value of long-lived transactions even though there never existed “reasonable assurances” that such income would be realized. Enron also benefited from the conventional view that there actually exists a primacy of the income account, and that premium prices would be paid for the common stocks of companies exhibiting a growth trend. This emphasis on earnings from operations as reported and on perceptions of growth by analysts and money managers permitted these people to ignore rather completely other factors that tend to be extremely important in any balanced analysis for which GAAP is useful: e.g., strength of financial positions; understanding the underlying business; and appraising management not only as operators and stock promoters, but also as investors of corporate assets and financiers of businesses.
At each of the Third Avenue Funds, common stocks are analyzed the old fashioned, pre-MCT, way. Despite shortcomings in the Funds’ approaches, it remains extremely unlikely that any of the Funds would ever acquire an Enron type common stock simply because Fund management does not focus on quarterly earnings as reported and growth trends. Rather, the Third Avenue criteria for acquiring common stocks encompass the following:
Unlike an analysis undertaken by conventional analysts and conventional money managers, a Third Avenue analysis is strictly bottom-up. Fund management looks at the company and its securities — period. Fund management does not have a view about when the current recession might end or a focus on technical analysis in decision-making. We had better understand the company, and understand it well. That is why corporate financial accounting is so crucial at Third Avenue. In contrast, the convention is to be primarily top-down, to forecast the outlook for Gross Domestic Product, interest rates, and the Dow Jones average or technical stock market factors. Many conventional analysts are successful though they have no detailed knowledge about securities they own, or trade; and are “babes in the woods” when it comes to understanding the uses and limitations of financial accounting. Indeed, when managing a high turnover portfolio, no investing institution, even if otherwise qualified, can be in a position to study individual companies and their securities in depth. This failure to study by the users of financial statements seems ordained to create many Enrons and Enron type situations. But probably many portfolio managers, and their portfolios, don’t suffer too much from their inability to use corporate accounting. As a substitute for knowledge about specific securities, many money managers have well-developed top-down programs for investing centering on portfolio diversification and asset allocation. For this, the precepts of MCT are valid and highly useful. Third Avenue is much less diversified than conventional portfolios. We think diversification is only a surrogate, and usually a poor surrogate, for knowledge, control and price consciousness. Third Avenue does diversify some; it is not a control investor, but we do try hard to bring to any common stock investment knowledge and price consciousness.
The Third Avenue goal in acquiring a common stock is to attempt to acquire the security at a price that represents a substantial discount from the price which would exist were the company a private business or a takeover candidate. In contrast, the goal for most conventional money managers seems to be to achieve near-term price appreciation for the common stock and/or to outperform a benchmark as consistently as possible. If one’s goal is the short-run outperformance of a benchmark, there is much to be said in favor of investing in companies with rapidly growing earnings per share as reported, without critically examining how these earnings are derived or what they mean. Such an approach just isn’t Third Avenue, and never will be.
In brief, conventional security analysts and conventional money managers frequently seem to employ the following approach:
- There exists an equilibrium price. In an efficient market, a common stock’s price at any moment in time is the right price reflecting the only real value extant. That price will change as new events unfold. Here, the principal analytic ability sought is the ability to predict the future. After all, maximum stock price appreciation will occur insofar as earnings from operations, and/or cash flow from operations, grow
- Quarterly earnings statements are always highly important
- What the numbers are, as reported, especially the earnings number, is much, much more important than what the numbers mean
- Ignore the balance sheet; indeed, in many contexts, a high book value is a negative factor
- Portfolios will tend to have a high turnover. Third Avenue portfolios average a turnover of under 20%. Most conventional funds seem to exceed 100%
- In buying into growth, buy generally recognized growth. There has been no way in stock markets of buying into generally recognized growth without paying up. In contrast, at Third Avenue, we try to buy into future growth that is overlooked or misunderstood. We don’t pay up.
- Rely much more heavily, sometimes exclusively, on management interviews and other interviews than on in-depth reviews of documents
- Emphasize the importance of top-down variables.
Financial accounting is crucially important to the U.S. economy. If financial statements are seen as unreliable, or untrustworthy, the whole economy could fall apart because corporate credit grantors — e.g., commercial banks, finance companies, and life insurance companies — would no longer be in a position to make safe loans to businesses. The United States has been steadily losing its manufacturing base, and as a consequence, suffers massive merchandise trade deficits. But in a double-entry world, the U.S. economy does not have to focus on the fact that it is characterized by a growing excess of merchandise imports over merchandise exports. Rather, the U.S. economy is benefiting from the export of participations in its capital markets — the best, most efficient, most honest, most informed in the history of mankind.
Fortunately for Third Avenue and similar institutions trained in the use and limitations of GAAP, financial disclosures have never been more complete, more informative, or better benchmarks than is now the case. This seems true despite the tremendous waste of the past 25 or 30 years in trying to have GAAP fulfill the needs of the types of people who speculate in securities such as Enron Common. Without reliable audits, all these “bests” and “mosts” might well disappear. I think no one can ever design financial statements to be more than objective benchmarks. Accounting, in general, just can’t tell the truth about quarterly income accounts. The standard for disclosure ought not to be, “Financial Statements for Dummies.”
GAAP has to be based on a relatively rigid set of limiting assumptions, which frequently are going to be unrealistic. For example, depreciation charges are based on historic cost, not replacement cost. GAAP, realistic in one context, has to be unrealistic in another context. For example, cash accounting omits descriptions of a company’s wealth creation, i.e., accrual experience. Accrual accounting, on the other hand, fails to describe a company’s cash experience. Both cash accounting and accrual accounting give valuable objective benchmarks to analysts trained to use all the numbers in an accounting. Determining what the numbers mean has to be the province of the users of financial statements, not the province of preparers of financial statements. The duty of the auditor ought to be to approve financial statements prepared in accordance with a conservative bias, and which statements are comparable and reconcilable while being sure that all material liabilities are disclosed in either the balance sheet or footnotes whether the liabilities are firm or contingent.
A company, for example, has an obligation to pay out $100 million cash in the future. Depending on the form of the transaction, the obligation will be recorded under different forms under GAAP, even though the true economics will be similar. The obligation will appear as a balance sheet liability if it’s a borrowing but not if it’s an operating lease, a put option written by the company, or even a credit insurance policy written by the company. Under GAAP, inventories, say of a department store chain, are classified as “current assets.” The inventories are current assets only in a liquidation analysis or if the analyst is looking at individual items of inventory rather than at inventory in the aggregate. If the department store chain is to stay operating as a going concern, its inventories in the aggregate tend to be fixed assets for any economic purpose.
GAAP can never provide a statement of true earnings. Earnings are subject to interpretation if one is to arrive at an analyst’s version of the truth. I think that in the case of most of the companies in which TAVF holds common stocks, GAAP data result in material understatements of true earnings.
Toyota Industries (“Industries”) has a huge portfolio of marketable securities, principally a 5%-plus interest in Toyota Motor Common. Industries’ income account reflects only dividends received from portfolio companies. As such, Industries’ reported earnings under GAAP for the 12-month period ended September 30, 2001 were $0.65 per share, assuming a yen value of 133 to the dollar. Had Industries’ income account also reflected Industries’ equity in the undistributed earnings of its portfolio companies, almost all of which are business affiliates, earnings on the same yen to dollar basis would have been approximately $1.45 per share.
Electronic component and semiconductor equipment suppliers in the 21st century are much like auto suppliers were in the 1960’s and 1970’s in that long-term growth trends for these cyclical enterprises seem favorable so that current expenditures are likely to result in materially enhanced future earnings power. Auto suppliers anticipated participating in future growth mostly by making capital expenditures for property, plant and equipment. In the case of electronic component and semiconductor equipment suppliers, the comparable expenditures are for Research and Development (“R&D”), not capital facilities. In the case of the auto suppliers, capital expenditures are capitalized and then charged against income by annual depreciation charges over the life of the capitalized assets. In sharp contrast, the electronic component and semiconductor equipment manufacturers expense all R&D expenditures by contemporaneous charges, as incurred, against the income account. Compared with auto suppliers, and indeed almost all of the old economy manufacturing companies, issuers such as Applied Materials, AVX, KEMET, and Electro Scientific Industries seem to be materially understating their true earnings, especially during periods when R&D expenditures are on an uptrend, i.e., most periods.
As The St. Joe Company develops its vast landholdings in Florida, there is a strong tendency for adjacent, undeveloped properties, also owned by St. Joe, to appreciate in value, sometimes markedly. This increase in unrealized appreciation is rarely, if ever, reflected in annual income accounts, whether for St. Joe, Tejon Ranch or other companies whose common stocks are in the Fund’s portfolio and which own developable properties.
GAAP income accounts also fail to fully reflect the annual increase in Adjusted Book Value for MBIA, or the value of annual increases in Assets Under Management for Legg Mason.
Determining whether GAAP earnings overstate, or understate, true annual (or even quarterly) earnings is a job for trained analysts, not CPAs or average investors. Fortunately, in the case of Third Avenue Funds, I think there is a strong tendency for GAAP financial statements to result in an understatement of true earnings and true net asset values as well as realistic disclosures about all liabilities, something that hardly seems to have been the case for Enron.
In the desire to fulfill the needs of the average investor, GAAP has become about as complex as the Internal Revenue Code. Complexity seems necessary for the Internal Revenue Code because its purpose is to determine an actual number — the taxpayer’s tax bill. GAAP is complex because of attempts to determine one number — true earnings per share. In fact, the goal of GAAP should be much simpler — provide the user with objective benchmarks, not truth.
Arthur Levitt, the former Chairman of the Securities and Exchange Commission (SEC), is a principal proponent of GAAP for the average investor. I think this is an unproductive goal. Incidentally, in citing who effectively regulates GAAP, Mr. Levitt seems to leave out the most important group that has been policing the accounting profession, for better or for worse, the Plaintiffs’ Bar. The awards attorneys have received in stockholder lawsuits and payments made to class member plaintiffs for accountants’ liability have profoundly influenced the audit profession. My experience in dealing with public presentations of accounting data is that the first question asked is, “How should this be presented so that we avoid stockholder suits, or, in any event, successful stockholder suits?” Arthur Andersen seems to have ignored this in the Enron matter. The vast majority of auditors don’t.
My suggestion for accounting reform is to go back to the old, pre-MCT, days. Financial statements ought to be aimed at people equipped to use them, not stock market speculators focused on earnings per share from operations. Financial statements should be, as a practical matter, designed to meet directly the needs of creditors; and all creditors need a conservative bias when examining financial statements. Companies should be viewed as stand-alone entities, separate and distinct from the shareholder constituency. In seeking to have GAAP serve the needs of creditors, similarities are found in other accounting systems. For example, Statutory Accounting for insurance companies is designed to protect policyholders, not owners; and broker-dealer accounting under SEC rules is designed to protect customers.
I am not a CPA. I am a user of financial statements. I admire the audit profession, the independence of most accountants, their knowledge, and their ability to provide all of us analysts at Third Avenue with the tools we need to do our job.