Increasingly, the Inmates Seem to Be Running the Insane Asylum
Washington politicians, corporate executives and securities analysts at times seem to be driven by a herd mentality. They frequently seem to be lemmings. Look at the dot com bubble before it burst in early 2000. Look at the extremely ill-advised “airline bailout” approved almost unanimously and in a hurry by Congress in the fall of 2001. That wasn’t an airline bailout; it was a temporary bailout of airline creditors. Look at the current stampede by corporate executives to account for stock options as a corporate expense. Stock options are not, in the vast majority of instances, a corporate expense; they are a stockholder expense. In my view, the most egregious malpractice of the herd today is to have everyone dump on public accountants. The vast majority of problems with financial accounting today have nothing to do with the preparers of financial statements, the public accountants. Rather, the problems lie with the users of financial statements, equity analysts appraising publicly-traded securities, who have little or no willingness or ability to use appropriately the vast amount of information imparted to them by financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). These analysts, and their cohorts in the media, in the Plaintiffs’ Bar and in the political arena, are the inmates who, increasingly, are determining what financial disclosures ought to be. They, indeed, seem to be running the insane asylum.
It ought to be instructive to Third Avenue Value Fund (TAVF) shareholders to compare how Third Avenue uses accounting disclosures with how the great majority of securities analysts in research departments use accounting disclosures. While the TAVF approach may appear to be aberrational compared with Wall Street convention and with the precepts that make up almost all of the academic literature, the Third Avenue approach seems to me to be the majority, mainstream approach in the U.S. economy. The TAVF approach is the same as that followed by private companies not seeking access to public markets for equities; businessmen seeking favorable tax attributes so that they can create wealth on a tax-sheltered basis; most creditors; and all investors who seek in the management of their own portfolios to maximize total return, rather than just invest for interest income and dividend income. Interest income and dividend income in investor portfolios is the precise equivalent of revenue from recurring operations for going concern corporations.
How Third Avenue Uses Accounting Disclosures
The TAVF objectives are to ascertain what a business and its securities might really be worth to a control buyer, and what the range of dynamics might be for the corporation over the long term. Short-term considerations are always ignored with the exception of risk arbitrage situations. Risk arbitrage situations exist only where there are relatively determinate workouts in relatively determinate periods of time, e.g., when there is an announced corporate merger.
Managements are appraised looking at three interrelated factors. Managements are appraised as operators of going concerns; as investors employing and redeploying the assets of a business; and as financiers obtaining the necessary capital to conduct company activities. Of the three interrelated activities, appraising management as investors, not as operators, is probably the most important single factor in a Fund analysis. A majority of the TAVF common stock investments are in companies acquired at substantial discounts from Fund management’s estimates of net asset value (NAV), where Fund management believes that prospects are good that NAV will be steadily increased over the long term. In many instances, those increases in NAV will come from places such as enhanced land values or securities market price appreciation, rather than going concern income from operations. At July 31, 2002, common stock investments in NAV driven (rather than earnings driven) companies accounted for 54% of the Fund’s common stock portfolio. Principal industry groups containing NAV companies were real estate, insurance, depository institutions, business development and Japanese issuers whose principal assets were portfolios of marketable securities.
In appraising managements as investors, there is no such thing as non-recurring charges or expenses. Non-recurring charges are the method used in GAAP accounting to record past investment mistakes.
In a TAVF appraisal, no one accounting number is ever all-important. Rather it is realized that every accounting number is derived from, modified by, and a function of, all the other numbers that comprise the accounting cycle. Most analyses are complicated, and different numbers — operating income, cash flow from operations, comprehensive income, book value, revenues, inventory turnover, capitalization ratios, returns on equity — are given different weights dependent on context.
In a TAVF analysis, one size never fits all. Depository institutions are analyzed differently than high tech companies, which are analyzed differently than real estate companies, and distress credits seem, in great part, to be off into a different world.
What is expected of GAAP accounting in a TAVF analysis is that it provides to the analyst objective benchmarks, which the analyst can then use to determine truth and accuracy. As a matter of fact, GAAP is usually the only source of numerical objective benchmarks for the analyst. Outside of mark-to-market accounting for investment companies, it is utterly ludicrous to expect GAAP to reflect truth and accuracy for all contexts. Like the Internal Revenue Code, GAAP is based on a relatively rigid set of unrealistic assumptions — e.g., depreciation of property, plant and equipment is based on historic cost; and most debt obligations of a company are carried at the face amount of the debt obligation, rather than marked to current market. Any system of accounting has to have shortcomings that cause it to be unrealistic in one, or more, contexts. Cash accounting has shortcomings in that it fails to reflect a company’s accrual, or wealth creation, experience during a period. Accrual accounting has shortcomings in that it fails to reflect a company’s cash experience during a period. Nonetheless, both cash accounting and accrual accounting are important. As a general rule, the common stock analyst might want to give overriding weight to cash accounting for companies whose financial positions are quite weak, while emphasizing accrual accounting for companies sitting with huge amounts of surplus cash.
A TAVF analysis focuses on what the numbers mean, rather than what the numbers are. Disclosure is what counts, not how things are disclosed, e.g., in the case of stock options, it is important that the term of options be disclosed in footnotes to GAAP audits. It is not important that the value of options (no matter how inaccurately value is determined) be deducted from accounting net income. Knowing the details of an item such as stock options enables the TAVF analyst to either adjust financial statements, adjust the price the analyst might be willing to pay for a security, or both.
For TAVF, financial disclosures have never been more comprehensive, more meaningful and more useful than is currently the case. This remains true even though, in general, accounting fraud à la WorldCom seems to have increased materially in recent years. Given the Fund’s modus operandi though, where few common stocks are acquired if the company does not enjoy an extremely strong position, it seems to me that the Fund remains far less likely in its common stock portfolio to be victimized by accounting frauds than will be conventional equity analysts.
GAAP accounting by Toyota Industries and GAAP accounting for debt on the balance sheets serve as two examples of how GAAP provides the Third Avenue analyst with objective benchmarks and how the Third Avenue analyst uses those objective benchmarks to get at his or her version of truth and accuracy.
Assuming that Toyota Industries’ going concern operations are valued at 6 to 7 times operating income, the assets dedicated to these operations, after deducting all non-convertible funded debt, constitute between 8% and 12% of Toyota Industries’ assets. 60% to 63% of assets are in Toyota Industries’ holdings of Toyota Motor Common Stock valued at market, and 28% to 29% of assets are in the market value of common stocks of other companies, most of which, like Toyota Industries, are also affiliates of Toyota Motor. In reporting earnings in accordance with GAAP, Toyota Industries includes in its earnings only dividends received from portfolio companies. Looked at this way, Toyota Industries Common is selling at around 21 times latest 12-month earnings. However, if Toyota Industries’ income account is adjusted to pick up, as additional earnings, the Company’s equity in the undistributed earnings (i.e., earnings not paid out as dividends) of Toyota Motor and the other portfolio companies, then Toyota Industries Common is selling at only 8.5 times latest 12-month earnings. Which is the more realistic reflection of Toyota Industries’ performance — as reported under GAAP, or as adjusted to reflect the equity in the retained earnings of business affiliates? I would think that the adjusted earnings figure probably is more realistic, but this is far from certain. Were I the CEO or CFO of Toyota Industries and was I asked to swear that the earnings as reported were true and accurate, I might decline to sign. However, it is doubtful that including the equity in the undistributed earnings of affiliates is 100% accurate either. Toyota Industries has no control over the uses to which these undistributed earnings might be put. Here, truth lies in the analyst’s interpretation of results, not in GAAP reports. Under GAAP, the presumption is that the undistributed earnings of affiliates would be included in earnings if Toyota Industries owned 20% or more of the outstanding common stock of the affiliate. 20% is a relatively rigid rule, which does not necessarily describe economic reality. The Third Avenue analyst, though, really does not have to make a decision about which of the two ways to report earnings is really proper. He or she need only decide at which price, if any, the analyst would recommend buying Toyota Industries Common. In fact, at TAVF we give much more weight to the fact that Toyota Industries Common sells at a 35%-40% discount from NAV than to the price to earnings ratios for Toyota Industries Common.
Whether debt obligations ought to be viewed as valued at the amount of claim, or at market prices, depends on who is doing the analysis and for what purposes. Regardless of the amount at which the debt obligation is carried on the company’s balance sheet for GAAP purposes, if the company lacks the financial wherewithal to acquire debt obligations at discounts from the creditors’ claims, then from the points of view of the corporation itself and its common stockholders, the debt ought to be valued at the amount of claim, i.e., principal amount plus accrued interest. In bankruptcy, there exists a “rule of absolute priority.” Senior debt has to be paid in full under the rule before the corporation can give any value to junior securities, including the common stocks owned by OPMIs. On the other hand, from the point of view of a distressed bond buyer seeking to reorganize the company, the market price of the debt obligation (particularly as a percentage of claim) becomes the key number. However, what the key number really is has to be decided by the analyst, not the accountant preparing the numbers in accordance with GAAP. GAAP will follow a set of rigid rules about recording debt. The Third Avenue analyst will determine economic reality for his or her purposes.
How Most Conventional Analysts Seem to Use Accounting Disclosures
The conventional analyst’s objectives seem to revolve around estimating what the market price for securities trading in an OPMI market will likely be in the weeks, months or years ahead. Put in conventional language, what is the target price?
Managements are appraised solely as operators of strict going concerns. Thus, one number becomes all-important whether it is reported, recurring earnings from operations, cash flow from operations, revenues, or Earnings Per Share (EPS) from normal recurring operations. Thus, there exists a primacy of the income account. Balance sheet considerations — both quantitative and qualitative — are denigrated.
One size tends to fit all. There tends to be one “magic” number which is the key to analyzing any company, whether that “magic” number is Discounted Cash Flow (DCF), EPS or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).
GAAP ought to reflect economic reality, i.e., give a true and accurate account of operating results for a period. What the numbers are becomes more important than what the numbers mean. Thus it becomes highly important that the value of options be reflected in reported net income, even if the details are contained in the footnotes.
This approach, combining a primacy of the income account plus reliance on numbers as reported without adjustment, seems the most appropriate approach insofar as the objective of an analysis is to predict what might happen to common stock prices in OPMI markets over the near term. Market players, most of the time, are focused on income numbers, not balance sheet numbers. Immediate market prices tend to react to earnings numbers as reported.
For the economy as a whole though, I think this current emphasis on reporting operating earnings accurately and truthfully is dangerous. First, there is no way reported numbers are going to really be truthful and accurate in all contexts no matter how many Chief Executive Officers and Chief Financial Officers so attest as they were required to do from August 14, 2002 forward. Setting the standards under which executives have to attest to the truth and accuracy of financial statements seems certain to give the Plaintiffs’ Bar license to pursue frivolous lawsuits. Society is better served when the Plaintiffs’ Bar is instead incentivized to take action against meaningful wrongdoing by corporate insiders, as for example the alleged stealing by the controlling shareholders of Adelphia Communications.
GAAP cannot be made to reflect economic reality. GAAP can only provide objective benchmarks. To try to get GAAP to be more than that results in making GAAP so complex that its usefulness for people trained to use it becomes impaired. The Internal Revenue Code has to be very complicated because it is designed not to reflect reality, but to determine one number, the taxpayer’s tax bill. GAAP ought to be designed to give trained users objective benchmarks. This doesn’t seem unduly complicated.
As I’ve stated in past letters, GAAP can be most useful insofar as it provides disclosure against the following background:
- The Company should be viewed as a stand-alone, separate and apart from its common stockholders and management. In other words, it does not make a lot of sense to have what is a stockholder expense, stock options, reflected as a company expense.
- The underlying assumption ought to be that the user of the financial statements will be a reasonably intelligent person who understands what the complete accounting cycle is.
- GAAP financial statements ought to, first and foremost, fill the needs and desires of creditors, not shortrun stock market speculators.
A Plauge Upon Almost All Their Houses
The shareholders of TAVF are Fund management’s constituency. Therefore, it is important that Fund management look at things primarily from the point of view of that constituency — broadly speaking, OPMIs — while remaining cognizant of the points of view of other constituencies within the financial community.
It is apparent, to me at least, that there has been an inexorable trend in the last 10 or 15 years toward having OPMIs in particular, and corporations in general, increasingly ripped off not only by corporate managements but also by the Plaintiffs’ Bar, by Bankruptcy Attorneys, by Defense Attorneys and by Investment Bankers. (Please note that public accountants are specifically excluded from this list of underperformers and overreachers.) Ameliorating the rip off problem probably will require various reforms that go well beyond the recently enacted Sarbanes-Oxley Act of 2002. Sarbanes-Oxley is a good start. However, many of the most desirable reforms will be fiercely resisted by politically powerful constituencies, e.g., corporate executives. Many of these desirable reforms could result in adverse, unintended consequences, e.g., strengthening the Plaintiffs’ Bar.
There seems to be an inherent conflict between Plaintiffs’ lawyers, bankruptcy attorneys and investment bankers, on the one hand, and the clients these professionals are supposed to represent, on the other hand. Put bluntly, which comes first for these professionals, their fees or their clients’ best interests? My observation is that many bankruptcy lawyers and many investment bankers not only tend to be hugely overcompensated, but also tend to prolong Chapter 11 cases unnecessarily in order to milk the estate for fees. For many plaintiffs’ attorneys prosecuting securities class or derivative actions, most of which are settled out-of-court, it is fees first and fuller restitution to clients a distant second.
As far as the Bankruptcy Code is concerned, OPMIs would be well served if payments to professionals were returned to what existed before the passage of the Bankruptcy Reform Act of 1978. Pre the 1978 Act, lawyers and investment bankers were paid generally only at the end of a case, and only if they demonstrated to the court that they had made a “substantial contribution.” Nowadays, it is pay-as-you-bill for the professionals, plus “success” fees. A principal reason for the 1978 change was the belief that highly qualified professionals would not take cases if they had to work for contingent fees. What utter nonsense. For better or worse, it is hard to find more competent professionals than plaintiffs’ attorneys. All of them work for contingent fees.
Like it or not, the principal cop enforcing laws against corporate fraud and management excesses will continue to be the Plaintiffs’ Bar. It won’t be the Securities and Exchange Commission (SEC), State Attorneys General, or State “Blue Sky” Commissions. Sarbanes-Oxley gave minor breaks to attorneys suing on behalf of OPMIs. But resistance to expanding the powers available to the Plaintiffs’ Bar probably will continue to be highly effective. For example, the New York Stock Exchange (NYSE) on June 6, 2002 put out a booklet under the auspices of the NYSE’s “Corporate Accountability and Listing Standards Committee” on recommendations to enhance corporate governance for the benefit of OPMIs. There the Committee states, “we wish to explicitly note — that we have rejected and that we strongly urge policy makers to avoid — repealing or weakening the Private Securities Litigation Reform Act.” There is, in my view, a good degree of merit to the Committee’s position but it ill becomes a group claiming to be working in the best interests of OPMIs to go out of its way to propose what is, in effect, protection for corporate insiders against OPMI lawsuits. It should be noted that there are considerable counter pressures, or trade-offs, so that the things done to protect OPMIs from overreaching by corporate insiders will continue to be limited, Sarbanes-Oxley and pronouncements by the Bush Administration notwithstanding. The underlying problem is that every financial and legal practice is not only subject to abuse, but will be abused. Stockholder lawsuits tend to result in abuse and seem to cause much waste. But look at the alternative. OPMIs are mostly raped in other western countries such as Germany and England where the minority stockholders lack access to the courts. See the terrific article on the front page of the August 16th issue of The Wall Street Journal entitled, “Toothless Watchdogs — Outside the U.S., Executives Face Little Legal Peril.”
I have very mixed feelings about contingency fee lawyers. From an OPMI point of view, those taking securities cases seem to do more good than harm, especially when one looks at the alternative, the so called “English System” where OPMIs are effectively denied access to judicial redress. Those contingency fee lawyers going after tobacco companies are my absolute heroes. My father, a heavy smoker, died of lung cancer at age 62. I hate contingent fee lawyers trying asbestos cases. They are a clear and present danger to Corporate America all the while the vast majority of their clients show no symptoms of any disease. Admittedly, TAVF is among the largest creditors of USG Corporation, an asbestos-tainted issuer.
In terms of corporate governance, management entrenchment, which has grown like wildfire in the past 20 years, is one area where there ought to be reforms. No one, but no one, is making any proposals that would make it easier for managements to be removed from office by stockholders. Instead, stockholder rights in this regard have been abdicated to Boards of Directors, almost all of who seem to be compliant management tools. Given that OPMI stock market prices change so capriciously, society is probably best served if a modicum of entrenchment in office exists. But as things exist now, whether for solvent companies or most issuers in Chapter 11, managements are either bullet-proofed in office, or are extremely well rewarded with severance parachutes if they leave office. In my view, OPMIs and society would be well served if the NYSE and NASD refused to list the common stocks of companies with overbearing provisions for management entrenchment. These provisions include “poison pills,” blank check preferreds, super voting common stocks, staggered elections for Boards of Directors, super majority voting provisions, preventing stockholders from convening special meetings, and having the company itself finance all of management’s expenditures where there is a contest for control. Relief, if any, on this score would have to come from Self-Regulatory Organizations (SROs), the NYSE and NASD. Not much seems possible at the state level. The SEC has no jurisdiction over corporate governance. But don’t hold your breath waiting for reforms in the area of management entrenchment.
The problem of corporate governance, it ought to be noted though, is not a TAVF problem. Most of the managements of most of the companies in which TAVF has invested seem to be doing a magnificent job for which they are either fairly, or modestly, compensated. Only a few companies represented in the portfolio seem to be run by managements which are overcompensated, underperformers, do really stupid things from the stockholder point of view, or pay no more than minimal attention to the needs and desires of OPMIs. Portfolio companies on this negative list, in my opinion, include Aquila, Electroglas, Head Insurance, ICSL, Kmart, MONY Group and Toyota Industries. None of the managements seem so bad though that the Fund should be exiting its positions wholesale at these prices. The toughest thing we do at TAVF is appraising managements. Sometimes we are wrong.
Despite all my carping about how OPMIs in this country are being increasingly ripped off by managements and professionals, the U.S. public and private markets still remain the fairest, best, most efficient, capital markets that have ever existed. This is especially true for the private placement credit markets where the quality of analysis tends to be much, much better than it is for public equity markets. Third Avenue ought to continue to be able to invest reasonably comfortably going forward, the growing amount of rip-offs of OPMIs notwithstanding.
Along these lines, the eminent economist, Lester Thurow, had an Op-Ed piece in The New York Times during the quarter. The title of the Op-Ed article said it all — “Government Can’t Make The Market Fair.” I agree. The solution to this problem for OPMIs is to buy in at prices far, far lower than is usually available in negotiated transactions or in purchasing control. Buying in at such prices is exactly what TAVF tries to do.