A radical change in thinking seems needed if GAAP are to be made more sensible, and even more useful as an analytical tool. Given its present direction, GAAP increasingly impose unneeded and counter-productive burdens on American corporations, American management and American capital markets. GAAP, first and foremost, ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short run stock market speculators, who are vitally interested in day-to-day stock market price fluctuations. Currently, GAAP are directed increasingly toward meeting the needs and desires of short run stock market speculators. This is accomplished by setting up increasingly rigid sets of rules designed to meet an impossible goal: have periodic statements of cash flows from operations, earnings and earnings per share be as accurate (or truthful) as possible.
If GAAP were geared to the needs of creditors, there would be a tremendous change in emphasis away from focusing on reported earnings per share. GAAP would, in a sense, go back to the standards in existence prior to the 1970’s:
- The company whose financial statements are being audited would be viewed as a stand-alone, an entity separate and apart from its stockholders and its management.
- GAAP would be governed by the modifying convention of conservatism rather than be a system striving for accuracy and for truth.
- There would be no Primacy of the Income Account. Balance sheets would be equally important and there would be general recognition that each accounting number is derived from, modified by, and a function of, all other accounting numbers.
- Financial statements would be prepared under the assumption that the users of such financial statements are reasonably intelligent, reasonably diligent, and are people who understand not only the uses, but also the limitations, of GAAP.
- Comporting with underlying principles would become far more important than specific GAAP rules.
- The analyst, i.e., the user of GAAP, would understand that the most GAAP can give him, or her, are objective benchmarks which the analyst then uses as a tool to determine his, or her, version of economic truth and economic reality. Only very rarely (e.g., the pricing of marketable securities by mutual funds) does GAAP reflect an economic truth or economic reality.
- It is extremely important in GAAP that material facts be disclosed in a conservative, consistent and reconcilable manner. How, and where, such material disclosures are made would become, by and large, unimportant.
Third Avenue has always analyzed equities from this creditor point of view. The underlying criteria for a common stock investment has been, and is, that the issue, after thorough analysis, appears to be “safe and cheap.” Safe for the Fund comes before cheap; in other words, safe has a first priority. Safe means that the company, in which TAVF is a long-term equity investor, is unlikely to suffer a permanent impairment in underlying value, while its common stock is held by the Fund. This approach to equity investing is similar to how creditors analyze credit investments. Creditors seek to determine whether a performing loan will remain a performing loan over the lifetime of the loan.
One good argument against the Fund’s approach is that many companies which need access to capital markets, especially equity markets, have to strive to maximize the trend of earnings per share as reported, or current earnings per share as reported, and to some extent also emphasize dividends. This, however, seems to have little, or nothing, to do with the TAVF portfolio. The Fund tries to restrict its common stock investments to companies with super strong financial positions who either do not have to access capital markets, or else pretty much control the timing of when they will access capital markets over, say, a five-year period.
The Company as a Stand-Alone — Full Disclosure vs. Where Disclosed
The current controversy over stock options, i.e., whether options ought to be expensed using the “fair value method” — FASB 123; or whether options ought to be expensed using the “intrinsic value method” — APB 25, sheds much light on the bad direction in which GAAP seem to be headed.
First, stock options are a stockholder problem, not a company problem. Stock options cause dilution of the existing ownership. Viewing the company as a stand-alone, the cost to the company of issuing stock options equals the present value of the net cash drain from future cash payments to the common stock to be issued on the exercise of options; and also the present value of the probabilities that the company might have less access to capital markets because of the stock options. Both of these “costs” seem difficult to measure.
From a creditor’s point of view there can be, and there usually is, a world of difference in the credit-worthiness of an issuer, if the issuer on the one hand, pays out, say, $200 million per annum in cash for executive compensation, or, on the other hand, issues stock options on a non-dividend-paying common stock with a “fair value” of $200 million.
As to that “fair value” of $200 million for stock options, it is a pretty ludicrous number if the company is viewed as a stand-alone. There seems no rationale whatsoever for equating the value of a non-cash benefit to a recipient (i.e., a corporate executive receiving a stock option) to the real cost to the company to bestow that benefit. It seems doubtful that the real cost to the company for issuing the stock option benefit is measurable, while the value of the benefit to the recipient of the benefit does seem measurable by “fair value” techniques. Why saddle the company with such a fictitious cost from a company perspective where the company is a stand-alone?
Fitch Ratings published an interesting article on April 20, 2004 in which it recognized that stock options were basically a stockholder problem, not a creditor problem; but then went on to state, “Because of their dilutive effect, many companies have a high propensity to repurchase shares issued upon exercise of employee stock options. In this context, from a bondholder perspective, employee options have a true cash cost and can be thought of as a form of deferred compensation, which has the effect of reducing available cash to service debt and increasing leverage.”
Fitch Ratings seems to be involved in overkill. First, most companies issuing stock options probably don’t have stock repurchase programs. Second, any company making cash distributions to shareholders for any reason — whether such cash distributions are in the form of dividends or share repurchases — “has the effect of reducing available cash to service debt and increasing leverage.” Indeed, from a creditor point of view, cash distributions to shareholders are helpful only insofar as they enhance the debtor’s access to capital markets. Third, share repurchases are strictly voluntary and thus do not have as adverse a credit impact as does required cash payments to creditors for interest, principal, or premium. Finally, some share repurchases can be beneficial to creditors and companies if the common stock being repurchased pays an ultra-high cash dividend.
The FASB 123 vs. APB 25 dispute is strictly about form over substance. Companies using APB 25, the “intrinsic value method,” are required under GAAP in financial statement footnotes to disclose the far greater expense of “the fair value method” as contained in FASB 123. The whole dispute revolves around whether disclosure of an ephemeral “expense” ought to be made in the income account or in the footnotes to the financial statements. The question for the serious investor who is not a short run stock market speculator is, “Who cares?” except that in an overall appraisal of management by a trained analyst, information about management attitudes can be gleaned from looking at management opting either for FASB 123 or APB 25.
When I was in graduate school, I studied under a great economist, Oskar Morgenstern, who used to say, “Everything is unpredictable, especially the future.” Given the uncertain nature of the world as described by Professor Morgenstern, and given that the maximum creditors can expect out of investments is that performing loans will remain performing loans through maturity, it is wise that creditors would want to view GAAP through the prism of the modifying convention of conservatism. The modifying convention means that there will be a plethora of choices under GAAP. Those choices which are chosen ought to be those that, other things being equal, understate profitability and understate asset values as computed in accordance with GAAP. It is the analyst’s job to adjust those understated, objective GAAP figures to the analyst’s version of economic reality.
Admittedly, it is sometimes hard to state what is conservative and what is not. The most glaring cases probably occur where the analyst has to decide on whether the company ought to be analyzed as a “going concern” or an “investment vehicle.” Two examples should suffice to demonstrate the point.
Many financial institutions – insurance companies and pension plans — have their assets invested mostly, or almost exclusively, in fixed income, interest-bearing loans and bonds. However, the liabilities making up the right hand side of the balance sheet are not interest rate sensitive. For a property and casualty insurance company, those liabilities are reserves for losses, while for pension plans and life companies, those liabilities are estimates of the amount and timing of future payments to be made to beneficiaries.
Suppose interest rates increase sharply. Viewing these institutions as investment vehicles, the market value of their fixed income assets will decline, reducing Net Asset Value (NAV). However, viewing these institutions as going concerns, future profitability will be greater than would otherwise be the case as the entities reinvest maturing credits at higher interest rates and as newly inflowing funds are invested at these higher interest rates. TAVF has a large portfolio of insurance stocks. Net, net, I think the odds are that the going concern benefits from higher interest rates will outweigh the investment vehicle negatives associated with higher interest rates for these insurance companies.
Accounting classifications under GAAP are rigid and never can be wholly realistic because of the going concern-investment vehicle dichotomy. Two of our largest portfolio positions — Kmart Holding Common Stock and Forest City Enterprises Common Stock — bring home the dichotomy.
At April 28, 2004, Kmart carried as a current asset $3.4 billion of merchandise inventory. Viewed as an investment vehicle, that merchandise inventory was indeed a current asset, something that, item by item, would be converted to cash over the next twelve months. Viewed as a going concern, however, that merchandise inventory is indeed a fixed asset, something that, in the aggregate, has to stay in existence, or even be enlarged, if Kmart is to continue as an ongoing operation.
At April 30, 2004, Forest City Enterprises carried as a fixed asset (PP&E) a figure of $5.2 billion for real estate, net. Viewed as an investment vehicle, most of those real estate assets — office buildings and multi-use complexes rented on long-term leases to high quality tenants — were, indeed current assets, readily saleable (or refinanceable), building by building, without interfering at all with Forest City as an ongoing operation. Viewed as a going concern, these long-term assets are the major source of Forest City’s operating cash flow and net income.
Whether Kmart’s merchandise inventories ought to be reclassified as a fixed asset, and whether Forest City’s PP&E ought to be reclassified as a current asset, is something for the analyst to decide. The GAAP classification seems all right to me. But then again, I only expect it to provide objective benchmarks, not reflect economic reality.
Another dichotomy which results in GAAP giving users objective benchmarks rather than realistic numbers is the split between making important the cash experience on the one hand and making important the wealth creation experience on the other. Accrual accounting gives the user tools to use in estimating future wealth creation. For example, the Fund is invested in the common stock of Encana Corporation, a company that has been a huge cash consumer as it discovers, develops, and acquires natural gas reserves in North America. The GAAP emphasis here is on Encana’s wealth creation experience, not its cash creation experience. The same can be said for TAVF’s investments in the common stocks of Tejon Ranch and The St. Joe Co., two wealth creators which consume cash. Cash accounting, on the other hand, shows flow results and short changes the wealth creation experience. In the case of investment builders where the Fund owns common stocks, say, Brascan, Catellus and Forest City, it is pretty easy to ascertain cash flow from operations, but difficult, using GAAP, to ascertain the periodic wealth creation which is occurring and is such an important component in the appraisal of these securities.
CIT Corporation (CIT), a going concern with a perpetual life, is an example of a company involved in creating wealth on a permanent basis rather than being a business creating cash flows from operations on a periodic basis. As CIT prospers, funds generated, coupled with increased borrowings and increased net worth, are used to increase CIT’s principal earnings asset — receivables; and are not used primarily either to increase CIT’s cash holdings or to increase cash distributions to shareholders. As the amount of creditworthy receivables expand, and net worth expands, CIT creates wealth by consuming cash (i.e., converting cash to more and more receivables). It should be noted, though, that for CIT to prosper, its existing receivables portfolio, receivable by receivable, has to be cash flow positive after accounting for the cost of money, i.e., the receivables portfolio has to have a Net Present Value (NPV) greater than unity. That CIT’s existing fixed-in-size asset base is cash flow positive can be viewed as a form of “project finance” where the analysis takes place individual asset by individual asset. That CIT is continually consuming cash as it expands its receivables base can be viewed as “corporate finance” where the analysis recognizes that the enterprise’s modus operandi is to grow by consuming cash, which cash is invested in earnings assets and which cash is generated in part by having CIT access the capital markets, especially credit markets, periodically.
A majority of the Fund’s equity investments are in the common stocks of companies that are extremely well capitalized and which have been acquired at prices that represent meaningful discounts from readily ascertainable NAVs. Obviously, for TAVF there is no Primacy of the Income Account.
Less obvious is the observation that the Fund’s investment style is a lot more mainstream than is that of the short run stock market speculators who emphasize the importance of periodic earnings per share as reported. First, TAVF tends to analyze the way creditors analyze, and of course, the amount of money invested in credit instruments of all types in our economy dwarfs the amount of funds invested in equities. Second, most people involved with investments are net worth conscious in the management of their own affairs rather than net income conscious. Their approach is “what is my portfolio worth and what is my total return,” rather than “what can I expect in the way of dividends and interest.” Most private companies, given a choice, seek to enhance NAV by means other than having reported operating income, which is taxable at maximum rates.
For many companies, there is no choice but to create wealth, i.e., NAV, by having operating income: NAV and operating income are each intimately related to each other. Nonetheless, this relationship hardly justifies a view that there exists a primacy of the income account for anyone other than a short run stock market speculator who has a vital interest in what each day’s closing price for a marketable security might be.
In fact, corporate and securities holders’ wealth is created in four separate, but interrelated, ways. To emphasize any one, or two, of the four to the exclusion of the others is to misunderstand corporate finance. And the present trend of GAAP is to overemphasize two factors — cash flow from operations and reported earnings — with a consequent de-emphasis of other factors that are at least equally important. The four factors involved in corporate wealth creation are as follows:
- Free cash flow from operations available for the common stock. This seems a relative rarity in the corporate world.
- Earnings where earnings are defined as creating wealth while consuming cash. This is what most prosperous businesses seem to do. Earnings may be of limited, or no, value unless also combined with access to capital markets to finance cash shortfalls.
- Asset redeployment and liability financing and refinancing. These activities include mergers and acquisitions, contests for control, diversification, the purchase and sale of businesses, the reorganization of troubled companies, liquidations, and spin-offs.
- Access to capital markets on a super attractive basis. Probably more wealth has been created through this venue than any other, ranging from the ability of real estate entities to finance on a long-term, fixed, low interest rate, non-recourse basis to venture capitalists selling common stock into an IPO bubble.
On April 27, 2004, an interesting advertisement appeared in The Wall Street Journal put out by the Association for Investment Management and Research (AIMR). The advertisement to encourage the fair value method of expensing stock options illustrates some of what is wrong with mainstream security analysis. For example, the ad states, “Investors Want Earnings to Reflect Reality.” In fact, investors really want full disclosure and objective benchmarks. Also the ad states, “Financial statements exist to help investors make informed investment decisions.” That statement is just plain wrong from either a public policy point of view or a creditor’s point of view. Financial statements exist to fulfill the needs and desires of many constituencies: managements, creditors, governments, customers, etc.
A number of academic texts seem off base also. For example, in Financial Reporting and Analysis by Revsine, Collins and Johnson 2nd edition, it is stated on page 12, “Investors who follow a fundamental analysis approach estimate the value of a security by assessing the amount, timing and uncertainty of future cash flows that will accrue to the company issuing the security.” That statement is news to me and I’ve been a fundamental analyst for over 50 years. I do want to predict future cash flows and earnings, but also future wealth creation from whatever source. It is just plain wrong to state that current earnings and past earnings records are better tools for predicting future cash flows and earnings (not to mention future wealth creation in the form of realized or unrealized capital gains) than are the present assets in a business measured qualitatively and quantitatively. As a matter of fact, sensible, good predictors use all three: current earnings, past earnings and the current balance sheet.
Investor Protection and the Securities Law
The basic thrust of certain Federal Securities Laws — the Securities Act of 1933 and the Securities Exchange Act of 1934 — in the disclosure area was to provide full disclosures of all material facts to Outside Passive Minority Investors (OPMIs). How the OPMIs used that full disclosure information was up to them and there was the implicit conclusion that if the OPMI was not reasonably intelligent and reasonably diligent, the OPMI could and should suffer the consequences. As things developed, though, this became insufficient at least as far as GAAP are concerned. A theory grew up that not only should GAAP reflect reality without adjustment, but also the form of presentation became important. It was no longer good enough to disclose all material facts, but rather where the disclosures were made became highly important, by, say, requiring that an “expense” be charged to the income account rather than presenting the facts in footnotes (see the Stock Option Controversy). To me, this change in emphasis really does nothing to enhance Investor Protection.
In 1940, the U.S. enacted the Investment Advisors Act and the Investment Company Act. The Investment Company Act regulated mutual funds. For the first time, there was a statute providing substantive protections for OPMIs; they no longer had to be on their own, disclosure-wise, in using the full disclosure information provided. Rather, they could rely on professional advisers, the managers of investment companies.
Put simply, if an OPMI does not want to go to the trouble of being reasonably intelligent and reasonably diligent, the OPMI can hire well-qualified money managers who are closely regulated. In the mutual fund area, there seem to be a good-sized number of qualified managers over and above the managers of the several Third Avenue Funds. Such managers include those managing funds at, among others, First Eagle, Gabelli, Longleaf, Mutual Shares, Royce and Tweedy Browne.
Principles, Not Rules
Given that in a creditor type approach, the investor seeks objective benchmarks rather than reality or truth, it becomes unimportant that there exist volumes and volumes of specific rules. Rather, GAAP should be governed by general principles – the Company is a Stand-alone; there exists a Modifying Convention of Conservatism; there exists a Balanced Approach where any accounting member can be important rather than a Primacy of the Income Account Approach; and where the object of financial statements is to provide the user full disclosure, consistency and reconcilability. Full disclosure for TAVF purposes seems to mean that the GAAP figures and footnotes be such so that the analyst can figure out what documents are material, and that GAAP statements provide the user a good road map to follow in seeking to do “due diligence.” Due diligence seems to mean “reasonable care under the circumstances.”
Interestingly, other types of accounting systems have to be governed by rules. The prime example of a complex system of rules is the United States Internal Revenue Code (IRC). Under the IRC, or any tax code, there has to be a precise definition of what taxable income is; and thus the system probably has to be relatively complicated, governed by myriad rules, because its objective is to derive just one number — what the taxpayer’s tax bill will be. This is just not the case for GAAP, where it can never provide more than objective benchmarks to be used as tools of analysis by users.
The United States has the best, most efficient, most honest, and deepest capital markets that have ever existed in the history of mankind. We ought to guard this national asset carefully. In our haste to satisfy the perceived needs of OPMIs, the U.S. is denigrating the quality, and depth, of U.S. capital markets. Already, and because of the Sarbanes-Oxley abomination, no foreign issuer who does not need to raise capital in the U.S. will subject their companies, and their executives, to U.S. jurisdiction. Thus, Toyota Industries, one of our largest common stock holdings, is unlikely to ever issue American Depository Receipts (ADRs). That is the Fund’s loss and the American capital market’s loss.
No modern economy can function well unless its financial institutions — both private and governmental — follow sound lending practices. A plethora of bad loans in an economy always leads to economic depressions, or worse, as witness the 10-12 year business depression in Japan; the economic crisis in Texas during the 1980’s as bad energy loans had to be worked out; the savings and loan crisis in the U.S. in the late 1980’s and early 1990’s; and problems in Russia and Indonesia, among others, in the late 1990’s. It would seem impossible, at least in the corporate arena, to have an economy follow sound lending practices unless the lenders are able to rely on audited financial statements, or the equivalent thereof, which provide good objective benchmarks, modified by a conservative bias. Thus, reliable GAAP remain essential not only to creditors, but also to the well-functioning of the U.S. economy. Put simply, corporate creditors couldn’t operate without GAAP to rely upon.
The vast majority of equity investment in the U.S. takes place through having corporations retain earnings rather than pay profits out to shareholders. Equity markets, by and large, are just too capricious, and expenses for corporate common stock offerings too great, for most corporate managements to rely much, if at all, on marketing equity issues on a reasonably regular basis in order to obtain needed or desired equity capital for companies. Having said that, it probably still remains true that the more diligent and intelligent, equity investors are as a group, the more efficiently the nation’s resources will be channeled. I, for one, doubt very much that short run stock market speculators in their buy-sell-hold decisions do much to enhance the quality of the channeling of resources in the economy. To me, the standards used by creditors result in a more productive channeling of resources. This is yet another reason GAAP ought to be directed primarily toward meeting the needs and desires of creditors.
From the points of view of creditors and value analysts who seek objective benchmarks from GAAP rather than “the truth,” GAAP, in particular, and disclosure, in general, have never before been as complete, as comprehensible, and as useful, as they are now. This currently favorable disclosure situation seems to have been part of an inexorable trend which I think dates back to the Securities Acts Amendments of 1964. Specifically, for Third Avenue, this means that I, as the manager, can be, and am, quite comfortable with the Fund’s portfolio because the quantity and quality of disclosures now available are so good. This high quality situation could have been achieved just as well if GAAP had been directed toward filling the needs and desires of creditors rather than stock market speculators. Concentrating on the perceived needs and desires of stock market speculators, it seems to me, has placed unnecessary, and counter-productive, burdens on American corporations, American corporate management and American capital markets.