So often with mega disasters such as One-Tel
and Enron, there have been a number of warnings signs. Here
I don't mean abstruse accounting jiggery pokery that only
professional accountants could pick up.
Rather I am talking about little snippets
that appear here and there that make you think that there
is something wrong. Or, at least, indicators of management
behaviour showing that this is not the type of company you
want to be associated with.
It is very easy to criticize the auditing
firms for sliding over rubbery or misleading figures. They
did it for financial gain for themselves and for their own
companies. In a word, greed. But we have to watch our own
motivations. Do we find ourselves skating past warning signs
onto thin ice because we have become fixated on big profits?
I know that I have.
Some of examples of warning signs are:
Increasingly large remuneration levels
when the profitability of the company as measured by
sales growth, earnings growth and return on equity is
Excessive behaviour by the chairman or
Problems with labour relations within
Publicity that contains large dollops
Annual reports that attempt to cover the
And I am sure you can add more of your own.
I am not suggesting that any of the examples
of companies mentioned in this article have committed fraud
or are about to commit fraud. They are warnings signs that
may point to declining profits, not to illegal practices.
Hide and Seek in the Annual Report
Regarding attempts to downplay declining profits
and profitability, consider Macquarie Bank. In the annual
report for the year ending 31 March,2002, we read in the
Highlights section that after-tax profits increased by 3.3%.
Not great, but at least it is something.
But it is earnings per share that is important
to shareholders, not total earnings. To find this out,you
have to dig into the body of the report. There you read
in the Statements of Financial Performance that EPS has
dropped from $1.40 to $1.32, a drop of 5.6%.Definitely not
Let us continue. In the Highlights we read
that it has an excellent return on equity ROE.
But when look at the ROE chart in Conscious
Investor we see that ROE is the lowest it has been for the
past six years. For example, last year it was 25.7% and
the average for the past five years excluding the current
year was 23.1%. Now it is well below 20%.
One more thing. The total remuneration for
the top executives was $A49.9 million in 2002 compared to
$A29 million in 2001. (In 2002 there were 13 in this category
and 12 in 2001.) This is an increase of 71%. Putting it
another way. This amount represented 19.9% of total profit
in 2002 compared to 12.0% in 2001.
On 25 June, 2002 the Southern Cross Airports
Corporation Consortium purchased the Sydney Airport for
$A5.4 billion. Macquarie Bank-managed funds hold a 53 per
cent shareholding in the asset. Also the bank put together
the deal as a financial advisor and underwriter.
There are many concerns that too much was
paid for the airport. Whether or not this is the case is
a very tough question. Some idea of just how difficult it
is can be gained from a recent statement by Allen Moss,
the managing director of Macquarie Bank. "In the case
of Sydney airport, a huge amount of work went in over two
years with more than 20 people in Macquarie bank and at
the peak up to 40 people and with an extensive expense in
terms of external support."
What I am talking about above is not nearly
so complex. They are very simple warning signals that do
not take any great expertise to uncover. But looking over
what we have just uncovered, I can't help thinking that
if any corporation was going to pay too much for something,
it is very likely to be Macquarie Bank.
Executives Who Talk Too Much
It is a good exercise to go to the annual
meetings of companies whenever you can. You often pick up
things that you may not otherwise hear. At the 2000 meeting
of AMP, its chairman Stan Wallis told the audience that
its shares were worth closer to $30 than to $20. Back then
they were around $15 in price, much the same as they are
now. If the chairman is wrong by a factor of two, we can
only assume that he is trying to bolster the share price.
When the CEO and chairman start to make statements
about how much they think stock in the company is worth
I start to feel uneasy. The business of the executives is
to run the company in the best way that they can, not to
try to inflate its share price.
As might be expected, Warren Buffet has had
a few words to say on this. In his Letter to Shareholders
in the 2000 annual report of Berkshire Hathaway we read:
One further thought while I am on the soapbox:
Charlie [Munger] and I think it is both deceptive and
dangerous for CEOs to predict growth rates for their companies.
They are, of course, frequently egged on to do so by both
analysts and their own investor relations departments.
They should resist, however, because too often these predictions
lead to trouble.
The problem arising from lofty predictions
is not just the spread of unwarranted optimism. Even more
troublesome is that they corrode CEO behavior. Over the
years, Charlie and I have observed many instances in which
CEOs engaged in uneconomic operating maneuvers so that
they could meet earnings targets they had announced. Worse
still, after exhausting all that operating acrobatics
would do, they sometimes played a wide variety of accounting
games to "make the numbers." These accounting
shenanigans have a way of snowballing: Once a company
moves earnings from one period to another, operating shortfalls
that occur thereafter require it to engage in further
accounting maneuvers that must be even more "heroic."
These can turn fudging into fraud.
Charlie and I tend to be leery of companies
run by CEOs who woo investors with fancy predictions.
A few of these managers will prove prophetic--but others
will turn out to be congenital optimists, or even charlatans.
Buffett ends by saying that it is not easy
to know in advance which species we are dealing with. So,
along with Buffett, I think that it is much better to stay
away from companies with such CEOs to begin with.
What are the shenanigans that Buffett is referring
to? In many cases you don't have to be a $300 per hour accountant
to find out about them. Often reading the newspapers or
attending annual meetings is enough. The main thing is to
be willing to see what is in front of you or willing to
listen to what is being said.
Long before One-Tel crashed, many newspapers
articles described its accounting shenanigans. I recall
one article describing how One-Tel changed their accounting
methods twice in one six-month period, each time capitalizing
various expenses so that their losses were reduced. In other
words, reducing their current losses by pushing them into
Sure, it takes a certain self-confidence to
get to the level of the being the CEO or chairman of a major
company. The danger comes when this self-confidence slips
over to arrogance and hubris.
I remember reading an interview with Rodney
Adler when he said that he didn't worry about the financials
of an investment. He went with his instinct about the management.
He used Jodie Rich, the co-founder of One-Tel,
as an example. This was just before the collapse of One-Tel
and its investigation by the ASIC.
Next in line was Mr. Adler himself. Just last
month the Supreme Court of New South Wales handed down penalties
for Rodney Adler, Mr Ray Williams and Mr Dominic Fodera
all former executives of the insurance company HIH. They
related to charges that these three had breeched their duties
under the Corporations Act.
Have a look at the statements made by the
senior executives of a company. You will often see signs
that that are pushing things just a bit too far. I don't
mean anything illegal. Just signs that maybe their eye is
not on the ball as much as it should be. Or that they are
making statements more for their own bottom line, rather
than that of the companies they are responsible for.
For example, Dick Warburton is chairman of
three large companies-David Jones, Caltex and AurionGold-in
very different areas. He is also a member of the boards
of the Reserve Bank and several other companies as well
as chairman of the Government's board of taxation. Too much?
He doesn't think so, recently asserting that most board
decisions are generic in nature so that the boards he is
on, the more efficient and experienced he becomes.
The Australian Shareholders Association is
one of those who disagree. "There's got to be an upper limit
to that argument and he's well and truly passed it," explains
its executive officer Stuart Wilson. "Director's shouldn't
overload themselves, particularly in this environment, when
they need to be critically examining the accounts and management's
explanations. The more overloaded they are, the greater
chance you have of missing something.
The moral is if you feel uncomfortable about
something that a company is doing, don't push it aside or
dismiss it. It is quite likely that there is thin ice ahead.
Even if there is not, it is not much fun having investments
that make you toss and turn at night.
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