“Let Them Eat Spreadsheets”

What good are financial statements?

Photo: Anatoly Babiychuck. Source: Dreamstime Stock Photos

Most of us have a vague idea that Apple makes iPhones, that Panera runs restaurants, and that Wal-Mart sells stuff. But how well do they do these things? Reports that Amazon earned 19 cents last quarter or that IBM had sales of $20.8 billion leave us cold. Numbers by themselves don’t tell us very much. Put another way, a text without a context can become a pretext.

Financial statements are intended to tell us what a company has (the balance sheet) and what the firm did with what it has (the income statement). They also disclose what management has done with its cash (the statement of cash flows). We need to know these things because ultimately any investment’s value is determined by how much cash it can generate for its investors, and how predictable (or unpredictable) this cash stream is.

Because we don’t let sports teams make up their own rules as they play, we have certain standards that companies are supposed to go by when they report their earnings. Accounting isn’t “Calvinball.” But electric utilities are different than banks, which differ from defense contractors. So management is allowed a little leeway as they apply the rules. Those choices, however, have to be reflected in the footnotes—usually “Footnote 1.”

In order to make sense of the raw numbers, equity analysts use ratios to compare companies with each other. It’s notable that Apple had a 40% profit margin the last year, but that’s even more remarkable when you see that Microsoft’s margin was only 23%, and that Samsung’s was just 10%. That may be one reason why Apple seems to be taking over the world.

Source: Bloomberg

Every year public companies have to hire outside accountants to examine their financial statements and verify that they’ve been playing by the rules. Although the financial news tends to report just one or two numbers each quarter – earnings per share and sales – there are lots and lots (and lots) of supporting statements that go into those. Businesses can be complicated, and disclosing their activities properly takes a lot of time and effort. Last year, GE’s annual financial statement was 247 pages long!

By looking carefully at these supporting ratios, and how they change over time, a careful analyst can sometimes sniff out whether a company’s earnings are real, or whether they’ve been enhanced by questionable accounting practices. Because financials are like a bathing suit: what they reveal is interesting, but what they conceal may be even more interesting.

Douglas R. Tengdin, CFA

Chief Investment Officer

Sweetness and Light?

“Nothing is so permanent as a temporary government program.”

“Still Life with Bread and Confectionary” by Georg Flegel, 1650. Source: Wikipedia

I thought of that quote when I read that the Trans Pacific Partnership talks may “disrupt” US sugar policy. Our sugar program is a complex mix of import restrictions, price supports, and loan guarantees designed to protect the domestic sugar industry. Tariffs and quotas on sugar have been in place in one form or another since 1789, when a host of protectionist measures were designed to support an infant nation’s industries. But the US is now the largest economy and the fifth largest sugar producer in the world, and those programs are being targeted.

The Trans Pacific Partnership is a 12-nation trade pact that seeks to lower trade barriers on many products produced and consumed around the Pacific Rim. Agricultural subsidies are a big part of this deal. Often, concentrated interests are able to secure government support at the expense of consumers, who don’t notice paying a few extra cents per pound. But trade agreements can open up new markets, and those protections become bargaining chips.

There’s no question that our sugar policy has worked. Domestic prices for raw sugar have been consistently higher than world prices for decades.

Source: USDA

In fact, it’s possible that artificially high sugar prices have induced food companies to use high fructose corn syrup as a cheaper substitute. Some studies have linked the rising use of these substitutes to increased rates of diabetes, although that research is not definitive.

Still, if a global trade pact can induce us to end two centuries of policies that fleece American consumers and can potentially improve our health in the bargain, that seems like a sweet deal.

Douglas R. Tengdin, CFA

Chief Investment Officer

Timing Is Everything

How important is time to an investor?

Photo: Petr Broz. Source: Wikipedia

The length of time investors have to plan for is the single most powerful factor in their investment process. If time is short, investments with the highest potential return are the least desirable, because they entail the greatest risk. But given enough time, assets that appear risky become desirable. Time transforms investments from least attractive to most attractive—and vice versa. Our time horizon has a major impact on our investment strategy.

This is true in the natural world as well. I’ve been to the coastal redwoods in California, and they’re awesome. John Steinbeck called them “ambassadors from another time.” In many ways, they are. They regularly reach ages of 600 years or more, and some are over 2000 years old. Their natural resistance to disease and insects allows them to grow slowly and gradually. But they have to. The high rainfall in their coastal habitat leaves the soil with few nutrients.

By contrast, stumbling into a thicket of pin cherries in the Northeast woods can leave you breathless, but in a different way. The undergrowth can be so thick it’s easy to get disoriented. Pin cherry trees sprout and grow quickly, taking advantage of any disturbance in the forest canopy. But they only live 20 to 40 years, and they’re an important source of food for many types of animals.

It would be foolish to say that either tree is more successful. Each has adapted to its environment. What works in one context doesn’t work in another. That’s why, for investors, the typical time period we use to calculate returns—one year—may be misleading. A single year simply doesn’t match the time available to different investors with their differing objectives and constraints. Different assets—and asset mixes—are appropriate in different circumstances.

Average return and dispersion of return for various asset classes over different time periods, 1926-2010.

Source: Jay Sanders, CPA

So if you’re worried about the market, be sure to ask yourself how much time you have until you need the money. Because the quickest way to turn a temporary fluctuation into a permanent loss is to sell the asset.

Douglas R. Tengdin, CFA

Chief Investment Officer

Turning Play Into Work

What’s wrong with the “PlayPump”?

Source: Marginal Revolution

The “PlayPump” uses a merry-go-round to pump water, transforming children’s play into a labor-saving way to obtain an essential commodity. The driver of the idea quit his job and raised millions from celebrities like Jay-Z, Steve Case, and Bill Clinton. He received prestigious awards and began installing the pumps in Africa.

But it didn’t work out very well. In order to pump the water, the merry-go-round requires constant force. The children playing on them quickly get exhausted. The people whose labor was supposed to be saved ended up pushing the merry-go-round themselves. And the complicated device requires extensive maintenance that can’t be done in many underdeveloped situations. It would have been simpler and easier to install hand-pumps. After connecting 1000 pumps over the course of 15 years, the project folded.

The PlayPump is an illustration of the failure of good intentions. Westerners love innovative solutions to seemingly intractable problems. But it’s really important think critically about the causes we support: did they talk to the people they want to help—to find out what they think is important? Did they try the idea on a small scale, with follow-up? And have they thought about what can go wrong?

When it comes to helping people, being unreflective often means being ineffective– wasting time and money. It’s a huge mistake to judge something based on its intentions rather than its results.

Douglas R. Tengdin, CFA

Chief Investment Officer

Jobs, Jobs, Jobs

How tight is the labor market?

Photo: Douglas Tengdin

After hitting 10% in October of 2009, unemployment has fallen to 5.3%. That’s pretty good. But there are still areas where the job market feels week—especially in long-term unemployment. Folks unemployed 6 months or more currently make up a quarter of the unemployed. That ratio has come down from almost 50% in 2010, but it’s still pretty high. That’s one reason why this recovery doesn’t feel very strong.

Another reason is the participation rate—the percent of the US population either working or looking for work. That number peaked in 2000 at just above 67%. It had risen pretty steadily until then. But it started falling after the dot-com bust, and continued to fall after the last recession. It’s currently down almost 5% from its peak to 62.6%, a level not seen since the late ‘70s.

Source: Alan Krueger and Princeton University

Still, 5.3% unemployment is pretty low. Conventional wisdom says that as the economy strengthens, people not in the labor force will start looking for work and push the unemployment rate higher, but there’s little evidence that this is happening. The rate at which people move from outside to inside the labor force has been pretty stable, between 7 and 8%. In fact, it recently slowed to just below 7%.

The best measure for tightness in the job market is compensation. When workers are scarce, employers have to pay up—both to attract new workers, and to hold onto the staff they have. And by this measure, things are getting better. During the ‘90s, real wages and salaries—after inflation—gradually increased. That’s part of the reason stocks got so bubbly at that time. We had a sense that things were getting better and better. But pay raises were harder to come by after the dot-come bust, and real wages and salaries actually fell in the shadow of the financial crisis. Gloom in the stock market was matched by gloom in the labor market.

Source: Alan Krueger and Princeton University

But lately, pay raises have perked up. Real salaries and wages rose 1½% last quarter, the biggest increase in over a decade. Indeed, with unemployment so low and real compensation rising so much, there’s some risk that wages will rise fast enough to squeeze profits. Among other issues, this has the market worried.

How tight is the labor market? If pay is any indication, it’s getting tighter.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Learning Discipline

What’s the key to successful investing?

Source: Get Refe

There isn’t one key. There are lots of them: understanding ourselves, diversification, setting good goals, managing risk—the list goes on and on. And there are many fruitful investment styles: value, growth, momentum, factors, index investing. Successful investors have to pay attention to lots of things all the time.

But when you study great investors like Mario Gabelli or Laura Sloate—the blind stock analyst whose blindness forces her to “see” everything differently—one thing stands out: they’re always learning. Whether it’s understanding how new drugs can trick our bodies into fighting cancer or a new quantitative technique for detecting financial fraud, great investors are intellectually curious. They’re interested in everything.

So whether it’s a new translation of Homer’s Odyssey or a recently discovered grove of giant redwoods in California, everything has value. After all, some of these coastal redwoods were seeds when Homer wrote his work. They have something to say about long-term strategies.

Henri Matisse said that the role of an artist is to see old things in new ways. For the investor it’s something similar—seeing old principles applied in new circumstances. And buying great companies at cheap prices.

Douglas R. Tengdin, CFA

Chief Investment Officer

You Must Remember This …

You Must Remember This …

Earnings are still earnings.

Dooley Wilson as “Sam” in Casablanca

Source: Wikipedia

That’s what I thought when I saw the quarterly reports for IBM, Apple, and United Technologies. These companies disappointed the market and their share prices fell dramatically after their earnings announcements. By contrast, Google, and JP Morgan, and Harley Davidson did better than expected. Those stocks traded higher.

It doesn’t matter whether management spins the story towards the usual suspects, claiming “it’s a building year” or “there was a speed bump.” Investors always have the numbers. Stocks are a discounting mechanism. The price is a weighted average of all the estimates of all their cash flows in all the world. When those estimates are adjusted, the share price moves.

I’m not saying those movements have to be rational. It’s not always a beautiful relationship. There are “hopium” stocks whose earnings will never justify their valuations. Conversely, there are other companies whose shares are so hated that they sometimes trade below the value of the cash on their balance sheets—often due to fears of bankruptcy or questions on their accounting. The entire market can be irrationally exuberant or irrationally gloomy.

But like Sam sings in the movie “Casablanca,” the fundamental things apply. In the short run, the market is a voting machine—where the biggest portfolios get most of the votes. But in the long run, it’s a weighing machine–as time goes by.

Douglas R. Tengdin, CFA

Chief Investment Officer

Dark Matters

Dark Matters

Is anything holding our financial universe together?

Globular Star Cluster. Photo: Skeeze. Source: Pixabay

In 1932 a Dutch astronomer couldn’t account for the movement of the stars given the current measurement of visible mass in the universe. He posited that dark matter must be holding the galaxies together. His hypothesis was confirmed 40 years later by another astronomer making observations about galactic rotation.

In the same way, our economic galaxy appears to be spinning apart, lurching from one crisis to the next. 50 years ago currencies were backed by gold reserves, loans were secured, and central banks had a mandate to “lend freely against good collateral.” Now every major nation has a fiat currency, secured bonds are less common, and central banks are critical supports to the global financial system. There’s nothing tangible holding borrowers to their commitments. For example, it’s estimated that the European Central Bank holds over €130 billion in unsecured deposits in Greek banks—over 5% of its balance sheet.

And it’s not just Greece. Secured bonds in the US have declined from 35% of the bond market to just 25% over the past 25 years, while unsecured government debt has risen by that amount. There’s not as much security serving as financial mass. Our monetary infrastructure is now based on a set of promises and paper agreements. But if those break down, there’s nothing holding it together.

In the “Star Wars” films, Luke was taught to “use the Force”—a mysterious energy field that “binds the galaxy together,”—something a lot like dark matter. But there’s nothing mysterious about our financial system today: trust has become the dark matter of finance.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Room of One’s Own (In a Portfolio)?

What good is real estate?


Photo: Joao Pacheco. Source: Picjumbo

I don’t mean as a place to live. Everyone needs four walls and a roof. I’m talking about real estate as an investment.

Lots of people consider investing in real estate. By this they usually mean private real estate—buying a small apartment or office building and renting out the space. There may be a lot of specific, local demand for living and working space: college students cycling through; young couples relocating to an area; small businesses starting out; and so on. But there’s also a lot of specific risk that goes along with local real estate—the local economy, local zoning laws, local property managers. And individual properties aren’t very liquid. The easiest way to invest in real estate is through a fund or real estate investment trust (REIT), which may have certain tax advantages.

Along with stocks and bonds, real estate is a major asset class. It’s estimated that the total value of commercial property in the United States is around $10 trillion. In a sense, income property is a kind of hybrid security. The lease income that comes from tenants is like a portfolio of short-term bonds, and the property owner holds a call option on the residual equity—benefitting from growth.

So a property’s value is determined by its rental income after all expenses, along with its growth prospects. That income can be compared with bond income. Real estate values are closely linked to interest rates and the economy. Rental income may go up with inflation, but if the economy weakens, that income can fall as well—as rents and occupancy fall. Returns are made up of income returns and price changes, just like stocks and bonds. Because of its nature, real estate returns can be uncorrelated with those of other asset classes.

Real estate can provide a diversified source of return for many investors. But it’s important to think clearly. All property is local, and local conditions will dominate any local investment. But diversified funds like REITs can enhance a portfolio.

Douglas R. Tengdin, CFA

Chief Investment Officer

Fraud, Fraudsters, and False Financials

Fraud, Fraudsters, and False Financials

Can we see financial fraud before it hits us?


Photo: Dave Meier. Source: Picography

Not always. But published financials can give us some clues as to when managers might be cooking the books.

Published financial statements are supposed to reflect reality on the ground. They’re supposed to give an accurate picture about how the business is doing in its day-to-day operations. But we live in a world where investors often fixate on one number—earnings per share (EPS). That number is supposed to the single best indicator of company profitability.

The problem is, since investors focus so much on EPS, company management is often paid based on how well EPS does—through incentive pay based on the stock price. And because management prepares the financial statements, we really do have a situation where the fox is guarding the chicken coop.

There are lots of ways to manipulate earnings. Some of the most common include inflating sales, understating amortization, delaying bad account write-offs, and using off-balance sheet derivatives in inappropriate ways.

Fortunately, we can see unusual changes in these accounting elements. The items that go into making earnings look good can themselves look out of whack. For example, when accruals go up but sales don’t, the average time to collect a receivable—receivable days—spikes. The balance sheet becomes bloated. Stocks with bloated balance sheets find it difficult to maintain their earnings.

Not all accrual increases are fraudulent, of course. But by using a weighted average of commonly manipulated items, we can sometimes sniff out fishy accounting before it starts to stink. Such an approach isn’t perfect, but it does reduce the likelihood that we’re investing in a swindle—like Enron, Adelphia, HealthSouth, Parmalat, or a host of other financial scams.

John Kenneth Galbraith once noted that at any given time the accumulated “bezzle” in an economy—the inventory of undiscovered embezzlement—amounts to many millions of dollars. Of course, that’s not real wealth, it’s fictional. By paying attention to what goes into earnings, investors can reduce the chances that they’ll be victims.

Douglas R. Tengdin, CFA

Chief Investment Officer