Investment Consult: Investing after Enron

April 26, 2002

Will companies be less likely to massage the numbers in the future? Don't bet on it.

 

Investment Consult

Investing after Enron

Will companies be less likely to massage the numbers in the future? Don't bet on it.

Lewis J. Altfest, PhD, CFA, CFP

The Enron mess is causing a lot of investors to wonder how many other companies might be using shaky accounting practices. People are asking, "What does Enron mean for future stock prices?" "How can I trust accounting statements?" and "How can I protect my portfolio from companies that could go bankrupt?"

Let me start provocatively: Accounting as practiced by many corporations is not a science. It's a blend of science and art. The "art" comes in when, to keep investors happy, the company's finance department uses creative accounting to show consistent earnings growth. In reality, though, even the best companies' earnings can fluctuate from quarter to quarter. Firms that aggressively try to cover these differences may be as prevalent as people who use makeup to hide their blemishes.

Assume for a moment that a CEO is interviewing two people for vice president of finance. One candidate says, "I'm the leading authority in the field, and I'll deliver the most accurate results possible." The second says, "I know how to deal with auditors. I will creatively give you the results you want to show to investors." Who do you think will get the job?

Many companies "manage" earnings, though they're careful not to tweak the numbers for too long or by too large an amount. When a recession hits or the stock market drops sharply in reaction to some major event, management knows that reporting good numbers probably won't boost the stock's price much. In fact, in that environment, poor results won't seem unusual. So the company adopts a "kitchen sink" mentality and writes off everything it can, to replenish the reserves that will be used to manage results for the next market cycle.

Then it'll be able to do what one major firm did when I was a security analyst on Wall Street. When I asked one of its executives what earnings would be like for the next quarter, he replied casually, "What would the Street like us to show?"

As long as people treasure consistent earnings growth—as they should—companies will attempt to deliver it, not only through accounting adjustments but by changing how they do business. For example, since sales and profits are recorded when shipments are made, shipments may be timed to help show more-positive earnings figures. Coca-Cola was accused of doing basically that a few years back.

In light of Enron, though, most auditors will be extra careful about how they report earnings. For a while, at least. There will be, I predict, a number of negative corporate earnings surprises, and for some companies, quarter-to-quarter results may not look quite as smooth as they have in the past. Investors will remain jittery, but they'll get over it as the economy begins to show clear signs of improving, which I expect will happen by midyear.

So how can you protect your portfolio? First, don't overpay for earnings, regardless of how large or small, well-known or obscure, the company is. Why pay a premium for a company that may be as likely to have negative earnings as one that's reasonably priced? I'd rather own a company like Bristol-Myers Squibb, which currently has a reasonable price-earnings ratio, than one like Cisco Systems, whose negative earnings have made its P-E meaningless.

Time and again, Cisco has failed to include in its financial statements substantial expenses tied to its employee stock-option program. (Although this strategy has come under intense scrutiny, it remains legal according to current reporting rules.) The company also had a big write-off that included $2.2 billion worth of inventory, which wiped out all of its 2001 net income.

In addition, you or your financial adviser should look at the sales figures, cash flow, and debt of each company whose stock you own. You don't have to be an accountant to know when certain numbers don't make sense and warrant caution. For instance, if a company reports a low single-digit sales increase and a double-digit profit gain while piling on debt, you ought to dig deeper.

To further protect yourself, review the numbers going back a decade or so. If you see a massive loss every five or 10 years, or "nonrecurring" write-offs every few years, think twice about investing in that company. It may be playing serious games with its financial statements. (For tips on what else to examine and where you can find this information, see my previous column, "Nine traits of winning companies," March 22, 2002.)

 

The author, a fee-only financial planner, is president of L.J. Altfest & Co. ( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: Investing after Enron. Medical Economics 2002;8:20.