February 2002
Voting with your feet
T
oday’s Wall Street Journal contained an interesting article
headlined “How to Buff Up a Company.” It was a good,
easy-to-understand, summary of some of the accounting
practices companies have used to beef up current earnings
reports or to avoid disclosing liabilities on the balance sheet.
None of these tactics are “new,” and all of them generally fall
into a “gray” area of Generally Accepted Accounting Practice.
Revenue recognition is one of the easiest areas to manipulate. Is
something sold when it is purchased, or when it’s paid for?
Obviously credit is used in almost every kind of sale in
corporate America today. As the interval between the “sale”
and the receipt of the cash lengthens, there is more “judgement”
involved and more chance for mischief.
On the other hand, cost recognition can also involve judgement.
If you lease something to another company or get a contract for
a service over a number of years, it certainly would seem
appropriate to amortize the cost over the life of the lease or
contract. The most conservative view of expensing everything
upfront would severely damage current earnings.
Telecom operators like Global Crossing were leasing their
facilities for years into the future, and booking all the revenue up
front, while they were amortizing costs over the long-term.
Certainly a cash mismatch.
As for avoiding disclosing liabilities, I’m sure a lot of us have
co-signed a note for a relative and didn’t put it on our personal
balance sheet when we applied for our recent mortgage
refinancing. Sounds like Enron.
A number of other areas were mentioned such as the valuation
of assets. What is the value of a contract to sell electricity to
someone in twenty years? Who can predict the future? Ask
Dynegy. Or, if you buy a company, doesn’t it make sense to
ask them to write off all of their bad assets before the official
merger. After all, you didn’t pay for them anyway. Ask Tyco
International.
changed. But we are back there. In bull markets, everyone winks
at these things. Bear markets and recessions bring them to the
surface. The good news is that the noise about Enron, Global
Crossing, etc., will likely be the crescendo that coincides with the
bottom of the stock market.
But, that is not what this letter is about. It is about selling and
diversification. Investors have responsibilities in all of this. In bull
markets investors often neglect these disciplines, only to be
reminded in dramatic and costly fashion when the bubble bursts.
As veterans of over thirty years in this wonderful activity, we have
learned over and over that diversification is your friend. At the
peak of the technology frenzy we refused to increase our bets there,
largely due to our diversification discipline. When the Russell 1000
Growth Index put on its last dying spurt in the fourth quarter of
1999, we lagged the index a bit and one “smart” consultant actually
asked me if we were asleep. Since that quarter, we have
outperformed that benchmark by about 30%.
But selling is even more important. In our endeavor, if you don’t
make mistakes you aren’t really trying. But you must remain
objective and subvert your ego. Marty Zweig said it best. “It’s
okay to be wrong. But it’s not okay to stay wrong!” So over the
years we have developed some well-defined sell disciplines
including setting target prices, monitoring changes in consensus
expectations, and utilizing some technical analysis to keep us from
staying wrong.
We owned Enron; we owned Sunbeam, and others. But our sell
disciplines made us look dispassionately on these positions even
though Wall Street analysts were continuing to push the stocks. We
got out early. Selling is part of investing. Perhaps it is the most
difficult part, and therefore the most valuable.
There will always be liars. There will always be gray areas in
accounting. Investors have responsibilities to know this. Learn to
vote with your feet!
-Robert C. Davis, CFA
February 21, 2002
Are these issues worse today than when Jimmy Ling put
together LTV during the conglomerate rage in the late 1960’s?
Or, how about the fortunes made and lost during Michael
Milken’s reign as king of junk bond financing in the 1980’s?
People lost money, politicians railed, and regulations were
A copy of our Form ADV, Part II is available upon request.
TWO HOUSTON CENTER 909 FANNIN, SUITE 550 HOUSTON, TEXAS 77010 PHONE: (713) 853-2322
FAX: (713) 853-2308
Davis Hamilton Jackson & Associates is an investment advisor registered with the Securities and Exchange Commission offering investment management services for individual and non-taxable accounts. This material is for your use only and is
based upon information which we consider reliable, but we do not represent that it is accurate or complete and should not be relied upon as such. The opinions are our opinions only. We welcome your inquiry.