Sunday, August 3, 2008

Previous Recessions in US History

* Panic of 1907 (1907 - 1908), begins with a run on Knickerbocker Trust Company stock October 22nd 1907 sets events in motion that will lead to a depression in the United States. Duration: 13 months
* Post-WWI recession - marked by severe hyperinflation in Europe over production in North America. Very sharp, but also brief.
* Great Depression (1929 to late 1930s), stock market crash, banking collapse in the United States sparks a global downturn, including a second but not heavy downturn in the U.S., the Recession of 1937. Durations: 43 and 13 months respectiviely.
* Recession of (1945) Duration: 8 months
* Recession of (1948 - 1949) Duration: 11 months
* Post-Korean War Recession (1953 - 1954) - The Recession of 1953 was a demand-driven recession due to poor government policies and high interest rates. Duration: 10 months
* Recession of (1957 - 1958) Duration: 8 months
* Recession of (1960 - 1961) Duration: 10 months
* Bond Inversion of (1965 - 1967) no recession materialized
* Recession of (1969 - 1970) Duration: 11 months
* 1973 oil crisis (1973 - 1975) - a quadrupling of oil prices by OPEC coupled with high government spending due to the Vietnam War leads to stagflation in the United States. Duration: 16 months
* 1979 energy crisis - 1979 until 1980, the Iranian Revolution sharply increases the price of oil
* (1981 - 1982) Duration: 16 months
* Early 1980s recession - 1982 and 1983, caused by tight monetary policy in the U.S. to control inflation and sharp correction to overproduction of the previous decade which had been masked by inflation
* Great Commodities Depression - 1980 to 2000, general recession in commodity prices
* Early 1990s recession - 1990 to 1992, collapse of junk bonds and a credit crunch in the United States leads to one quarter of US GDP decline, and therefore not an official recession.

Friday, July 11, 2008

Seven Tests of Defensive Stock Selection
Keys to Putting Together a Conservative Portfolio of Common Stocks
By Joshua Kennon, About.com

Each autumn, I read Benjamin Graham's Intelligent Investor. Its principles are timeless, unquestionably accurate, and contain a sound intellectual framework for investing that has been tested by decades of experience. As I considered the content of my weekly article, I decided to focus on the seven tests prescribed by Graham in Chapter 14, Stock Selection for the Defensive Investor. Each of these will serve as a filter to weed out the speculative stocks from a conservative portfolio. Note that these guidelines only apply to passive investors seeking to put together a portfolio of solid companies for long-term appreciation; an investor that is capable of financial statement analysis, interpreting accounting decisions, and valuing an asset based on discounted cash flows may take exception to any of the following as long as he is confident his analysis is both conservative and promises safety of principal.
1. Adequate Size of the Enterprise
In the world of investing, there is some safety attributable to the size of an enterprise. A smaller company is generally subject to wider fluctuations in earnings. Graham recommended [in 1970] that an industrial company should have at least $100 million of annual sales, and a public utility company should have no less than $50 million in total assets. Adjusted for inflation, the numbers would work out to approximately $465 million and $232 million respectively.
2. A Sufficiently Strong Financial Condition
According to Graham, a stock should have a current ratio of at least two. Long-term debt should not exceed working capital. For public utilities the debt should not exceed twice the stock equity at book value. This should act as a strong buffer against the possibility of bankruptcy or default.
3. Earnings Stability
The company should not have reported a loss over the past ten years. Companies that can maintain at least some level of earnings are, on the whole, more stable.
4. Dividend Record
The company should have a history of paying dividends on its common stock for at least the past twenty years. This should provide some assurance that future dividends are likely to be paid. For more information on the dividend policy,
5. Earnings Growth
To help ensure a company's profits keep pace with inflation, net income should have increased by one-third or greater on a per-share basis over course of the past ten years using three-year averages at the beginning and end.
6. Moderate Price to Earnings Ratio
For inclusion into a conservative portfolio, the current price of a stock should not exceed fifteen times its average earnings for the past three years. This acts as a safeguard against overpaying for a security.
7. Moderate Ratio of Price to Assets
Quoting Graham, "Current price should not be more than 1 1/2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1 1/2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)"

Saturday, June 21, 2008

Oil hits $100 barrel

Oil has broken through the landmark $100 a barrel, driven by a slumping dollar, geopolitical instability and worries over a winter fuel supply crunch.

See how the price of oil has risen - and fallen - since 1970 against a background of key world events.

1973 ARAB-ISRAELI WAR

Fighting between Arab and Israeli forces sent jitters through the Middle East.

Alarmed by Israeli successes, the Organisation of Petroleum Exporting Countries (Opec) orchestrated the Arab oil embargo, sending prices soaring by 400% in six months.

It was the first time oil had been used as a political weapon, putting pressure on the US which, in turn, persuaded Israel to accept UN mediation on the crisis.

1979 IRANIAN REVOLUTION

Months of turmoil in Iran led to the exile of the Shah and the declaration of an Islamic republic.

It also led to a reduction in oil production and, at one point, the flow of crude oil from Iran was almost halted. Nervousness about the stability of Iran brought together the other major Arab oil-producing states to ensure supply and increase prices.

1980 IRAN-IRAQ WAR

Iran weakened by the revolution was invaded by Iraq in September 1980. By November, the combined oil production of the two countries was only one million barrels a day, 6.5m fewer barrels than the year before.

It meant a worldwide reduction in crude oil production of 10%. The combination of the Iranian revolution and the Iran-Iraq war caused crude oil prices to more than double from $14 in 1978 to $35 in 1981.

1986 OIL PRICE CRASH

Higher oil prices led to a reduction in demand as consumers and industry looked at ways of becoming more energy-efficient.

The price rise also led to increased exploration for new sources of oil outside the traditional oil-producing regions.

Saudi Arabia suffered from the reduction in revenue, made worse by new Opec quotas which meant it had also been forced to reduce production.

It responded by increasing production in early 1986.

Crude oil prices plummeted below $10 per barrel - but the Saudi revenue remained about the same.

1990 GULF WAR

The Iraqi invasion of Kuwait, partly prompted by the low price of oil, led to uncertainty about production and prices spiked.

Iraq wanted to gain control of the world's third largest oil producer to give it more control over the world market.

Following the Gulf war to liberate Kuwait, crude oil prices entered a period of steady decline, reaching their lowest level in 1994 for 21 years.

1997 ASIAN FINANCIAL CRISIS

The rapid growth in Asian economies came to a halt leading to lower consumption of oil - just at a time when Opec had begun increasing production.

The combination sent prices plummeting, through to December 1998.

2001 9/11

Oil prices suffered a downturn as Russian oil production increased, and the US economy went into decline.

Opec tried to stem the reduction by cutting production - but the terror attacks on 11 September sent oil prices plummeting again.

Prices were down by about 35% by the middle of November. Opec delayed cutting production again until early 2002, when prices began to move upwards once more.

2003 IRAQ WAR

The American-led invasion of Iraq led to the loss of oil production in the Gulf state. In mid- 2002, there were over six million barrels per day of excess production capacity and by mid 2003, this had dropped to below two million.

It dropped still further in 2004-5. A million barrels per day is not enough spare capacity to cover for any sudden drop in production and it led to an increase in prices.

2006 LEBANON CONFLICT

After Israel launched attacks on Lebanon, oil prices reached a new high of $78 per barrel.

Although neither Israel nor Lebanon are oil producers, the conflict increased tension in the Middle East sending prices soaring.

2008 $100 BARREL

Geopolitical tension in Kenya, Algeria and Pakistan, as well as the threat of US sanctions against Iran have played their part.

At the same time, there are fears of a cold winter in the US and Europe, and increased demand from China and India as well as the US.

The falling US dollar has also driven up oil prices as they have to gain to compensate for a slide in the currency.

Story from BBC NEWS:
http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/7083015.stm

Published: 2008/01/02 18:39:19 GMT

© BBC MMVIII

Wednesday, March 19, 2008

March 19, 2008

Big Payday for Wall St. In Visa’s Public Offering

By ERIC DASH

In a boon for big banks and Wall Street, Visa, the credit card giant, went public Tuesday in the largest initial public offering in American history.

The company’s shares, priced at $44 each, will begin trading on Wednesday on the New York Stock Exchange under the ticker symbol V.

The $18 billion public offering was greeted with fanfare in the financial industry but was unlikely to unleash a new wave of initial stock sales given the turbulence in the markets.

Even so, the offering will generate a windfall for Visa’s thousands of member banks, which own the company. JPMorgan Chase is expected to reap about $1.25 billion, while Bank of America, National City, Citigroup, U.S. Bancorp and Wells Fargo are likely to receive several hundred million dollars each.

Wall Street firms, in the meantime, stand to collect upward of $500 million in underwriting fees from the sale.

“That is a good infusion of capital,” said John E. Fitzgibbon Jr., the founder of IPOScoop.com, a Web site that tracks the industry. “And it’s no secret that Wall Street is capital starved right now.”

Shares of Visa were priced above the expected range of $37 to $42. More than 406 million shares are being offered, with an option to add 40.6 million if there is demand. That means the size of sale could reach as much as $19.7 billion.

In going public, Visa is following in the footsteps of its smaller rival MasterCard, whose shares have risen more than 439 percent since its public offering in May 2006.

Many other companies, however, are struggling to sell stock given turmoil in the markets.

“There are just not the buyers out there in this environment,” said Scott Sweet, a partner at IPOBoutique, an industry research firm. “They are scared by the market volatility.” Just 10 companies went public during the first two months of 2008, according to Dealogic, a financial services research firm. That compares with 50 public offerings in the first three months of 2007.

Analysts say that the market has essentially been closed to companies outside the energy, natural resources and health care industries. Excluding Visa, roughly 190 deals, valued at a combined $37.7 billion, are still in the pipeline, according to IPO Scoop.com data.

Several high-profile initial public offerings have been scrapped or delayed in the last few months, including one for Kohlberg Kravis Roberts & Company, the big buyout firm. In all, about 77 percent of all public offerings have been withdrawn or postponed, according to bankers, including one this week by Pogo Jet, a jet charter service.

Many companies that have moved forward with sales have scaled back their offerings. CardioNet, a health care technology start-up which Citigroup is taking public on Wednesday, cut the number of shares it allocated in half and lowered the price after several big shareholders backed out of the offering.

Visa, however, is the biggest player in its industry and has a brand known to nearly everyone with a credit card. Wall Street also understands the company’s business.

Visa and MasterCard have prospered as Americans increasingly swipe their cards rather than use cash nearly everywhere. The companies have not been hurt by the credit squeeze, because they do not actually make credit card loans; they merely process transactions for banks that do.

Visa, whose offering is being led by JPMorgan and Goldman Sachs with 17 other banks contributing, has been contemplating such a move for more than two years. In that time, it has bolstered its management team and revamped the company.

Industry observers say investors are complaining that they are being given only a fraction of the shares they requested. “I hear that allocations are being given out with eyedroppers,” Mr. Fitzgibbon said.

Tuesday, March 18, 2008

Would you like a mortgage that lends you more than the value of your house?

Would you like it structured so that your first payments are extra low?

If the mortgage weren't structured that way, would you be unable to afford the payments?

Are you convinced that real estate prices will continue to rise?

Do you have a poor credit history?

Congratulations if you answered "Yes" to most or all of those questions! You're an ideal target for a subprime mortgage lender.

Of course, there is a downside amid all the fine print, as hundreds of thousands of American consumers are now finding out. Mortgage delinquencies and foreclosures are way up. Dozens of companies that lent money to anyone with a pulse have gone belly up. And suddenly, some economists are starting to worry that the whole mess could send the U.S. economy into recession.

How did this happen?

What makes a mortgage "subprime"?

The term "subprime" isn't well known in Canada because most of our mortgage lending is "prime," or conventional. In the U.S., however, rapidly rising house prices and a poorly regulated industry combined to create a mortgage monster that is now busy running amok.

"Subprime" refers to the risk associated with a borrower, not to the interest rate being charged on the mortgage. Typically subprime mortgages are offered at interest rates above prime, to customers with below-average credit ratings. Subprime mortgage lenders in the U.S. tend to target lower-income Americans, the elderly, new immigrants, people with a proven record of not paying their debts on time — just about anyone who would have trouble getting a mortgage from a conventional lender such as a major bank.

Their pitch is irresistible and it unfolds along lines like this: "You want to buy your first house? We'll make it happen! And don't worry about a down payment. In fact, we'll even lend you more than the house is worth. We'll even charge you a super low rate [the "teaser"] during the first year or two to keep your payments low. Sure, the loan will eventually reset at prevailing rates, but since housing prices are rising by 20 per cent a year, all you have to do is refinance your house to keep your payments low!"

Needless to say, the subprime bubble soon burst. After enjoying a short period at low fixed rates, people with subprime "bargains" suddenly found their loans were being reset at rates that were in the double-digits. U.S. housing prices, which had been soaring, started falling. People with subprime mortgages found they could no longer count on the increasing value of their homes to refinance their way out of the mess.

By late 2006, one subprime loan in eight was in default across the U.S. Foreclosures were soaring. More than 20 subprime lenders were bankrupt. And the National Community Reinvestment Coalition estimated that as many as 1.5 million Americans could lose their homes by the time all the damage is done.

Could it happen in Canada?

Subprime mortgages are available in Canada. But it's a different story up here. For one thing, the subprime market share is much smaller in Canada. About 20 per cent of all U.S. mortgages are of the subprime variety in 2007. That compares to just five per cent in Canada, according to industry figures.

All high-ratio mortgages in Canada — those with less than 20 per cent down — must be secured by mortgage insurance, through, for example, the Canada Mortgage and Housing Corporation. In addition, Canadian financial institutions do not finance more than 100 per cent of a home's purchase price, and that value must be verified with a separate appraisal.

Canadian mortgage lenders have been scrambling to assure the population that there are major differences between the subprime markets in the two countries. "We have not seen the aggressive lending practices common south of the border," said Paul Grewal, chair of the Canadian Association of Accredited Mortgage Professionals. The association says Canadian underwriting practices are "more prudent."

Outside analysis backs up that assertion. Benjamin Tal, an economist with CIBC World Markets, noted recently that "only 22 per cent of subprime borrowers in Canada use variable rate mortgages — half the rate seen in the U.S." Tal also says there is no evidence linking the use of subprime lending in Canada with the increase in house prices. In the U.S., there is a "very high correlation," he says.

"Our view is that the price appreciation in the U.S. housing market over the past two years was, in many ways, artificial — boosted by aggressive lending and irresponsible borrowing."

Overall mortgage arrears in Canada are at just 0.5 per cent, the industry says, near record lows.

That doesn't mean there's nothing to worry about in Canada. A drop in Canadian housing prices and increases in interest rates would pose problems for borrowers. But with Canadian real estate showing fewer of the warning signs, with fewer subprime mortgages in this country, tighter borrowing restrictions and fewer mortgages at floating interest rates, the risks do seem to be considerably lower.

But the U.S. subprime meltdown has recently shown signs of spreading to the wider U.S. economy and into Canada. General Motors cancelled a shift at a truck plant in Oshawa, throwing 1,200 out of work, because sales of pickup trucks have plunged in the U.S. Most of Oshawa's production goes south of the border.

Stock markets in Canada and the U.S. began moving lower in the summer of 2007 as investors reacted to signs that lenders were beginning to tighten credit, boosting fears of a slowdown. Many Canadian companies reported having millions in cash tied up in normally safe short-term debt products that suddenly became illiquid as no one wanted to buy investments perceived as being risky.

Central banks on both sides of the border are watching closely for further signs of subprime fallout in the months ahead, as interest rates in many more U.S. subprime mortgages reset at higher levels.

NICK LEESON: Let me tell you about losing billions - by the original rogue trader

When markets are going your way, the feeling is brilliant - more intoxicating than champagne, more exhilarating than sex.

A successful trade makes you feel invincible.

But when things start to go wrong, you hide your losses and blithely try to carry on in the hope that you can recoup them.

You can't tell your colleagues that you've lost money - the macho ethics of the trading desk do not tolerate admissions of failure. You certainly can't tell your wife that your high-end life is at an end.

It is as if you are slipping into a personal abyss as the panic begin to eat at you.

The only way back is to bet more, risk more - and lose more until there is no hope of return.

That's what I felt back in 1995. So I experienced a sickening twinge of recognition when I heard of Jerome Kerviel's £3.5billion loss at Societe Generale.

Here, I thought, was someone going through exactly what I had experienced.

When you are losing such vast sums of money, you try to carry on in the misguided belief that can beat the market for a couple of days. But, in the end, the market always breaks you.

Of course, you may have a few good days when the markets go in your favour and you are persuaded that you can make the money back.

You still think you can pull yourself out the nightmare and get back to a break-even position. But ultimately you are living on borrowed time.

To work in such fast-paced environments, the City attracts a certain obstinate and compulsive character - especially in the derivatives market where Kerviel and I worked.

The truth is that banks need people with confidence who enjoy taking risks - traders who are prepared to gamble by betting on futures which their rivals might be too to timid pursue.

Then there's the intensity of trading on electronic systems which hold you in a trance.

You are watching up to ten screens at a time for the smallest change in the numbers as they update themselves every second, as Kerviel would be doing monitoring the French and German indexes and their main stocks.

When things start to go wrong, the creeping, paralysing panic takes hold. At first, you just shut down your browsers and walk away and seek a bit of light relief.

It's as if you are in a parallel universe. In the false world outside your head, all is well; everyone's celebrating their good times, your wife and family are enjoying the fruits of your success.

in your private world of mental turmoil, there is only a gnawing fear.

You realise you are going to lose your job and everything that goes with it.

You are going to lose the respect of your family. You're probably facing time in jail.

You are juggling two totally opposite worlds, trying to keep the positive things alive.

Drink often becomes a way to escape, although not in my case.

A marriage ought to bring you back to reality. But the danger is that your wife is too heavily committed to the success story and the enjoyment of all its trappings.

How can you break it to your partner - and your kids if you have them - that the car's going to be returned, the house is going to be repossessed and that your name will be a byword for failure around the world?

You don't want to let them down - which makes it harder to face up to the truth and stop trading.

Fortunately, I didn't have kids at the time, but I lost my wife.

I have since remarried and I'm grateful that my children grew up knowing the real me rather than the newspaper and film image.

One of the problems with success is that it creates a feeling of unthinking omnipotence.

Not only have you made millions for your bank and earned the admiration of your peers on the trading desk but you have also beaten hundreds of the smartest financial brains on the planet.

But at the back of everyone's mind who works the financial markets is an unspoken fear of failure.

Indeed, there are plenty of traders who go on to the trading floor after smoking cannabis to calm themselves down.

Equally, the bank bosses never want to talk about risk systems or how they might avoid mistakes and save money.

They simply want to know how traders are going to make more millions.

A bank's trading desk is like a tribe - the smartest and most powerful tribe in the financial house's building.

A perfect example of this sense of teamwork was the case of John Rusnak, a trader with a U.S. subsidiary of Allied Irish Banks who placed large oneway bets that the yen would rise against the dollar and lost £345million.

At the time, everyone bought into his success story and failed to spot the danger signs.

But the tribal loyalties are very frail. When in trouble, you cannot turn to someone close to you in the office for support.

At the height of my losses while working for Barings, I remember coming back from Singapore to England and having a family dinner.

No one knew what was going on at that point. I kept sneaking away to be sick out of pure fear.

Telling my family the truth, I thought, would be far worse than returning to face the markets.

Although I eventually fled to Malaysia, Thailand and finally to Germany, I had still never admitted to anyone by the time I got off a plane at Frankfurt airport what I'd done.

I never even told my wife, Lisa. Everyone had to read the truth in the newspapers.

This latest loss of £3.5billion is an awful lot of trouble to get yourself into. I do not believe that the losses were racked up over a short period. It took me three years.

I also don't believe that no one knew that it was going on. For the bank to ignore that degree of exposure stretches credibility.

For me, I took 100 per cent of the blame for what happened at Barings. I knew what I was doing and I realised that I shouldn't be doing it.

Traders are highly intelligent people and anyone who makes a mistake and claims they didn't know what they were doing is not being honest.

Of course I didn't know how catastrophic my actions would be for Barings and that I would destroy the bank.

It was simply a case that the losses that I had incurred got so big that it was impossible to unwind.

It took me a long time to return to normal, to look at people I respected in the eye.

For years I avoided looking at stories about firms losing large sums of money - I just couldn't bear being reminded of the horror I'd been through.

Only now I can look back and try to understand what happened. It will, I predict, be a long time before Kerviel will be able to do the same.

In February of 1995, one man single-handedly bankrupted the bank that financed the Napoleonic Wars, Louisiana Purchase and the Erie Canal. Founded in 1762, Barings Bank was Britain’s oldest merchant bank and Queen Elizabeth’s personal bank. Once a behemoth in the banking industry, Barings was brought to its knees by a rogue trader in a Singapore office. The trader, Nick Leeson, was employed by Barings to profit from low risk arbitrage opportunities between derivatives contracts on the Singapore Mercantile Exchange and Japan’s Osaka Exchange. A scandal ensued when Leeson left a $1.4 billion hole in Barings’ balance sheet due to his unauthorized derivatives speculation, causing the 233-year-old bank’s demise.

Nick Leeson grew up in London’s Watford suburb, and worked for Morgan Stanley after graduating university. Shortly after, Leeson joined Barings and was transferred to Jakarta, Indonesia to sort through back-office mess involving £100 million of share certificates. Nick Leeson enhanced his reputation within Barings when he successfully rectified the situation in 10 months (Risk Glossary).

In 1992, after his initial success, Nick Leeson was transferred to Barings Securities in Singapore and was promoted to general manager, with the authority to hire traders and back office staff. Leeson’s experience with trading was limited, but he took an exam that qualified him to trade on the Singapore Mercantile Exchange (SIMEX) alongside his traders. According to Risk Glossary:

"Leeson and his traders had authority to perform two types of trading:

1. Transacting futures and options orders for clients or for other firms within the Barings organization, and

2. Arbitraging price differences between Nikkei futures traded on the SIMEX and Japan's Osaka exchange.

Arbitrage is an inherently low risk strategy and was intended for Leeson and his team to garner a series of small profits, rather than spectacular gains."

As a general manager, Nick Leeson oversaw both trading and back office functions, eliminating the necessary checks and balances usually found within trading organizations. In addition, Barings’ senior management came from a merchant banking background, causing them to underestimate the risks involved with trading, while not providing any individual who was directly responsible for monitoring Leeson’s trading activities (eRisk). Aided by his lack of supervision, the 28-year-old Nick Leeson promptly started unauthorized speculation in futures on Nikkei 225 stock index and Japanese government bonds (Risk Glossary). These trades were outright trades, or directional bets on a market. This highly leveraged strategy can provide fantastic gains or utterly devastating losses; a stark contrast to the relatively conservative arbitrage that Barings had intended for Leeson.

Nick Leeson opened a secret trading account numbered 88888 to facilitate his furtive trading. Risk Glossary says of Leeson:

He lost money from the beginning. Increasing his bets only made him lose more money. By the end of 1992, the 88888 account was under water by about GBP 2MM. A year later, this had mushroomed to GBP 23MM. By the end of 1994, Leeson's 88888 account had lost a total of GBP 208MM. Barings management remained blithely unaware.

As a trader, Leeson had extremely bad luck. By mid February 1995, he had accumulated an enormous position—half the open interest in the Nikkei future and 85% of the open interest in the JGB [Japanese Government Bond] future. The market was aware of this and probably traded against him. Prior to 1995, however, he just made consistently bad bets. The fact that he was so unlucky shouldn't be too much of a surprise. If he hadn't been so misfortunate, we probably wouldn't have ever heard of him.

Betting on the recovery of the Japanese stock market, Nick Leeson suffered monumental losses as the market continued its descent. In January 1995, a powerful earthquake shook Japan, dropping the Nikkei 1000 points while pulling Barings even further into the red. As an inexperienced trader, Leeson frantically purchased even more Nikkei futures contracts in hopes to gain back the money already lost. The most successful traders, however, are quick to admit their mistakes and cut losses.

Surprisingly, Nick Leeson effectively managed to avert suspicion from senior management through his sly use of account number 88888 for hiding losses, while he posted profits in other trading accounts. In 1994, Leeson fabricated £28.55 million in false profits, securing his reputation as a star trader and gaining bonuses for Barings’ employees (Risk Glossary). Despite the staggering secret losses, Leeson lived the life of a high roller, complete with his $9,000 per month apartment and earning a bonus of £130,000 on his salary of £50,000, according to “How Leeson Broke the Bank.”

The horrific losses accrued by Nick Leeson were due to his financial gambling, as he placed his trades based upon his emotions rather than by taking calculated risks. After the collapse of Barings, a worldwide outrage ensued, decrying the use of derivatives. The truth, however, is that derivatives are only as dangerous as the hands they are placed in. In this case, Nick Leeson was reckless and dishonest. Derivatives can be tremendously useful if used for hedging and controlling risk or even careful trading.

After a series of lies, cover ups and falsified documents, Leeson and his wife fled Singapore for Kuala Lumpur, Malaysia. By then, Barings’ senior management had discovered Nick Leeson’s elaborate scheme. The total damage suffered by Barings was £827 million, or $1.4 billion. In February 1995, England’s oldest, most established bank was unable to meet SIMEX’s margin call, and was declared bankrupt. Leeson and his wife were arrested in Frankfurt, Germany on March 3 rd , 1995. That same day, the Dutch bank, ING, purchased Barings for a mere £1 and assumed all of its liabilities (eRisk).

Nick Leeson was placed on trial in Singapore and was convicted of fraud. He was sentenced to six and a half years in a Singaporean prison, where he contracted cancer (Risk Glossary). He survived his cancer, and while imprisoned, wrote an autobiography called “Rogue Trader”, detailing his role in the Barings scandal. “Rogue Trader” was eventually made into a movie of the same name. Nick Leeson

Spot Accounting Red Flags the Easy Way
Use cash flow to detect creative accounting

It’s bad news when one of your holdings reduces its earnings forecasts, or actually reports earnings below expectations. Such events usually trigger a substantial share price drop.

That’s why some investors go to great lengths to detect “red flags” warning of future earnings shortfalls. But that kind of analysis entails taking calculator in hand and digging into financial statements. Many investors don’t have the time it takes to perform a detailed financial statement analysis. Here’s the good news: there is an easier way by comparing cash flow to net income.

Let me define the problem before getting to the details.

Why Creative Accounting?
Firms often experience fast growth during their early years. During these heady times, everybody involved assumes that the strong growth will continue indefinitely and the stock price invariably reflects those expectations. But eventually the firm begins to saturate its market and the growth rate falters.

Since a growth slowdown will sink the share price, some managers resort to creative measures to mask the falloff. For instance, they may encourage customers to order unneeded products by offering longer payment terms (e.g. one-year instead of the usual 60 days), a practice known as “channel stuffing.” Another way to stimulate demand is to cut prices. Of course reducing prices without corresponding cost savings decreases profit margins and hence earnings. But that result can be masked by inflating inventory dollar values, which increases margins.

These high jinks leave tracks. Channel stuffing increases accounts receivable (monies owed by customers) levels since customers are taking longer to pay. Profit margin manipulation abnormally increases inventory values.

Detect Creative Accounting
Savvy investors detect these shenanigans by watching for unusual increases in accounts receivable or inventory levels. But there is an easier way.

I’ll explain, but you first need to know a couple of definitions.

Net income is the after-tax profits figure that is divided by the number of shares outstanding to determine the all-important earnings per share figure.
Operating cash flow measures the cash that moved into, or out of the firm’s bank accounts resulting from its main operations. Cash flow is difficult to manipulate since it must be reconciled to actual bank balances.

The accounting hanky panky that I described earlier increases earnings, but not cash flow. For example, extended terms means that the company isn’t receiving its usual payments from customers.

Compare Net Income to Cash Flow
Recent academic research found that you could detect these accounting tricks by simply comparing net income to operating cash flow, instead of digging into the details. What you’re looking for are instances where net income increases, but cash flow doesn't. You can find both figures on the cash flow statement. Here’s how to do it.

Because quarterly cash flows are volatile, the analysis works best using annual numbers. Morningstar’s new 10-years financial report is ideally suited to the task. The report shows condensed versions of a firm’s income statement, cash flow statement, and balance sheet, in separate columns for each of its last 10 fiscal years.

I’ll use camera maker Concord Camera (ticker symbol LENS) to explain the process. From Morningstar’s home page (www.morningstar.com), get a price quote, select Financials (10-years), and then scroll past the income statement to the cash flow statement. There, net income is the top line, and cash from operations is four lines down.

Concord wasn’t consistently profitable until its 1998 fiscal year (June 1998) when it reported earnings of $6 million. Earnings rose to $7.7 million in 1999 and then shot up to $19.6 million in fiscal 2000. But operating cash flow told a different story, falling 45 percent in fiscal 2000 from 1999. That was a red flag, since earnings more than doubled, but cash flow declined.

The signal worked! Earnings turned into losses the next year. Concord filed its June 2000 annual report on August 30, 2000. You would have had plenty of time to analyze the report before Concord’s share price peaked near $40 in mid-October. Earnings shortfalls drove it down to the $5 range a few months later.

I found similar examples for outsource manufacturer Jabil Circuits, Gateway Computer, Ford Motor, Lucent Technologies and software maker Autodesk.

The occurrence of rising earnings combined with falling cash flow doesn't necessarily imply accounting shenanigans. Accounts receivables could increase because customers don’t have the cash to pay. An unforeseen sales slowdown could push inventory levels up. However, these events could also foretell an earnings slowdown.

Don’t’ take my word for it. Morningstar’s report format makes it easy to look up your own stocks and determine whether the correlation between rising earnings and falling cash flow signals future earnings declines. You don’t even need a calculator.
published 12/15/02

Forensic Investing

Forensic investing involves looking beyond the obvious. A normal investor acts like a watchdog, but a forensic investor acts like a bloodhound looking for red flags. Investors must look beyond the numbers on financial statements and dig into the corpse of a company or a mutual fund. The author and creator of Sherlock Holmes [Sir Arthur Conan Doyle] said that "detection is, or ought to be, an exact science, and should be treated in the same cold and unemotional way."

Many investors and creditors are discouraged from using financial statements and the related footnotes because of their complexity. And, indeed, a thorough knowledge of financial statements of a company of any size can required considerable time and effort. But it is possible to glean important information about a company's prospects by spending time looking for specific indications of potential problems or red flags.

But suppose the financial statement is wrong? Some companies use creative accounting techniques to disguise damaging information, to provide a distorted picture of the financial health of the business, to smooth out erratic earnings, or to boost anemic or no earnings. Investors should have a healthy skepticism when reading and evaluating financial reports. Businesses are often clever in hiding these accounting tricks and gimmicks, so investors must be ever alert to the signs of outright financial shenanigans. Investors must attack financial statements and company information the way the fictional Sherlock Holmes approached murder cases.

According to Howard M. Schilit, "financial shenanigans are acts or omissions intended to hide or distort the real financial performance or financialconditions of an entity." Schilit provides seven shenanigans; the first five boost current year earnings, and the last two shifts current-year earnings to the future:

Recording revenue before it is earned
Creating fictitious revenue
Boosting profits with non recurring transactions
Shifting current expenses to a later period
Failing to record or disclose liabilities
Shifting current income to a later period
Shifting future expenses to an earlier period

[H.M. Schilit, Financial Shenanigans, New York: McGraw-Hill, Inc., 1993]

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Red Flags

Clues that a company may be heading for trouble include:

Earnings problems. One of the most significant red flags is a downward trend in earnings. Companies are required to disclose earnings for the last three years in the income statement, so don't look just at the "bottom line." The trend in operating income is just as important as the trend in earnings.

Reduced cash flow. To a certain extent, management can exploit GAAP to produce the appearance of increased earnings. Some popular shenanigans include booking sales on long-term contracts before the customer has paid up, delaying the recording of expenses, failing to recognize the obsolescence of inventory as an expense, and reducing advertising and research and development expenditures. You can use the cash flow statement to check the reliability of earnings. If net income is moving up while cash flow from operations is drifting downward, something may be wrong.

Excessive debt. Crucial to determining whether a company can weather difficult times is the debt factor. Companies burdened by too much debt lack the financial flexibility to respond to crises and to take advantage of opportunities. Small companies with heavy debt are particularly vulnerable in economic downturns. Investment professionals pay special attention to a company's debt-to-equity ratio, the total debt to stockholders' or owners' equity. While the optimum ratio varies from industry to industry, the amount of stockholders' or owners' equity should significantly exceed the amount of debt by a significant amount. This information should be available on the balance sheet, but Enron hid millions of dollars of debt in special purpose entities.

Overstated inventories and receivables. Look at the ratio of accounts receivable to sales and the ratio of inventory to cost of goods sold. If accounts receivable exceeds 15 percent of annual sales and inventory exceeds 25 percent of cost of goods sold, be careful. If customers aren't paying their bills and/or the company is saddled with aging merchandise, problems will eventually arise. Overstated inventories and receivables are often at the heart of corporate fraud, resulting in future declines in profits. As significant as the ratios are, trends overtime are also important. Although there may be good reasons for a company to have bloated or increasing inventory or receivables, it is important to determine if the condition is a symptom of financial difficulty.

Inventory Plugging. Inventory fraud is an easy way to produce instant earnings and improve the balance sheet. Crazy Eddie, an electronic equipment retailer, allegedly recorded sales to other chains as if they were retail sales (rather than wholesale sales)

Balancing Act. Inventory, sales, and receivables usually move in tandem, because customers do not pay up front if they can avoid it. Neither inventory or accounts receivable should grow faster than sales. Furthermore, inventory normally moves in tandem with accounts payable, since a healthy company does not often pay cash at the delivery dock as purchases are received.

Off-Balance Sheet Items. Enron had more than 2,500 offshore accounts and around 850 special purpose entities.

Unconsolidated Entities. Enron did not tell Arthur Anderson that certain limited partnerships did not have enough outside equity and more than $700 million in debt should have been included on Enron's statements.

Creative or Strange Accounts. For their 1997 fiscal year, America Online, Inc. showed $385 million in assets on its balance sheet called deferred subscriber acquisition costs.

Barter deals. A number of Internet companies used barter transactions (or non-cash transactions) to increase their revenues.

Look at revenues. Compare the trend in sales with the trend in net income. For example, from 1999 to 2001, HealthSouth's net income increased nearly 500%, but revenues grew only 5%. On March 19, 2003, the SEC said that HealthSouth faked at least $1.4 billion in profits since 1999 under the auditing eyes of Ernst & Young.

Hockey stick pattern. Look for aggressive revenue recognition policies (Qwest Communication, $1.1 billion in 1999-2001) which form a hockey stick pattern.

Nonrecurring charges. Beware of the ever-present nonrecurring charges (e.g., Kodak for at least 12 years).

Avoid Buying Shares of a Mutual Fund Just Before it Pays Dividend. Merrill Lynch says to wait until after the fund's record date before making your investment. Otherwise, you'll owe taxes on the dividend, even though that dividend is, in a sense, return of the principal you've just invested. Also, the share price is typically lowered by the amount of the dividend after it is paid. So, by waiting, you may acquire more shares for the same investment amount.

Be Careful of Your Cost Basis When Selling or Exchanging Fund Shares. Merrill Lynch gives an example of this caution flag. Suppose you originally invested $10,000 in a mutual fund several years ago and that your shares are now worth $20,000. Does that mean that you'd have a $10,000 taxable gain to report on your tax return if you were to sell or exchange all of your shares today ? Not necessarily. According to Merrill Lynch, you may increase your cost basis by any sales charges you paid to acquire your shares. And if you have reinvested dividends and/or capital gains, you may increase your cost basis by the amounts reinvested. Increasing the cost basis may help reduce your tax liability.

Choose the Most Favorable Method From Among These Three Options to Calculate Your Cost Basis When Selling or Exchanging Some of Your Shares.

The Average Cost Method:

2. The Specific Identification Method: You identify specific shares to be sold (before you sell or exchange them). You may choose the shares with the highest cost basis to reduce taxes on the transaction.

3. If You Don't Use One of the Above Methods, the IRS' "Default" Method (First-In, First-Out) is Applied: The IRS assumes you are selling the first shares you purchased, which may result in a higher tax liability than necessary if you purchased shares later at a higher price.

CPA Switching. Auditor switching and the financial condition of a company are dependent to a limited extent. Firms in the midst of financial distress switch auditors more frequently than healthy companies.

Underwriter Broker Basis. The long run performance of initial public stock offerings that are recommended by their underwriters is dramatically worse than the performance of firms recommended by non-underwriters. Roni Michaely and Kent Womack found significant evidence of bias-- and possible conflict of interest -- between the analyst's responsibility to his investing clients and his incentive to market stocks underwritten by his firm. Contrary to the conventional wisdom, they found that the market does not come close to recognizing the full extent of this bias.

Hyped Sales. According to court documents, CEO Emanuel Pinez used a form of trickery rarely seen: He hyped sales by using his ample personal fortune to fund purchases. 'Any auditor would have had a hard time catching that,' says William Coyne, an accounting professor at Babson College. Centennial Director John J. Shields, a former CEO of Computervision Corp., says in an affidavit that Pinez admitted to him that he altered inventory tags and recorded sales on products that were never shipped. Pinez' lawyer says he is innocent. (Geoffrey Smith, "Why Didn't Anyone Smell a Rat at Centennial?" Business Week, March 24, 1997, p.190.)

Board of Directors. The "Heard on the Street" column in the April 25, 1997 issue of the Wall Street Journal, written by E. S. Browning, discusses red flags that relate to a company's board of directors. Wharton Professors John Core, Robert Holthausen and David Larcker published a study that found six different board characteristics linked to both higher CEO pay and weaker performance of the company's common stock. These factors cause poor governance systems and ultimately lead to poor financial performance by the firm, according to the authors. The characteristics of boards that are danger signals for a company's common stock are the following:

Chairman and Chief Executive are the same person
Large board
Chief Executive himself appoints outside directors
Outside directors who have business dealings with company
Outside directors over the age of 70
"Busy" outside directors who serve on many other boards

Index Funds. According to the April 29, 1997 Deloitte & Touche Review, index funds do not alleviate market risk--the possibility that stocks and bonds will decline in value. If the market that a particular index fund is tracking declines, the value of shares of the index fund will decline. Many index funds have achieved excellent returns as a result of the strong overall performance of the U.S. market in recent years. When the U.S. stock market experiences a correction or decline, stock index funds may not performas well as actively managed equity funds, because stock index funds are fully invested in equity security at all times. During market declines, actively managed equity mutual funds may have a larger percentage of their assets in cash and investments other than stocks. Investment risk is reduced through the diversification achieved by investing in mutual funds (index or actively managed funds). Most mutual funds hold securities of many different companies; therefore, the risk that an individual security loss will negatively impact the overall return of a mutual fund is reduced.

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Statements on Auditing Standards No. 82 and 99

Before the Sarbanes-Oxley Act, the American Institute of Certified Public Accountants was responsible through its Auditing Standards Board in developing auditing standards that had to be satisfied by public accounting firms. The SEC required publicly traded firms to be audited by public accounting firms to provide reasonable assurance of presentation in conformity with generally accepted accounting principles. In conducting an audit, public accounting firms had to observe generally accepted auditing standards as promulgated by the Auditing Standards Board. Today the PCAOB is responsible for developing auditing standards.

One of the most highly publicized statement on fraud auditing standards in recent years was published in early February of 1997. Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, provided guidance to the auditor in the detection of financial statement fraud. This statement, effective December 15, 1997, clarified the auditor’s responsibility to detect fraud.

The statement is rather lengthy but it has an interesting discussion of what it calls risk factors (what we call red flags) that should be of interest to our readers. Although subsequent SAS No. 99 replaced SAS No. 82, the following section of SAS No. 82 is still of particular relevance:

Risk Factors relating to management’s characteristics and influence over the control environment. Examples include:

A motivation for management to engage in fraudulent financial reporting. Specific indicators might include:

A significant portion of management’s compensation represented by bonuses, stock options, or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position, or cash flow.
An excessive interest by management in maintaining or increasing the entity’s stock price or earning trend through the use of unusually aggressive accounting practices.
A practice by management of committing to analysts, creditors, and other third parties to achieve what appear to be unduly aggressive or clearly unrealistic forecasts.
An interest by management in pursuing inappropriate means to minimize reported earnings for tax-motivated reasons.

A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might include:

An ineffective means of communicating and supporting the entity’s values or ethics, or communication of inappropriate values or ethics.
Domination of management by a single person or small group without compensating controls such as effective oversight by the board of directors or audit committee.
Inadequate monitoring of significant controls.
Management failing to correct known reportable conditions on a timely basis.
Management setting unduly aggressive financial target and expectations for operating personnel.
Management displaying a significant disregard for regulatory authorities.
Management continuing to employ an ineffective accounting, information technology, or internal auditing staff.
Nonfinancial management’s excessive participation in, or preoccupation with, the selection of accounting principles or the determination of significant estimates.
High turnover of senior management, counsel, or board members.
Known history of securities law violations or claims against the entity or its senior management alleging fraud or violations of securities laws.
Risk factors relating to industry conditions. Examples include:
New accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity.
High degree of competition or market saturation, accompanied by declining margins.
Declining industry with increasing business failures and significant declines in customer demand.
Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence.

Risk factors relating to operating characteristics and financial stability. Examples include:

Inability to generate cash flows from operations while reporting earning and earnings growth.
Significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity -- including need for funds to finance major research and development or capital expenditures.
Assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, or that are subject to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity -- such as ultimate collectibility of receivables, timing of revenue recognition, realizability of financial instruments based on the highly subjective valuation of collateral or difficult-to-assess repayment sources or significant deferral of costs.

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Green Flags/ Yellow Flags

Is this a good time to buy or sell stocks ? Stock analysts usually have an answer to this perennial question, but individual investors can form their own judgments by looking at several relatively simple yardsticks or

green flags

1. Start up Dividends. Kent Womack, Professor of Finance at Dartmouth University, believes that companies that start paying dividends (or resume paying them after a long pause) are great buys. Such stocks get an initial boost of about 3%, and then go on to outperform the market by more than 20% in the next three years. [Red flag: stocks whose dividends are eliminated tend to fall in price an average of 7% in the first two days, and then outperform the market by 15% the next three years.]

2. Price-to-earnings gauge. This ratio measures the relationship between the price of common stocks and their annual earnings per share by dividing the price of the common stocks in the S&P 500 index by the earnings per share of the stocks in the 500 index. The market is fairly valued when stock prices reflect reasonable expectations regarding earnings growth. When the price-earnings ratio is high--above 20 say--the market is expecting significant positive future earnings increase (a prediction that may not occur). When price-earnings ratios approach historic lows--under 10--the market may be too pessimistic about future earnings growth. Since 1950, stocks in the Standard &Poor's 500 index have traded an average of 14.3 times the previous 12 months' earnings per share. This ratio is provided weekly in Barron's. A ratio above 18 historically indicates that the market may be ready for a correction (green flag). Like all stock market predictors, the P/E gauge does not have a perfect record, especially in the short run. Extreme readings can be reached and maintained for long periods of time.

3. Fund Performance. According to D Enterprises, a Baton Rouge-based strategic planning and consulting firm, this area can be very elusive to the investor, because the fund's performance should not be looked at as the annual return that the fund realized. Performance should be compared to an appropriate benchmark for that fund. For example, benchmarks used could be the average performance of peer funds or the market index that this particular fund tries to outperform. Once you determine what benchmark the fund is using and if it seems appropriate, then you look to see if the fund outperformed the benchmark. An underperforming fund is not necessarily a bad thing. It could be that the fund manager's strategy is to reduce risk relative to the benchmarks, and thus, he expects the fund to perform below the comparative benchmark.

4. Rule of 23. This measure offers a simple method of evaluating whether or not the market is vulnerable. According to this rule, when the price-earnings (P/E) ratio of the Dow Jones Industrials plus the current rate of inflation total 23 or more, watch out (red flag). Prior to the October 1987 crash, the rate of inflation was 5% and the P/E ratio of the Dow Jones Industrials was 18.4. The P/E ratio of the DowJones is available daily in Investor's Business Daily and weekly in Barron's.

5. Presidential election cycle. An interesting indicator is based upon the presidential election cycle. Simply put, every four years, stock prices tend to perform much better in the last two years of an administration rather than in the first two years. This difference arises because the incumbent President in years three and four acts politically to ensure the party's return to power.

Yale Hirsch has extensively researched the cycle, with the results providing evidence of the validity of this indicator. The last two years, (election year and pre-election year) of the 41 administrations since 1832 produced a total net market gain of 557%, far in excess of the74% gain of the first two years of these administrations. Although the evidence is convincing, there have been misleading signals. For example, in 1985 and 1986, when stock prices should have been weak, they were up 27% and 17% respectively.

An update of the presidential election cycle is provided annually in Yale Hirsch's Stock Trader's Almanac (The Hirsch Organization, Inc., 184 Central Avenue, Old Tappan, NJ 07675). This publication contains a wealth of information useful to investors.

6. Real Estate Investment Trusts. During a down market, a person may consider investing in a Real Estate Investment Trust (REIT). According to Martin Cohen, Cohen & Steers Realty Shares, because REITs invest in properties--not manufacturers or producers--they are more dependent on real estate values than on the economy as a whole. That's why REITs tend to rise or remain stable in volatile market environments.

7. The January 20, 1997, Deloitte & Touche Review indicates that when invested solely in equity securities, a mix of approximately 70% U.S. stocks and 30% foreign stocks produces the best return with the least amount of risk. In the past, individuals who invested 100% in U.S. stocks could have improved their rate of return and lowered their risk by allocating a portion of their portfolio to foreign equity securities.

Many people are intimidated by financial statements and, as a result, ignore them. Financial statements, which can seem extremely complex, are based upon certain accounting rules with which you should be familiar; once you learn the basic rules and terms, the statements seem much less formidable. The goal of forensic investing is to help you become proficient in understanding and interpreting financial statements, looking for those red flags. To be a good investigative investor, you need to be a good detective to detect financial tricks and gimmicks.

8. Stock Funds.

9. Corporate Takeovers. In a recent study of 1,000 corporate takeovers, according to Bottom Line Personal, stock price increases for the first five years after the takeover were highest when takeovers were hostile and for cash...and lowest when friendly and for stock. In friendly for-stock situations, the price over the next five years typically increased less than at similar companies that had not made acquisitions. Bottom line: If you own shares in a company that is taken over for stock, consider selling after the takeover.

10. Mutual Fund Classifications. According to the September 1997 issue of the ABA Journal, in the Winter 1997 issue of The Journal of Portfolio Management, John J. Bowen Jr. and Meir Statman discuss ways that funds can be manipulated to boost ratings. "People know that a sure way to look tall is to stand next to short people, and mutual fund managers know that a sure way to a high standing is a short benchmark." As crucial as category assignments are to fund raisings, they can be highly capricious. The authors note that funds focused on various overseas stock markets are lumped into a single "international stock" category even though they have little in common. Likewise, stock/bond blend funds that diversify risks by having fixed ratios of assets in each market are in the same category as a fund whose manager can switch assets entirely from one market to another. Uncovering mismatched classifications is one thing, but circumventing fund managers' attempts to play the ratings game is even tougher Bowen and Statman say. It can be done, but "fund detectives will always be slower than fund managers,...[and] investors will know only later what fund managers know now."

11. For years experts have suggested a 60-40 mix of stocks and bonds, but this benchmark may no longer be the appropriate ratio. Jonathan Clements in the Wall Street Journal on 12/16/97 at page C-1 states that even if 60-40 is no longer the optimal mix, a stock-market investor should still own at least some bonds, argues John Bogle, chairman of Vanguard Group, the Malvern, Pa., mutual-fund company.

"They should have at least 5% or 10% in bonds," he says. "It's psychological comfort, and it reduces the volatility of your portfolio."

The same holds true for bond investors. "If you start with an all-bond portfolio and add a small amount of stock, you don't increase risk," notes Pittsburgh investment adviser Roger Gibson. "There's a small free lunch. An 80% bond and 20% stock portfolio will have a similar risk level to an all-bond portfolio, but with modest incremental returns."

12. Deloitte & Touche says that the goal of asset allocation is to maximize potential return based on the investor's acceptable level of risk. There is no one "correct" allocation for any particular situation. An investor should understand the principles of risk and return and the potential impact of the allocation strategy on his/her financial situation before determining the target asset allocation.

"An asset allocation strategy that has a long-term focus will help take the emotion out of investment decisions, especially during times of market volatility," notes Greg Sandor, Financial Counseling Services Group, Deloitte & Touche LLP.

13. Tracking your mutual fund basis. The Taxpayer Relief Act of 1997 reduced the tax rate on long-term capital gains, but increased the complexity of tracking and computing an investor's cost basis in shares of mutual funds. Investors must compute the cost basis in mutual fund shares in order to determine the gain/loss from a sale, and the method used to compute basis can affect the amount and type of gain/loss realized.

The tax rate differential between capital gains and ordinary income can exceed 19.6 percent for high-income taxpayers. The lowest capital gains tax rate is currently 15 percent (for taxpayers above the 15 percent federal tax bracket). Because of the tax rate differential, investors should maintain records of their mutual fund basis (rather than rely on reports provided by the mutual fund company).

Basis in Shares. The original basis in a mutual fund share is generally the purchase price, plus any fees paid in connection with buying or selling the share (front-or back-end load). Other items that increase basis include reinvested dividends (taxable and nontaxable), reinvested capital gains, and undistributed long-term capital gains. Among the items that reduce basis are nontaxable distributions and taxes paid by the mutual fund on undistributed long-term capital gains. Failure to consider reinvested dividends is a common mistake taxpayers make when computing basis in mutual fund shares sold-- a mistake that results in double taxation of dividends (as ordinary income and increased capital gain) from tracking your mutual fund basis, Deloitte & Touche Review, June 22, 1998, page 7.

14. The Auditors are always last to know. It's clear that something's not quite right in the world of accounting. "It used to be you'd see two, three, four, or five accounting restatements in a year," says class-action attorney Bill Lerach of Milberg Weiss Bershad Hynes & Lerach. "Now you see one almost every other week." Part of the increase is due to tremendous competition among companies to boost results and stock prices, Lerach says. More directly, he traces it to the passage of new securities legislation in December 1995,which made it harder to hold accountants culpable in securities-fraud cases notes Herb Greenberg, Fortune, August 17, 1998, page 228.

15. John Dorfman in the July/August1998 issue of Bloomberg Personal Finance indicates that earnings can lie:

a. Watch the Inventories
b. Beware of Rising Receivables
c. Uncover Extraordinary Expenses
d. Investigate Asset Sales
e. Who's Skimping on Research?
f. Note Reduced Capital Spending
g. When Is Revenue Really Not?
h. Who's Playing Currency Roulette?
i. Look for Pension Shenanigans
j. Spot Out-of-Balance Growth

16. A bond's worth...

When interest rates go up, bond prices drop; and when interest rates drop, bond prices go up. To better illustrate, let's suppose you own a 10-year bond with a face value of $1,000 that pays 6 percent interest. If it was issued three years ago, the bond will mature in seven years. Let's suppose interest rates rise to 8 percent. It makes little sense for an investor to purchase your 3-year-old bond yielding 6 percent when the investor can buy a newly- issued bond at 8 percent.

If you were to sell your 6 percent bond, you would probably sell it at less than its face value - at a discount. Conversely, if interest rates declined to 4 percent, you could sell the bond for more than its face value - at a premium. The reason: Investors might be willing to pay more for the 6 percent yield when new issues offer a yield of only 4 percent.

Confessions Of A Former Auditor
Richard Lehmann, Forbes/Lehmann Income Securities Investor, 05.15.02, 2:00 PM ET

The current wave of accounting concerns is welcome because it instills caution in an investment market that too recently succeeded by shooting from the hip. Aside from this, it is a necessary comeuppance for those thirty-something MBAs running their investment portfolios as if numbers tell the whole truth. Accounting is not an exact science, nor are corporate managers meticulous in telling on themselves. I was an auditor for PricewaterhouseCoopers for many years, and I can attest that manipulation of the books goes on in most corporations--usually for the good of shareholders. This is due in no small part to the market's knee-jerk reaction to short-term disappointments. I ask you, what shareholder really benefits from class-action suits automatically filed by predatory tort lawyers just days after any unexpected earnings shortfall? Since auditors don't certify quarterly results, management has leeway to lag in reporting bad news while preparing shareholders.

Aside from the numbers, there are any number of corporate events, which all investors--equity and fixed-income--should look out for.

CEO Retirement--When the top dog is scheduled to retire, it will generally be a bumper quarter or year. He wants to go out with a bang, as well as a big bonus and high exercise price on his remaining options. Needless to say, the follow-on year should be a downer. For example, just look at General Electric (nyse: GE - news - people ).
CEO Overhaul--If the new chief executive is an outside hire or replaces one who left under a cloud, look out! The first priority of such an executive, if he's smart, is to write off anything not nailed down. In this case, the follow-on year should look quite good.
Restructuring Rumblings--If management begins talking about reorganizing or restructuring the business, expect bad news. Such talk is a euphemism for big-time screwups that need to be buried in a larger event. The news here is negative, but oddly enough the market often reacts positively, perhaps because it's pretty good at knowing that, when guys can't shoot straight, the bad news is factored in. Also, often the writeoffs have unburdened future years' earnings.
New Bean Counters--When the company auditors resign voluntarily, run for the phone. This is almost always bad. We are likely to see it happening a lot more, post Enron (otc: ENRNQ - news - people ). Similarly, when the company decides to change auditors suddenly, look out. This can mean they wouldn't go along with some questionable transactions or practices. In today's market there will be little tolerance for this.
CFO Leaves--The top financial guy should have the inside scoop on the company's books. If he quits or--even worse--is fired, there is usually big trouble brewing.
PR Double-Talk--If the pace of company press releases slow and/or begin using terms like "unforeseen," "may result in" or "could portend," watch out. Also, any "special" announcements are worrisome. Assume the worst when you see wording such as, "We have retained the services of _____ to (investigate, explore, pursue, study) the (possibilities, alternatives, remedies) for _____ ."
Informal Inquiries--Of course if the company reports that it has received notice of an informal inquiry from the Securities and Exchange Commission, Justice Department or any other regulatory body, head for the exit--fast.

And don't think that by merely buying a mutual fund instead of investing directly, you will be spared. Fund managers are just as sheepish as Wall Street analysts. Plenty of fund managers owned Enron while the stock plummeted. Investors need to take responsibility for their decisions. A Morningstar Star rating is no insurance policy.

Earnings Management
Accounting Red Flags

How can investors protect themselves from companies that spend more time managing earrings than managing their business? As shown by "Enrongate," it is very difficult to determine a company's real profitability even if a company complies with generally accepted accounting principles and with Securities and Exchange Commission regulations. At best it can be done in hindsight. The best protection for investors is knowledge, independent thinking and portfolio diversification.

Assuming a properly diversified portfolio, investors can further protect themselves by knowing where to look for signs of earnings manipulation. (We can't help you with the independent thinking bit.) Many companies exploit gaps in the generally accepted accounting principles (GAAP) and, although the specific techniques may be deemed acceptable under accounting and tax regulations, the results can be dire for shareholders if economic reality does not match the accounting.

What follows are five of the most abused techniques. Click on anyone to read an explanation.

Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Accelerating Revenue

This technique allows companies to record revenue in the current quarter (accelerating revenue) while delaying recognition of the related costs (delaying expenses) for several quarters or years. This can boost revenue for the early quarters, but if business activity slows (due to a recession), earnings will drop significantly as revenue growth falls and expenses remain unchanged.

Global Crossing (otc: GBLXQ - news - people) is currently being criticized for selling long-term contracts (sometimes called indefeasible rights of use) that allow other telecommunications companies to use their fiber routes. Global booked the lump sum payment as revenue in the quarter it received the cash payment, although the service was, in fact, supposed to be delivered over a period of several years. Global also entered into separate contracts with another (or possibly the same) telecom to buy capacity on their fiber and recorded these costs as a capital expense that was spread out over the life of the contract (also several years) and which resulted in small quarterly expenses. In essence, Global was accounting for all the revenue from providing a service in a single quarter, while accounting for the cost of providing that service over several years.

In general, watch out when revenue and costs for the same product are accounted for over different timeframes. In Global's case, companies were willing to enter into these contracts while the economy was booming and the dot-com bubble was growing. As both collapsed, these companies faced falling prices, excess capacity and nobody wanted to enter into any more long-term agreements. As a consequence, Global's and many other telecoms' revenue growth slammed to a halt and these companies now face high fixed costs or are forced to write off these expenses.

Introduction | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Delaying Expenses

Under certain circumstances, companies are allowed to delay recognizing expenses on their income statements. For example, if a company makes a major investment in a plant or large machinery (a capital investment), the benefit of that investment will be returned over a number of years. In order to match the benefit with the expense, GAAP allows companies to depreciate the investment over the useful life of the asset.

In recent years, however, companies have gotten creative by delaying expenses by capitalizing them. For example, a few years ago AOL (before it purchased Time Warner) capitalized the costs of producing the millions of CDs it gave away to market its online service. As people started to sign up, profit and revenue grew rapidly, but the cost of making and distributing the CDs were being spread over a longer period of time. Eventually, the regulatory bodies required AOL to restate results and expense the cost of the CDs over a much shorter period of time.

Another example of delaying expenses was the way telecoms would buy the right to use the capacity of another carrier over a long period of time. The buyer of the capacity would classify the transaction as a capital expense, reducing the impact on earnings. Combining this with selling capacity to another carrier and booking the revenue up front (see: Accelerating Revenue) would result in astronomical earnings growth.

Introduction | Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Accelerating Expenses

In order to improve future earnings, companies will "front-load" expenses and book them in the current quarter. Cisco Systems (nasdaq: CSCO - news - people) and Tyco (nyse: TYC - news - people) have been accused of having the companies they were acquiring write off as much as possible in order to maximize earnings per share (EPS) after the acquisition was finalized. Investors can spot these techniques by looking for "nonrecurring" expenses such as "in-process R&D" charge-offs, and most recently, "impaired goodwill" writeoffs. Regardless of what it is called, management decided to take an earnings "hit" instead of recording the expense over a number of quarters, as was previously planned.

"Nonrecurring" Expenses

Nonrecurring expenses is the generic term used for supposedly one-time charge-offs. This technique deserves special mention because it's a classic--and an oxymoron if ever there was one. These one-time charges were meant to take care of extraordinary--in other words, nonrecurring--events in order to separate them from "normal"--in other words, recurring--expenses. But, it seems like some companies take a "nonrecurring" charge each year. During the 1980s, Borden made many acquisitions in the food and chemical sectors. When management started to integrate the operations, it posted a string of one-time charges that were for restructuring charges and severance payments. To be fair, it takes time to integrate new operations and nonrecurring expenses represent management's best guess at any one time. When new information is available, companies adjust their estimates and this creates the "new" nonrecurring expense. I expect many of Wall Street's favorite stocks of the late 1990s to start posting nonrecurring expenses as the downturn in the economy has made many of their investments go bad.

Goodwill Impairment (FAS 142)

Goodwill represents an amount paid above book value to buy something because the buyer perceives a greater value in that something. For example, people go to Starbucks (nasdaq: SBUX - news - people) and pay $3.00 for a cup of coffee when you can get a cup of coffee for $1.50 at McDonalds (nyse: MCD - news - people). The $1.50 more you pay at Starbucks represents the goodwill you perceive in that particular cup of coffee.

Companies record goodwill on their balance sheets when they paid more than book value for an acquisition. The acquiring companies were willing to pay more than the value of the plant and equipment because of the value they perceived in the technology or brand name they were buying. Under the old accounting rules, companies had to periodically expense, or amortize, this goodwill over a period of years. However, a recent change in GAAP will eliminate the amortization of many forms of goodwill, but another change is expected to result in large charge-offs in 2002.

The new accounting rule is called FAS 142 and will generate a flood of "impaired goodwill" charges this year. If the goodwill on the books of a company is greater than the current market value of the asset, then the goodwill is deemed "impaired" and it must be charged off. The best example of this is any dot-com acquisition that occurred in 1999 where the buyer used its stock. After the bubble bursting and stock market crash, the value of that "business" is much less than the millions in stock that was paid for it and which is sitting on the balance sheet. Under FAS 142, it must all be written off. Think of it like your stock portfolio: In 1999, you may have bought tech stocks for $10,000. Today the market value is more like $500. Since you can't keep valuing your portfolio at $10,000, the $9,500 loss represents impaired goodwill that the market has written off for you.

The most recent example of this was AOL Time Warner's (nyse: AOL - news - people) announcement in January 2002 that it will take a $60 billion hit to write down bad assets. Other sectors that will be hit hard by this new accounting rule are the darlings of the dot-com era that acquired other companies at inflated prices and paid with stock. Under the new rules, many of these deals can be viewed as "impaired." The way FAS 142 was written, it behooves companies to take their "hit" as soon as possible in 2002. If the charge is taken now, it will be treated as a nonoperating expense and will not reduce EPS. If a company waits too long, the charge will be treated as an operating expense and will reduce EPS.

"In-Process R&D" Charge-Offs

This is a type of nonrecurring charge that graced many a tech stock's income statement during the 1990s. A large tech firm often acquired smaller companies that were heavily involved in developing new technologies or software. Because the technology was not yet commercially viable (thus "in process") the acquiring company could deem it worthless and write off the related costs. However, there could be some future revenue derived from the technology, otherwise why would the company have been acquired? Any future revenue would thus be recorded without the expense of the related R&D and EPS would be overstated.

You don't see much "in-process R&D" writeoffs these days because it is being replaced by goodwill impairment charges. But it is useful to know that charging off capitalized expenses has been around for some time.

Other Income

This category is especially susceptible to earnings manipulation because it houses a multitude of sins. It is a catchall for other revenue and expenses that aren't classified in the other major line items or are not large enough to be "material" in the eyes of the company's executives. This is the category where companies book any "excess" reserves from prior charges (nonrecurring or otherwise) and offset them with "other" income.

Introduction | Accelerating Revenue | Delaying Expenses | Off Balance Sheet Accounting | Pro Forma EPS

Off Balance Sheet Accounting

Off balance sheet accounting refers to the methods a company can use to remove assets and liabilities, as well as income and expenses, from its balance sheet and income statement. In one sense, off balance sheet accounting is good because, done properly, it can protect investors by moving business risk from the parent company onto independent partners and minimize taxes, both of which benefit shareholders.

There are three main ways companies can move assets, liabilities, income and expenses from their books; special purpose entities, spinoffs, and synthetic leases.

Off Balance Sheet Companies (Special Purpose Entities)

Off balance sheet companies are separate legal entities that are jointly financed by the parent company and supposedly independent outside investors. These companies are sometimes referred to as special purpose entities ("SPE"). GAAP and tax laws allowed these structures as a legitimate way to finance risky business ventures, such as oil exploration or developing a product that is radically different from the corporate parent's main line of business.

Under normal circumstances, off balance sheet entities are legitimate tools that can protect investors. For example, oil exploration is a high-risk/high-return business and one that might not appeal to investors in more steady business, like an oil refinery. In order to facilitate oil exploration, accounting "rules" allow the refinery to establish a separate business to explore for oil and that can be invested in by others who are willing to bear that risk. Removing this exploration risk from the parent actually protects its shareholders who invested in the refinery business and do not want any part of the riskier oil exploration business.

Originally, it appears that initially Enron (otc: ENRNQ - news - people) was using SPE's appropriately by placing nonenergy-related business into separate legal entities. What they did wrong was that they apparently tried to manufacture earnings by manipulating the capital structure of the SPEs; hide their losses; did not have independent outside partners that prevented full disclosure and did not disclose the risks in their financial statements. Or to put it another way, they got greedy.

Any system can be abused and misused. If management uses nonpublic SPEs as a way to hide debt and manipulate earnings, it will lead to Enron-type disasters. Enron has highlighted serious flaws in GAAP that hopefully will soon be corrected. In the meantime, investors should make sure that companies using off balance sheet financing conform to a few simple rules.

There should be no interlocking management: The managers of the off balance sheet entity cannot be the same as the parent company in order to avoid conflicts of interest. This was clearly not the case at Enron.

The ownership percentage of the off balance sheet entity should be higher than 3% and the outside investors should not be controlled or affiliated with the parent: This is necessary in order to prevent the "Three-Card Monte" that was used by Enron. In order to circumvent the outside ownership rules, Enron funneled money through a series of partnerships that appeared to be independent businesses, but which were controlled by Enron management. While this type of Ponzi scheme is very difficult to detect, let's hope that the regulators act fast to plug this gap.

The financial risk of all off balance sheet entities should be disclosed in the parent's financial statements: If nothing else, this must be done in order for investors to evaluate the total risk of investing in any company. Footnote disclosures of the leverage risk and any guaranteed debt would have alerted Enron shareholders of the growing risk they faced.

Under current GAAP, companies are required to disclose (albeit barely) ownership in separate legal entities. If little else is disclosed, take that as a red flag.

Spinoffs

Spinning off a subsidiary into a separate publicly traded entity is another way to establish a SPE. The only difference is that the spinoff is publicly owned and must disclose its financial statements just like the parent. For example, Williams Companies (nyse: WMB - news - people) spun off Williams Communications (nyse: WCG - news - people) in order to separate the business risk of a telecommunications from their shareholders who wanted to invest only in an energy company. As part of the normal process, the parent had to guarantee the debt of the spinoff. With the telecommunications crash, banks are now relying on those guarantees, which are raising the concern about the parent's ability to handle all that debt.

Synthetic Leases

A synthetic lease is a way for a company to finance a new building or plant and improve its financial performance ratios (such as return on assets and return on equity) by keeping assets and debt off its books and boosting EPS by avoiding depreciation expenses. Under the synthetic lease, a company pays a relatively small lease payment for a number of years, which usually represents the interest on the loan used to finance the building. However, at the end of the synthetic lease, the company must take ownership of the building and refinance the debt, which may not be easy if the economy is in a recession or if the company is losing money. (For more information on how Krispy Kreme (nyse: KKD - news - people) tried to use synthetic leases, see: "Debt? Who, Me?")

Introduction | Accelerating Revenue | Delaying Expenses | Accelerating Expenses | Pro Forma EPS

Pro Forma EPS

The words "pro forma" indicate that assumptions were used to derive whatever number is being discussed. Used correctly, pro forma earnings are a good way to compare "apples to apples." For example, if a company doubled its size with an acquisition, investors would want to know how much of the sales and earnings growth was generated by the core business (also referred to as "organic growth") and how much came from the new acquisition. Companies normally use pro forma sales and earrings to compare the core results and avoid the distortion caused by comparing the combined results to the historic results of the original (smaller) company. Likewise, if a company sold a division, it would use pro forma data to compare the results of the remaining business.

Recently, however, pro forma earnings have been used as a way for companies to divert attention from their actual GAAP earnings to a semi-fictional number management thinks will please Wall Street. Amazon (nasdaq: AMZN - news - people) is the pro forma poster child because it raised pro forma reporting to a high art. Most recently, it announced that it "earned" a pro forma $0.09 per share in Q4 of 2001. But the GAAP number was $0.01 (and I even think that number is suspect). In the past Amazon has tried to focus attention on pro forma earnings that excluded expenses that could be considered necessary and which should have been used to calculate EPS. If there is a large difference between pro forma EPS and GAAP reported EPS, this should be a big flag to investors of the need to dig into the financial statements because it generally indicates that the company is trying to divert attention from "real" earrings.

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