Are the Books Cooked?

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Yesterday I promised to reveal how you can ferret out if a company is faking earnings. I should warn you, the tips I discuss below are nothing close to an exact science, and they won’t catch all of the deception all of the time. 

They’re just the bare minimum of the due diligence necessary to act responsibly as an investor. After all, it’s your hard-earned money. If you don’t do the work, then you’re only hurting yourself. 

*****But even if you scrutinize an investment and research its earnings beyond any shadow of a doubt, and talk with their Investor Relations representative, and pore over their SEC filings, it’s still possible to get tricked by a crooked company. That’s not to say you shouldn’t ever invest in stocks. Our society is based to some extent on good will and trust. 

Think about how much trust you put into other people on a daily basis: even driving to the grocery store is an exercise in trust. You trust that other drivers will follow traffic laws. You trust that the produce you buy isn’t tainted or spoiled and that the cashier won’t steal your credit card information. You do your due diligence, and drive carefully, inspect the groceries and keep an eye on the cashier – but there’s still a degree of trust. 

Okay, enough soapboxing. 

So, there are three basic things to look out for. Eliminating companies that fall into any one of these categories will help you avoid the overwhelming majority of companies that might falsify earnings. 

The first one is actually pretty easy. Unless you’re an industry insider, or you personally know the CEO or board of directors, it’s generally a good idea to steer your portfolio away from companies that trade on the over the counter exchange, or on the pink sheets. These companies are easily spotted: they’ll have either .ob or .pk after their ticker. 

These companies are not as stringently regulated as companies traded on real exchanges like the NYSE, Nasdaq, AMEX, etc. In the case of the pink sheets, there’s virtually no regulation at all. On the OTC exchange, companies need to have current SEC filings, but there are no regulations on corporate governance, which is just a fancy way of saying that they don’t publicize if there’s any insider ownership of stock. 

Essentially, any earnings reports from a company on one of these exchanges are to be taken with many large grains of salt. There’s no way to know if the earnings are real. 

These companies can easily skyrocket in very short order, but share prices can fall just as quickly. If you must invest in one of these companies, don’t bet the farm. Invest only what you can afford to lose. 

The second way to know you can trust a company’s earnings is to study the business. If the company’s balance sheet is too complicated, or its quarterly report seems needlessly wordy and convoluted, it might be an indication that company is hiding something, or worse, that they don’t really understand their earnings either. You might remember how the insurance giant AIG (NYSE: AIG) got into trouble, but not really understand why. The details of credit-default swaps related to sub-prime mortgage securities are incredibly complicated. 

If it’s too complicated, odds are the market can’t figure it out either. AIG reported $110 billion in earnings in 2007 for earnings of over $6 billion. But in 2008 their earnings was an astounding -$99 billion. In retrospect, it’s pretty clear that they really didn’t know how much they were earning, and that all of their projections and reported earnings were inflated at best. 

And to be fair, this situation wasn’t exactly borne of malice. AIG legitimately didn’t know what was coming. But we can avoid similar situations by understanding the business. Look at a simple business like Coca-Cola (NYSE: KO). They make, distribute and sell soda. Their business is incredibly easy to understand, and their earnings reports make sense. 

If you buy companies that you understand, then it’s nearly impossible to get blindsided by an unforeseen calamity. 

I hate to beat a dead horse, but Enron is such a great example of a deceptive company. And they were good. They had lots of people fooled, and they employed an accounting firm in Arthur Anderson which at the time was almost beyond reproach. 

But there was one thing that just didn’t add up. For years, Enron’s wholesale division reported steady, slow growth of their earnings. By year end of 2000, they reported $1.4 billion. Enron sold gas and electricity – they were essentially a utility. 

Unless there is a huge population boom, utilities don’t grow their earnings very fast. But by the end of the third quarter in 2001, Enron reported earnings of $3.8 billion – nearly three times higher than the previous year, and 2001 wasn’t over yet! Even Enron’s corporate secretary, Paula Rieker later noted:

“The reason I say $3.8 billion is an alarming level is because the wholesale business portrayed by Mr. Lay, Mr. Skilling and others was steady predictable growth. And tripling of numbers from one year to next would have alarmed investors, in my view, of the types of risks they were taking.”