Annual reports good fiction reading

By DAVID MOON, Moon Capital Management, LLC
May 30, 2010

My wife and I dined recently with two other couples and we began a discussion about books we had recently read. Apparently my list was not exciting enough to suit one of our guests who, after describing the latest Stieg Larsson novel, practically attacked me asking, “Moon, don’t you read any fiction?”

Of course I do. They are called annual reports.

While many people can escape into the fantasy world of Mary Higgins Clark or a business autobiography (fiction, if there ever was any), I enjoy sitting down with the combined efforts of corporate accounting and marketing departments. Not that there is anything wrong with accounting or marketing departments, but we just have to be careful trying to ascribe too much short-term significance to their work product.

Particularly the accounting departments.

The marketing folks are the ones responsible for putting all of those smiling pictures of happy employees, customers and managers in the annual report. Or people who are supposed to be happy employees, customers and managers.

But behind all of the glossy pages, deep in the dry flat pages of the financial statements, a reader can find much more interesting - and sometimes difficult to understand - fiction.

Within reason, accountants can manipulate the reported quarterly earnings of a company. If the quarter is going fantastically, they can “save” some earnings for a rainy day when things aren’t as rosy.

If there has been an unexpected negative surprise at a company, they can always “borrow” some earnings from future quarters and try to make this quarter look as good as possible.

It is amazing how reactionary Wall Street is to earnings announcements. Wall Street anticipates a company’s earnings. The company does everything possible to hit the anticipated target. When the target is missed, the company is punished, even if the reason is a rational one.

Researchers at Boston University and Harvard discovered that most reported corporate earnings gather around three different targets: Wall Street’s expectations, the earnings from the last period and zero earnings.

In dynamic marketplaces with changing prices, costs and customer preferences, it is unlikely that real earnings would be as smooth and predictable as they appear to be. Until the recession of 2008, most large companies reported incredibly smooth earnings.

How can that be? Revenues are seldom smooth. Neither are costs. Stock prices, which ought to move in correlation to the earnings (and values) of the companies certainly aren’t smooth.

That’s the fun of this type of fiction reading. Yes, Coca Cola may have met its earnings estimate, but how much of the reported earnings were from the sale of discontinued operations? For years, banks have adjusted their loan loss reserves in order to “store” or “borrow” earnings from future periods. JP Morgan recently set aside enormous loan loss reserves – much more than they will likely need. Think of it as putting a little something away for a rainy day.

None of these examples is illegal, just misleading.

But it is nice beach reading.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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