Author and keynote speaker at the CLSA conference, Howard Schilit has strong views and is much in demand these days. An expert at spotting accounting shenanigans, his Centre for Financial Research & Analysis is now lock in step with the mood of the times post-Enron.
What role should analysts have in interpreting company accounts?
They should have a big role. They should be able to understand how to detect unusual changes in patterns in company accounts; and then know how to ask the right questions to management to try and determine whether something good or bad has occurred. So analysts can play a vital role in helping investors.
Do you think the quality of analysts today in the US is as high as it was in the 1970s and 1980s?
It is hard to make a sweeping statement that things are better or worse, but I can say that things could and should be a lot better. That's ignoring the issue of conflict of interest.
There's just not a lot of time being spent by analysts digging through financial reports, and management can dress up results in a way that portrays them in a very favourable light.
How do you draw the line between creative accounting and outright fraud?
I don't know where that line is. Our organization has written reports on over 1000 companies since 1994, and many have included some of the biggest accounting frauds of the period; and at the times I was writing the report I did not know it was going to be a big fraud.
That's not a particularly important distinction to make - let me explain a little. If I find signs that a company is having an operational problem, for example, I looked at a retailer called Rite Aid, where I found an unusual pattern in their inventory. It turned out to be a fraud [the profits were inflated by half a billion dollars]. But lets say that it did turn out that it was not a fraud, and the company was quite simply having some serious problems with their business. In either case, the stock would have behaved very badly and the investor would have lost a lot of money. If the stock dropped 50% because there is a serious deterioration in the business and an analyst didn't detect that, or if that same stock dropped 50% because the analyst did not detect a fraud, the investor gets hurt just as badly.
In fact, there are many more occasions where an investor will be hurt - not as a result of a fraud - but because they have not spotted early enough an operational deterioration in the business.
But I guess what I am getting at is if it is fraud the management will be held legally accountable, whereas there may be no punishment for creative accounting.
It depends. If the financial presentation distorts the underlying performance of the company, then even if the company is technically in compliance with all of the [accountancy] laws, the company could be subject to lawsuits under the Securities Act. Again, finding where that line is - particularly in today's world - is tough. But if a company is in violation of the rules of fair play, whether its violating the law or not, there will be a lawsuit, the stock will drop dramatically and senior management is going to have to pay.
The world has changed in a demonstrable way. If you are now doing something that distorts the underlying financial presentation, something very bad is going to happen to the stock price; and management is going to suffer along with the investors.
What sort of role should auditors have in this process? Should they be doing more smell tests on the validity of accounts?
The auditors really should be the buffer, protecting investors against management doing things that are improper. Sadly, the auditors don't always do their job properly or well, and if they have a consultancy relationship they will stand up for management interests. That's probably the saddest development of the last decade. Auditors have not been the friends of the investors. Indeed, rather than being part of the solution, the auditors are part of the problem.
In the wake of Enron, is that going to change?
No. Arthur Andersen could likely disappear, but then you are left with four large firms that are more powerful, more intransigent and if anything, the situation may be worse. Those four firms won the lottery - they got Andersen's clients; and nobody is asking questions about their behaviour. I don't think the behaviour of the other four is markedly better. So are things better? No, things are probably going to be worse.
What would keep the auditors honest?
In a broader sense, I am optimistic that investors will be better off in the wake of Enron. The reason is simple. There is a level of anger I have never seen before. There is the beginning of a grassroots movement where they are saying, I'm mad as hell and I'm not going to take this anymore. If you look at the stock prices of the companies that have been perceived as the most aggressive, those stock prices have been hit the hardest. Investors are collectively saying, we are not going to invest in companies we don't trust.
So the auditors are not necessarily involved in solving the problem. The shareholders have been empowered themselves, and corporate governance professionals are being listened to ever before.
The behaviour of senior executives at these more aggressive companies will change when they see that investors are not interested in them anymore.
In a longwinded way, I am saying the rules have changed. Under the old rules, the companies that won and the executives that got the biggest payout, were the most aggressive companies, such as Global Crossing, MCI-Worldcom, Enron. Those were the companies that won the game. The stock did the best, and the senior executives got the biggest stock options.
Under the new rules, the most aggressive companies are the ones that are losing. So what's going to solve the problem? The executives don't like to lose. These guys like to win. They want positive stories written in the media and they want their stock to do well.
Do you have a sense that, as in 1929, the US government is going to intervene to clean things up via regulations?
Absolutely not. There were at least a dozen different congressional committees and a dozen pieces of legislation proposed, and I don't think any significant governmental regulations will arise.
The solution is changing the behaviour of senior management and what will change their behaviour is the fact that there stock price will be out of favour if they continue to behave the way they did in the past.
Market dynamics may work in the short term, but do you not feel that over the long term - when the bull market return - that investors will forget all about Enron and return to the same behaviour as before?
You hit it really on the head when you talk about the bull market. Perhaps the most important element related to the Enron saga is the bull market ended. If this had played out three years earlier it would have been a teflon story, and the bad news would have bounced off. We had a major fraud with Cendant in 1998, were over $3 billion was paid out to settle. Were there Congressional hearings? No. In fact, the CEO of that company is still the CEO today, and the stock has more than doubled in the last 18 months.
I think the fact that investors had lost so much money over the past two years. The indices will drop for three straight years - we haven't seen anything like this in over 50 years. This has been why Enron has become such a big issue. Investors are angry that they have lost so much money with the end of the bull market.
But a bull market will return, and if companies go back to bad behaviour, and investors' vigilance drops, can we go back to a situation where there will be very aggressive accounting?
Absolutely. The pendulum swings back and forth. Even if there were new laws, it won't change the fact that there will be different attitudes at different points of time. The thing that will solve the problem today is market forces, but I am not suggesting it will be a permanent solution.
So when you address the Asian companies at the CLSA conference, what will be the message you convey?
The message is: we have to understand that financial reports are people communicating information to people. It is understanding the human dynamics. Accounting tricks that we've studied in US and European companies, have a universal characteristic - they are driven by greed and fear. While our organization has not yet begun looking at Asian companies - we are launching that service in the second half of the year - it would be absolutely shocking if we didn't find the same type of human characteristics. So I will be talking to the audience one should expect these companies to use, and what are some of the techniques that we've pioneered for our detection of these.
Given Asia has quite a large number of conglomerates, what would be the most popular accounting trick to use in this type of company?
A conglomerate is simply a series of different types of business operations, many of which have little to do with one another. Many of the businesses are low growth and in order to increase the size of the business, they are very often acquisitive. When companies are growing by acquisition, what are the accounting tricks? One is they tend to write off assets at the time of the deal, and one trick is to then remove normal operating expenses that would be reflected on future statements of income; also they could create reserves, which can be released as income at a later period. Those are among the most common accounting tricks you would see in conglomerates.
What's your view on the 'smoothing' of earnings?
Smoothing is a problem. A comment I often hear, is "Well, investors like smooth predictable earnings". I say , you're correct, but only if that is how the company's business has been performing. Investors would not be happy if they learned a company's business is generating uneven, jerky earnings, but the company artificially smooths those.
An investor wants to know when a company is having good times, when the business is starting to struggle, when the business is hitting a very bad period. We need to know that in order to make the right decisions.
Do many companies smooth?
Absolutely.
When is it a big deal
It's a big deal if the smoothing process changes the storyline. If, for example, the company has three or four different business lines and each of those is fundamentally healthy, and the company uses a smoothing technique to eliminate uneven-ness. That does not particularly concern me. In contrast, if a company is experiencing difficulty in one or more of those operating units and the smoothing technique camouflages that problem, then you are changing the storyline.
How do you figure out if a company is abusing derivatives?
If a company is not marking the value properly to the market value or if a company is marking it one direction and not another - ie not reporting negative results.
Will some companies keep derivatives off balance sheet?
Attempts to push bad information off the balance sheet is a whole other area of accounting tricks. A large part of the Enron fiasco was the creation of a structure to keep bad news off of the balance sheet.
One thing our analysts will regularly do when we interview management is ask the question: are there any obligations or liabilities that are not consolidated. So the fact that something is not on the balance sheet, or the fact that a company has certain interests that are not consolidated, doesn't preclude you as an analyst from asking the simple question: "Is this all the contingent liabilities the company has?'
Would a company management lie to this question too?
My experience is that if you ask the right question, companies will generally not reply with a bald-faced lie. Companies are very skilful at selective disclosure. They are not going to lie, but they'll give you only a half-truth.
Let me give you an example. A company may have taken a restructruring charge. They say they are laying off a thousand people and there's a $20 million charge. One quarter later, you could interview management and you could ask them how much of that $20 million remains on the books. They'll answer that question, and let's say there is $6 million remaining. The next question they don't like to answer. And that is: did any of that $14 million that was used up, did any of that hit income this period; was any of it get released into earnings. They don't disclose that in the financials. And if you don't ask that question you'll never know.
They're not going to say it did not hit income, if it did. If they say they don't disclose that information, then they're really answering the question. If the answer was 'No, none of it did' they would have said that.
Where some analysts are not as experienced and not as skilful is in the process of asking good questions.
Has the whole process of earnings guidance, analyst consensus forecasts and so forth, become a bit of a game?
The quarterly consensus that Wall Street gives and then management knowing what that consensus is, has created enormous pressure and enormous focus on short term performance. Who is at fault? Everybody is at fault. The Wall Street analyst have created a pressure whereby management know if they disappoint then the stock is going to perform very badly.
Do investors need that sort of guidance?
No.
So if tomorrow those recommendations disappeared, would that make any difference?
The best investors are the ones that don't invest on a quarter to quarter basis, the best managers don't run a company on a quarter to quarter basis. Warren Buffett would not care one bit if any of the companies he invested in, decided tomorrow to eliminate any of these short term projections.
A generation ago, companies didn't come out with short term targets. Can we wake up tomorrow and go back to that. Probably not. We have to live in the world we live in and consensus estimates will be around in the future.
Management just has to be honest. Some periods the consensus is going to be right and some times it will not. If I can put myself in the position of a CEO of a company, I'd like to have an investor base that looked at us as a long term decisionmaker, making sensible decisions and trying to grow the business. I would do everything in my power to discourage investors who have a very short term horizon.
There's an excellent book called the Loyalty Effect', and it is a study of the most successful businesses. Those businesses don't look at themselves based on normal measures of profitability. They look at three factors: striving to have zero turnover in employees, zero turnover in customers, and zero turnover in investors. Wall Street's quarterly earning forecast won't matter, because my investor base won't care about that.
You want to have investors who have a similar philosophy to you - and that is, we're not in this to manage the business for results on June 30th. Because if you do, it will invariably lead to bad decisions, and also trying to push a sale into the last week of June, or invariably pushing against some very aggressive accounting.
I like to invest in companies that say, we're in no rush. We're going to hire the right people, build the right infrastructure and find customers and investors who share the same vision. There are great companies like that.
Is it Wall Street's job to produce analysts who can expose Enron-type situations?
Yes, the role of anybody who is giving advice to investors is foremost to do their homework, and understand whether a company is healthy or not, and whether management is honest or not, and convey their conclusions without any other conflicts.
If this were not the role, then those analysts are nothing more than part of the public relations department of that company. I hope that's never going to be the case.
Do you think investors will ever be prepared to pay for research?
Investors would love to be able to write out a cheque for the research services they find give them the greatest value.
You want to know a little secret that's how it used to be done. Sellside research was something you paid for. Today, it's something that nobody pays for.
