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One of the golden rules for a value investor is to thoroughly understand the business you are investing your money into. A part of that involves the examination of the integrity of the managers.
And one of the indicators of their integrity is whether they have a penchant for manipulating profit numbers from one year to the next to perhaps “smooth” the rising trend, or to “match” or “exceed” expectations they had previous fed analyst.
All of this fiddling is wasteful of their time and their juniors’ time; and suggests less than honest communication of the reality of their business lives.
Profits can be lumpy, moving in fits and starts, even for companies with great long term prospects. And there might even be years of losses if negative surprise come out of the blue (e.g. Covid).
In aiming at what they perceive as a “respectable” (but mediocre) rise in earnings year on year many managers sacrifice higher returns for shareholders over a span of say a decade, as they limit risky big-payoff projects that on average would be good for shareholders, but would make the managers look bad when one or two go wrong, as they inevitably will.
Warren Buffett says that he and Charlie Munger, “prefer a lumpy 15% return to a smooth 12% return.” It’s a pity so many managers prefer the reverse – a fondness for a smooth 12% to a lumpy 15%.
So there are two problems with managers trying to “hit the numbers” they think desirable.
- Manipulation to boost profits
- Avoiding risk and lowering long run returns from high-paying but riskier opportunities
In his latest letter to Berkshire Hathaway shareholders Buffett launched a full-throated denunciation of managers who manipulate accounting numbers:
“Operating earnings figure[s]…can easily be manipulated by managers who wish to do so. Such tampering is often thought of as sophisticated by CEOs, directors and their advisors. Reporters and analysts embrace its existence as well. Beating “expectations” is heralded as a managerial triumph.
“That activity is disgusting. It requires no talent to manipulate numbers: Only a deep desire to deceive is required. “Bold imaginative accounting,” as a CEO once described his deception to me, has become one of the shames of capitalism.”
I recommend observing managers over a period of time (much of it using past statements, annual reports, videos as well as face to face meetings) to see whether they are the type of people who think manipulation is OK – say they throw in lots of “exceptional items” of the same nature every year. Restructuring is an old favourite – they “restructure” every year for 10 years while other managers are quite prepared to call that just normal business improvement expenditure to be written off as incurred.
Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk)
