Thursday, February 23, 2006

How to Beat the Quarter-Playing Mouse Olympics

A terrific link from Jeff Matthews reminds us of the dangers in following too closely the spectacle of earnings surprise.

Jeff Matthews

Though thankfully few companies suffer the corruption of Enron's management, all of us should remember that generally accepted accounting principles (GAAP) offer considerable flexibility to a management.

Analysts love to receive guidance and companies love to set the hurdles and expectations, to establish a game which a friend of mine describes it Mouse Olympics, a game where the hurdles are really low. Whispers from seemingly connected buyside clients, especially hedgies confirm or deny a company's ability to beat those expectations. IR types, or CFOs with whom one has a "great relationship" also contributes to establishing the expectations framework. Of course, analysts and managements would never violate Sarbanes-Oxley guidelines...consequently analysts become experts at reading facial expressions or body language or "how he sounds on the phone."

CNBC contributes to the charade by over-emphasizing whether or not the company beat the Street. Beating estimates by a penny requires only slight adjustments in certain estimates that a management must guess at every quarter. If you need a penny, you simply use a lighter pencil in your slightly breach briefly some principles of conservatism. Things will clarify over time and management can hone in on the real number toward year end.

The fact of the matter is that there is no REAL number when it comes to earnings! Accounting with its matching principles necessitates guesswork and estimates of accruals. Increasing complexity and a determination to establish everything at "fair market value" where no markets exist only adds to the confusion. Non-recurring charges appear regularly as estimates change and divisions are bought and sold.

What do we do as individual investors? Use Buffett principles rather than what CNBC, most managements, and much of Wall Street would like you to use.

Ask yourself about the competitive advantage that a business has. How durable is it? Will this business throw off cash flow or is it essentially a sinkhole for cash and management ambitions? What does the competitive landscape reveal? Is this a commodity business where you are as good as your worst competitor (once again, TY Warren!) Does this management treat you like a partner? In other words, does it return capital to you in the form of dividends and buybacks or is the business so good that the company can continue to reinvest its cash flows. How does the company treat its invested capital? Is the return respectable, well above the company's cost of capital, or would all of us be better off if someone merely rolled T-bills quarterly?

Put simply, it is difficult for us to get increasing value from our stock if management is not creating shareholder value. Shareholder value is, in my opinion, not created by earnings surprises, except for an evanescent moment where the hallelujah chorus of Wall Street ballyhoos the spasmodic "success." Shareholder value only comes from building a business that can generate cash in excess of its needs, and earn a return on its capital in excess of its cost.

FASB means flexibility and complexity. Cash pays payrolls, capex, and ultimately dividends. Which would you rather follow in measuring success?


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