A Question to Investors: Who is Failing Us?

I am beyond sick of reading about the sub-prime mortgage mess, "hidden" losses emerging from Wall Street balance sheets and CEOs being ousted for poor risk management. We find ourselves with a market environment that is very uncertain, so much so that every day seems to bring a new revelation about losses to be realized or firms on the brink of a liquidity crisis. And we can talk for days about the factors that got us to this point.  But the bottom line, IMHO: it's about bad governance. All the problems that have been written about are tangential to this basic fact. And if there are two items related to governance that have most profoundly failed investors, I believe they are weak accounting practices and poor investor relations practices. And the problem is that these two items are actually quite closely related, and both relate to a simple and unimpeachable fact: investors often get bad information. And this has got to stop. Now. And corporate Boards of Directors and their senior management charges are the primary vehicles for change. If they can rise to the challenge.

Weak Accounting Practices or "How Real Are Those Earnings?" or "Can I Bank on That Shareholders' Equity?"

Let's face it - this is not a new issue. Accounting shenanigans have been around as long as dual-entry bookkeeping itself. Cookie-jar reserves. Earnings smoothing. Off-balance sheet transactions for financial statement presentation purposes. And every time the accounting rule-making bodies move to change a rule the lobbyists crank into gear, the comment periods stretch out interminably and the eventual change is either so watered down that is has little value (i.e., accounting for employee stock options) or so out-of-touch with actual business practices that the change does more harm then good (i.e., hedge accounting rules). Didn't we think that Enron-type off-balance sheet deals were done for (meaning deals that shifted assets from the balance sheet without true shifting of risks)? Think again. And while deals like these (off-balance sheet deals but with recourse if certain events come to pass, i.e., an inability to re-market auction-rate commercial paper) certainly impact the balance sheet, they also impact the income statement as well. Just look at Citigroup and Merrill. Running a massive carry trade until - whoops - liquidity goes away and that nice income stream you were booking as income turns into billions of mark-to-market losses overnight.

So who's to blame? Wimpy accounting rule-makers? Congress, who also can weigh in on such issues? Game-playing corporate managements who want to protect their own bonuses? Corporate Boards who should be watching this stuff but are likely long on other commitments and short on meaningful domain expertise? How about investors themselves for not being more critical and demanding answers to opaque financial disclosures before buying the shares? There is more than enough blame to go around. And there's nowhere to hide. The information investors are getting is often-times very poor, either because disclosures are intentionally vague or because active steps were taken to present the financial picture in a way other than the way it is from an operating perspective (i.e., certain sale-leaseback and asset defeasance transactions). And this sucks.

Poor Investor Relations Practices or "What is the MD&A Really Saying" or "Where is my Quarterly Earnings Guidance?"

The way I see it, most of the stuff coming out of corporate investor relations departments is pure drivel. Puffed-up press releases. Milquetoast, vacuous commentary by the CEO and/or CFO as it relates to the Company's prospects. Many companies' emphasis on earnings guidance, and the associated warnings and alerts that go with it. Quite frankly, it insults a thinking investor's intelligence and wastes a ton of corporate resources keeping up this charade. I've got a really new and innovative idea: how about being really, really clear about Management's strategy and plans, risks to these plans and mitigants that will be employed, and articulation of a medium and long-term strategy against which Management's efficacy can be measured? I'm not talking about giving away the formula to Coke; I'm talking about straight communication that is deserved by the owners of the company. All owners - and no favoritism (though I think Reg FD did a decent job of addressing that issue). And drop earnings guidance; it is completely worthless and foments the idiotic short-term thinking that both destroys shareholder value through perverse decision-making and enables Management to avoid a more substantive discussion of the issues.

And who is at fault? Everybody. Boards who favor "stealth" (yeah, like so much is really out of view today) over clarity. Managements who would rather sidestep the hard questions and tap dance when necessary. Investors who put money in companies that don't communicate well and serve to perpetuate the bad behaviors that have gone on for decades. No more! Get clear. Get substantial. Get real. Few words. Fewer releases. Greater substance. This isn't rocket science. It's just good leadership.

In Quest of Good Information

So where do we need to get good information from?

Company financial statements. Enough will all the off-balance sheet stuff. If it is a legitimate partnership that shouldn't be consolidated, ok. But all of the money that is spent pushing stuff off the books just to make things look better? Pure corporate waste and greed. And analysts shouldn't have to adjust for all of these hair-brained transactions, and it isn't like there is always enough information to properly adjust even if they wanted to. Management's need to stop doing this and Boards need to enforce a policy of simplicity and economic clarity. And investors need to use their brains and their wallets to reward companies that act in this manner.

Company Managements. Investors need straight talk. Talk about strategies. Long-term goals. Steps that will be taken. Markets to be entered and relevant time frames. Stuff that investors can analyze in order to make their own determination of value. Enough with the emphasis on earnings guidance. Managements live in fear of these figures and are highly motivated to do things to hit these numbers. This does not make for value-creating decision-making. The calculus of Management incentives needs to change. A focus on long-term value creation, not short-term EPS attainment. And investors need to accept this new paradigm and to focus on doing good analyst work with better information, not merely trying to read Management's voice inflection and sweat glands on the earnings call.

The Internet. There is a wealth of valuable information out there that can be found in places other than SEC filings, earnings releases and mainstream media. Customers talk. Suppliers talk. Employees from other companies talk. Lots of good stuff that can be used to augment one's investment mosaic. The world has changed and information has changed along with it, and if an investor is closed off to all the new media that is available then they will be at a distinct disadvantage to those who take a more enlightened, technology-enabled perspective.

So that's it. With some eminently doable changes in corporate governance investors should be able to get much better information than they are getting today. And this would bode well for the markets. And we as investors can play our part to demand the kinds of changes I've proposed. Let's make it happen.

Comments

[Agoracom]

Roger, I firmly believe that our quarterly reporting system has a lot to do with pressures that lead to poor governance.

How can anybody properly operate and grow a company on a quarterly basis? By the time you are done reporting on the previous quarter, you are already half-way into the next quarter.

I know that my business would suffer if I had to operate, report and grow on a quarterly basis in front of the entire world. As a private company, I can choose to take a hit this quarter by spending extra money and resources on initiatives that will provide great growth in 2-4 quarters. As a public company, I couldn't make those decisions without taking a beating in the markets and losing my job.

I think quarterly reporting was appropriate in the days of old when information flow was fast as a glacier - but does anybody believe we actually need quarterly reporting today? Between press releases, financial blogs, blogs of those with domain knowledge and all of the other information sources out there, there isn't much a company does that we don't already know.

Moreover, companies are bigger, faster and more complex than ever. How can we expect them to weigh their options, make decisions and execute on a quarterly basis? Is it any wonder companies are fudging their numbers?

Don't get me wrong, lying is lying and you can't blame the game if you choose to accept the rules in the first place. However, quarterly reporting and its pressures require skills and intelligence on levels that fewer and fewer people can deliver...let alone enough people to manage 10's of thousands of public companies.

As such, do we now start thinking about moving to reporting every 6 months? H1 and Annual vs, Q1, Q2, Q3 and Annual?

Personally, I don't care about a company that can grow each and every quarter. I much prefer a company that makes decisions that deliver long-term growth at the expense of quarterly results.

Regards,
George

[Andy Mayo]

Bad information serves executives who know they have only a short time to make their bundle before they lose their place at the top. When you get a multi-million dollar exit package, why worry about the risks you're taking with the shareholder's money? Cover them up long enough to get your payday and be happy. Until boards make executives accountable -- financially -- investors will get keep getting garbage as information.

[eric]

The problem with exposing a company's short and long term strategy is that your competitors get to read it too.

[VennData]

Hopefully Chinese and Middle Eastern SWF's will enforce a new level of transparency upon the highly-compensated individuals doing such a bang up job on the risk side of things... or maybe not.

[Dave Iverson]

"And who is at fault? Everybody." Boards. Managements. Investors. Auditors. the Press. Gov. Overseers (e.g. Congress, the Administration, Gov. agencies, the Fed). Yes indeed!

And maybe, finally the shit has hit the fan in a big enough way that people will demand change -- eventually after enough pain has been felt by enough people -- as they did after the mess that began in the eurphoria of the 1920s and ended with the mess of the 1930s.

Only after a big-enough mess will the corruption within the various, connected systems be dealt with and cleaned up. Yes: Good governance is needed from within (corporations) and from without (government, press, academia).

After the cleansing, if and when we get such, we can once again expect honesty from corporations and gov agencies who will be trying hard to win back the respect they have squandered during what Joseph Stiglitz has rightfully called "looting" -- the "main play" of the recent-past era (assuming that it began to end in August (and continued to end this week)).

[Dave]

I understand your argument, but there are two obvious problems with it: (1) lawyers loathe transparency and so approve only the most obfuscatory prose, and (2) company executives do not know how to communicate clearly and concisely because it is a skill that few learn in either college or business school/grad school.

To accomplish what you suggest would require that (1) the malign influence of lawyers on communication cease and (2) business executives learn oratorical and prose skills.

Neither of these are going to come to pass.

[Tom]

Two comments:

First, I don't really see retail investors getting detailed information from companies, even at the threat of boycots. (Yeah, that would hurt.) So we would have to put that role on institutionals or (better?) hedge funds. Would that work? Maybe.

Second, the problem with straight talk and information flowing around is litigation. I'd guess part of the opaqueness comes from prudence.