Some time in my mid-teens, my dad had handed me a copy of Terry Smith’s Accounting for Growth, an exposé of how companies manipulate accounts to create the appearance of profit growth. Most of the specifics went over my head, but the main message stuck: corporate propaganda can be a million miles away from the underlying economic reality.
When Enron imploded in 2001, going from one of the world’s largest companies to the bankruptcy courts almost overnight, I (like the rest of the world) smelt a rat. So I dug out Enron’s annual 10-K report – a comprehensive summary of a public company’s financial performance, filed annually and required by the regulator.
Could you tell it was a wrong’un just from reading that report – what the company has to tell you, not what it wants to tell you?
Yes, you could!
Dad always bothered to read the small print, because “if it didn’t need to be there, it wouldn’t be.”
How many analysts and investors were reading these things at all, let alone properly? I was amazed how much information could be unlocked by a careful and skilled reading of these required financial disclosures. It was like finding the corner pieces of each company’s jigsaw.
Shortly after, I joined an accounting-based research firm where I learnt to read accounts properly and relished the chance to detect and unmask corporate obfuscation.
These lessons are critical to our approach to equity analysis at Ruffer today and help us avoid catching falling knives. For example, the sell-off in tech stocks in 2022 prompted us to look more closely at the sector in the hope of identifying a bargain. But almost all of the companies we looked at shared a common trait – the enormous use of stock-based compensation, where staff take a proportion of their compensation in newly issued stock.
Compensating staff this way is fine when the share price is rising. But it becomes a problem on the way down, when the same dollar amount of compensation requires the issuance of ever larger amounts of stock to staff, at the expense of other shareholders. Nevertheless, many companies report financial metrics which exclude this cost, in an attempt to distort the economic reality.