As I study for my Level I CFA Exam, I'm reading Financial Statement Analysis by Fridson and Alvarez. Everything I've written below is learned from them, but in my own words...this helps me to understand the information better. Thanks for your patience!
If you're a financial analyst, ploughing through voluminous balance sheets, income & cashflow statements, then you're likely looking for a few handholds. You need to know the key signs of what will be either a positive or oftentimes (in this market) negative analysis report.
One of the red flags that oftentimes preceeds failure to meet future earnings are unrealistic sales increases in the current and/or prior quarters. Oftentimes, managers will incent higher-then-expected sales increases in order to meet a bonus (especially if the bonus is based off Earnings-per-Share rather than shareholder equity). Look for these at the end of the quarterly reporting period. This practice, however, must be 'paid for' in the future, which will likely depress sales, thus further depressing earnings.
Another telltale sign of a company that is on a downward slippery slope is a senior executive resigning. Consider Wachovia Bank's removal of CEO Thompson back in June. This was after several writedowns, due to their deteriorating Option-Arm portfolio (which continues to erode shareholder equity). Additionally, senior execs may resign due to the pressure from the Board to meet quarterly numbers...they may know that this "GAAP-allowable" bending of the numbers may be the straw that breaks the camel's back...so they resign.
Further, and a bit more obvious, is an earnings restatement. Companies oftentimes, as a result of an audit, investigation by the SEC, or new accounting rules will restate their previous earnings even though they deemed those earnings allowable under GAAP standards. What starts to be one inquisitive question by a financial analyst may end up in an entire slew of earnings restatements, thus further eroding shareholder equity.
This one should be obvious, but oftentimes, to investors, it is the reverse. Managers of companies that have been pinpointed by analysts as reporting erroneous figures will often lash back vehemently with a defensive, almost formulaic, statement. They will say their accounting conforms to GAAP, they are meeting their goals, and other various and sundry chants. Consider Freddie Mac's recent statement that they are "well capitalised" even while Treasury Secretary Hank Paulson was working to get Congressional approval to use taxpayers funds to keep Freddie's stock price up by buying as much stock as necessary...and 'unlimited' use of funds! But, some people really are that gullible! Maybe it comes from our motivational speaker culture, us looking in the mirror and telling ourselves we really are that good...
Additionally, when a company delays their earnings reports, that would probably be a good time to short them. Or, at least buy a put or two.
Also, management can play the red herring logical fallacy. They can point to an independent auditor's stamp of approval on their earnings reports. While that can be a check and balance, a savvy investor should not let that satiate them entirely.
Lastly, an increase in working capital can be a bane to a company, but not recognized as such by investors. For instance, if I'm a clothing manufacturer, and I produce a new line of clothing that simply falls flat on its face, chances are that I don't want to write if off and incur a huge loss that quarter, highly increasing the chance I'll miss my quarterly numbers. So, I keep it in inventory, thus delaying the final writeoff...which has to come sooner or later. It costs to keep the product in inventory, this cost is part of my working capital. Alternatively, I could extend credit to non-creditworthy borrowers and delay the amount of time required to collect, extend their payment periods, thus delaying eventual collection. (Freddie Mac just extended their foreclosure procedure from 4 months to 10 months...) As a result, I'm carrying these costs longer, which drains shareholder equity because of the increased working capital.
Those are just a few red flags that should be detected by a knowledge-hungry analyst...not just one who likes to plug in numbers, but one who likes to ask "WHY?".
Friday, August 8, 2008
Thursday, August 7, 2008
The affects of a credit market on an investor
In this short essay, I present the thesis that our current credit market increases the desire for short term capital gains over gains from income derived of the assets purchased.
What do I mean by this?
I mean that the availability of credit increases the desire for leverage, which further increases the desire to "do deals" and acquire gains from thoses deals. This incentive to 'do deals', I believe, trumps or greatly truncates the desire to purchase an investment and receive gains from the productivity of that asset (i.e. purchasing retail stores and receiving quarterly sales profits).
A credit market increases the highs and the lows of the natural business/economic cycle. In a credit market, there are more eligible buyers. Hence, that means there is more demand. If the supply is constant, and the demand increases, the price increases. This means that the seller receives more gain on the asset they're selling.
Without a credit market, the buyers have to pay cash, or find another manner of exchange. (Note--there is never a total absence of credit...the seller, in this case, could always issue seller financing) If this is the case, without credit, then buyers are fewer and prices are lower...and subject to fewer fluctuations.
Given the above, in a credit market, with more eligible buyers; the more increasing the supply of credit is, the more increasing the buyers (and price) are. That being said, that gives the buyers more of an incentive to "flip" the assets by purchasing it, reconfiguring the furniture, and then selling it again on the open market.
If the buyer purchases the asset in an expanding credit market, there is a solid chance that he doesn't have to do anything to the asset but simply hold on to it while the credit expands. As long as credit expands, buyers expand, and the price rises; this increases his short term capital gains. (This assumes many aspects about the business remain constant, routine maintenance on the asset is done, etc.)
This, therefore, I believe, incents 'doing deals'. There is not the incentive to buy an asset and hold on to it, while receiving income from the productivity of that asset.
As a result, dealmakers arise by the number. Middlemen emerge. Note the abundance of people hopping into the realtor, mortgage broker, title & escrow market during the housing boom in recent years. Now note the absence of such people as delinquincies rise, fears mount, and people look elsewhere for work.
If one were to understand these cycles in credit markets, they would be able to benefit from an expanding credit policy as well as a contracting one. In the expanding policy, they would acquire cash, and in the contracting one, they could just as easily buyback their old assets for likely a price less than they bought it for in the first, with part of the cash acquired from selling those assets to the ones they sold it to in the first place...and they would have cash leftover for other acquisitions depending on whether credit is contracting or expanding.
I know it's not that simple, but it is a simple paradigm.
What do I mean by this?
I mean that the availability of credit increases the desire for leverage, which further increases the desire to "do deals" and acquire gains from thoses deals. This incentive to 'do deals', I believe, trumps or greatly truncates the desire to purchase an investment and receive gains from the productivity of that asset (i.e. purchasing retail stores and receiving quarterly sales profits).
A credit market increases the highs and the lows of the natural business/economic cycle. In a credit market, there are more eligible buyers. Hence, that means there is more demand. If the supply is constant, and the demand increases, the price increases. This means that the seller receives more gain on the asset they're selling.
Without a credit market, the buyers have to pay cash, or find another manner of exchange. (Note--there is never a total absence of credit...the seller, in this case, could always issue seller financing) If this is the case, without credit, then buyers are fewer and prices are lower...and subject to fewer fluctuations.
Given the above, in a credit market, with more eligible buyers; the more increasing the supply of credit is, the more increasing the buyers (and price) are. That being said, that gives the buyers more of an incentive to "flip" the assets by purchasing it, reconfiguring the furniture, and then selling it again on the open market.
If the buyer purchases the asset in an expanding credit market, there is a solid chance that he doesn't have to do anything to the asset but simply hold on to it while the credit expands. As long as credit expands, buyers expand, and the price rises; this increases his short term capital gains. (This assumes many aspects about the business remain constant, routine maintenance on the asset is done, etc.)
This, therefore, I believe, incents 'doing deals'. There is not the incentive to buy an asset and hold on to it, while receiving income from the productivity of that asset.
As a result, dealmakers arise by the number. Middlemen emerge. Note the abundance of people hopping into the realtor, mortgage broker, title & escrow market during the housing boom in recent years. Now note the absence of such people as delinquincies rise, fears mount, and people look elsewhere for work.
If one were to understand these cycles in credit markets, they would be able to benefit from an expanding credit policy as well as a contracting one. In the expanding policy, they would acquire cash, and in the contracting one, they could just as easily buyback their old assets for likely a price less than they bought it for in the first, with part of the cash acquired from selling those assets to the ones they sold it to in the first place...and they would have cash leftover for other acquisitions depending on whether credit is contracting or expanding.
I know it's not that simple, but it is a simple paradigm.
Wednesday, August 6, 2008
Delaying the Bottom
"Any propping up of shaky propositions postpones liquidation and aggravates unsound conditions." -Murray Rothbard
- "President Bush on Wednesday signed into law a sweeping housing bill that aims to boost the struggling housing market and bolster mortgage finance giants Fannie Mae and Freddie Mac." -CNN Money
- "[Treasury Secretary] Paulson is pushing Congress to authorize the Treasury to purchase equity stakes in Fannie Mae and Freddie Mac, which account for about half of the $12 trillion mortgage market, and expand government-backed credit lines to them." -Bloomberg
"The ultimate result of shielding man from the effects of folly is to people the world with fools." -Herbert Spencer
- "The Federal Reserve extended its emergency lending programs to Wall Street firms through January after policy makers judged that markets are still `fragile.' "-Bloomberg
- "The Federal Reserve extended its emergency lending programs to Wall Street firms through January after policy makers judged that markets are still `fragile.' Emphasizing the dangers to the economy, the Fed said in its statement that a substantial easing of interest rates in recent months, 'combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.' " -New York Times
"[It is] the most michievous doctrine ever broached in the monetary or banking world in this country; viz. that is the proper function of the Bank of England to keep money available at all times to supply the demands of bankers who have rendered their own [illiquid] assets unavailable." former 19th Century governer, Bank of England
- The British monetary authorities plan to inject liquidity into the country's banks as they seek to restore health to financial institutions battered by the credit crisis...the Bank of England will exchange [liquid] government bonds for [illiquid] mortgage-backed securities...The central bank will hold the illiquid mortgage assets as collateral. -International Herald Tribune
- The actions by the Fed and other central banks are expected to help banks and brokerages temporarily swap their [illiquid] mortgage-backed securities for [liquid] Treasury debt and possibly unclog credit markets, say analysts. -AFP
I wonder what history has to say about our current mortgage crisis?
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