Wednesday, June 30, 2010
Schilit and Perler, Financial Shenanigans
With Jeff Skilling (and now Richard Scrushy) back in the news it seems fitting to revisit the world of “creative” accounting. In fact, the third edition of Financial Shenanigans by Howard M. Schilit and Jeremy Perler (McGraw-Hill, 2010) starts with Enron. What were some telltale signs that Enron was engaged in a massive accounting fraud? The simplest was that Enron’s revenue growth (from under $10 billion to over $100 billion in five years) defied reality. Moreover, Enron’s profits never kept pace with its sales. For instance, while sales grew by more than 150% in 2000, profits increased by less than 10%. In the five-year period that witnessed the tenfold growth in sales, profits didn’t even double.
The authors outline a series of financial shenanigans that Enron engaged in, from recording revenue too soon and recording bogus revenue to cash flow antics—e.g., shifting financing cash inflows to the operating section and shifting normal operating cash outflows to the investing section. And we all remember the so-called key metrics shenanigans—showcasing misleading metrics that overstate performance and distorting balance sheet metrics to avoid showing deterioration. (p. 8)
In introducing some warning signs that even those unskilled in deciphering balance sheets can heed, the authors quote from a Warren Buffett annual letter. In it Buffett describes a conversation between a patient, whose X rays showed him to be seriously ill, and his doctor: “I can’t afford the operation, but would you accept a small payment to touch up the X rays?” Buffett continued, “In the long run . . . trouble awaits managements that paper over operating problems with accounting maneuvers. Eventually, managements of this kind achieve the same result as the seriously-ill patient.” (p. 23)
One way that companies fudge their books is by tinkering with time. It’s common practice for salesmen to push hard, often offering incentives to customers so they can meet or beat their quarterly quotas. But if this legal strategy doesn’t work, why not just extend the quarter? It seems that, among its many other sins, Computer Associates “regularly stretched out the last month of the quarter to as much as 35 days.” (p. 48) And Computer Associates was not alone in this practice. Both Sunbeam and Peregrine were known to keep their books open well past the official end of the quarter. At Peregrine this practice became something of a joke, with late transactions described as having been completed on “the thirty-seventh of December.” (p. 50)
Then there are those companies who book revenue prematurely, sometimes very prematurely. Krispy Kreme profited by selling donut-making equipment to its franchisees. But in 2003 the company entered the world of make-believe by “pretending to ship equipment to franchisees. It actually shipped the equipment out, but to company-owned trailers to which the franchisees had no access. Krispy Kreme still recorded the revenue, even though the franchisees had failed to take possession of the machines shipped.” (p. 63)
AIG was involved in bogus transactions long before the most recent financial crisis. They marketed a product known as finite insurance, sometimes used to paper over companies’ earnings shortfalls. In 1998 Brightpoint was coming up short by some $15 million in its December quarter. AIG had a “perfect world” solution. It created a $15 million retroactive insurance policy to cover Brightpoint’s unreported losses, which meant that Brightpoint could immediately book the $15 million as income (“insurance recovery”) and report in line with the guidance it had provided Wall Street at the beginning of the quarter. In turn, it paid “insurance premiums” to AIG over the next three years. As the authors note, “Economic sense dictates that this transaction was not an insurance contract because no real risk had been transferred. Indeed, the transaction was nothing more than a financing agreement.” (p. 77)
Financial Shenanigans is a fascinating book. In more than 300 pages it not only explains accounting ruses, it illustrates them with real-life examples. It shows how companies, even ostensibly reputable ones, try to hide their problems and how the savvy investor can ferret them out. It’s an ideal handbook for short sellers.
The authors outline a series of financial shenanigans that Enron engaged in, from recording revenue too soon and recording bogus revenue to cash flow antics—e.g., shifting financing cash inflows to the operating section and shifting normal operating cash outflows to the investing section. And we all remember the so-called key metrics shenanigans—showcasing misleading metrics that overstate performance and distorting balance sheet metrics to avoid showing deterioration. (p. 8)
In introducing some warning signs that even those unskilled in deciphering balance sheets can heed, the authors quote from a Warren Buffett annual letter. In it Buffett describes a conversation between a patient, whose X rays showed him to be seriously ill, and his doctor: “I can’t afford the operation, but would you accept a small payment to touch up the X rays?” Buffett continued, “In the long run . . . trouble awaits managements that paper over operating problems with accounting maneuvers. Eventually, managements of this kind achieve the same result as the seriously-ill patient.” (p. 23)
One way that companies fudge their books is by tinkering with time. It’s common practice for salesmen to push hard, often offering incentives to customers so they can meet or beat their quarterly quotas. But if this legal strategy doesn’t work, why not just extend the quarter? It seems that, among its many other sins, Computer Associates “regularly stretched out the last month of the quarter to as much as 35 days.” (p. 48) And Computer Associates was not alone in this practice. Both Sunbeam and Peregrine were known to keep their books open well past the official end of the quarter. At Peregrine this practice became something of a joke, with late transactions described as having been completed on “the thirty-seventh of December.” (p. 50)
Then there are those companies who book revenue prematurely, sometimes very prematurely. Krispy Kreme profited by selling donut-making equipment to its franchisees. But in 2003 the company entered the world of make-believe by “pretending to ship equipment to franchisees. It actually shipped the equipment out, but to company-owned trailers to which the franchisees had no access. Krispy Kreme still recorded the revenue, even though the franchisees had failed to take possession of the machines shipped.” (p. 63)
AIG was involved in bogus transactions long before the most recent financial crisis. They marketed a product known as finite insurance, sometimes used to paper over companies’ earnings shortfalls. In 1998 Brightpoint was coming up short by some $15 million in its December quarter. AIG had a “perfect world” solution. It created a $15 million retroactive insurance policy to cover Brightpoint’s unreported losses, which meant that Brightpoint could immediately book the $15 million as income (“insurance recovery”) and report in line with the guidance it had provided Wall Street at the beginning of the quarter. In turn, it paid “insurance premiums” to AIG over the next three years. As the authors note, “Economic sense dictates that this transaction was not an insurance contract because no real risk had been transferred. Indeed, the transaction was nothing more than a financing agreement.” (p. 77)
Financial Shenanigans is a fascinating book. In more than 300 pages it not only explains accounting ruses, it illustrates them with real-life examples. It shows how companies, even ostensibly reputable ones, try to hide their problems and how the savvy investor can ferret them out. It’s an ideal handbook for short sellers.
Tuesday, June 29, 2010
The growth curve of highly successful businesses
Since trading is a business, it makes sense to look at business management books now and again. David G. Thomson’s Mastering the 7 Essentials of High-Growth Companies: Effective Lessons to Grow Your Business (Wiley, 2010) doesn’t have a lot to offer the individual trader. But here’s an interesting takeaway.
More than 60% of the companies that went public in the last three decades no longer exist; 4% now have more than $1 billion in annual revenue. The highly successful 4% have a common growth curve. First, an entrepreneurial phase where an idea is transformed into a viable business model and growth is modest; the average length of this “runway” is five years. Second, an inflection point “where revenue breaks out into an exponential trajectory.” And, finally, variable growth rates to reach $1 billion in revenue.
Ratchet down the dollars, but the growth curve (or equity curve) of highly successful traders should be somewhat similar. Lots of time figuring out a personal style and an edge, honing the craft, and carving out modest profits. And then, with very careful money management, increasing size and letting the powers of compounding work their exponential magic.
But doesn’t this presume the best of all possible worlds? No, according to Thomson. A “bad” market environment is no excuse for a major drawdown in the equity curve. “America’s exponential-growth companies . . . have a consistent track record of growing through recessions.” (p. 23)
What separates the winners from the losers? Although almost all companies had passionate management teams, the failing companies, Thomson contends, demonstrated “blind passion—they never knew when to quit. . . . These teams fail to self-correct.” (p. 21) In brief, we’re back to the themes of flexibility, agility, nimbleness. Only traders who are flexible, who can self-correct, stand a chance of joining and staying in the top 4%.
More than 60% of the companies that went public in the last three decades no longer exist; 4% now have more than $1 billion in annual revenue. The highly successful 4% have a common growth curve. First, an entrepreneurial phase where an idea is transformed into a viable business model and growth is modest; the average length of this “runway” is five years. Second, an inflection point “where revenue breaks out into an exponential trajectory.” And, finally, variable growth rates to reach $1 billion in revenue.
Ratchet down the dollars, but the growth curve (or equity curve) of highly successful traders should be somewhat similar. Lots of time figuring out a personal style and an edge, honing the craft, and carving out modest profits. And then, with very careful money management, increasing size and letting the powers of compounding work their exponential magic.
But doesn’t this presume the best of all possible worlds? No, according to Thomson. A “bad” market environment is no excuse for a major drawdown in the equity curve. “America’s exponential-growth companies . . . have a consistent track record of growing through recessions.” (p. 23)
What separates the winners from the losers? Although almost all companies had passionate management teams, the failing companies, Thomson contends, demonstrated “blind passion—they never knew when to quit. . . . These teams fail to self-correct.” (p. 21) In brief, we’re back to the themes of flexibility, agility, nimbleness. Only traders who are flexible, who can self-correct, stand a chance of joining and staying in the top 4%.
Monday, June 28, 2010
Patel, Trading with Ichimoku Clouds
Ichimoku Kinko Hyo is billed as an extension, perhaps even an evolution, of candlestick charting. I personally have never used it, so I approached Manesh Patel’s Trading with Ichimoku Clouds (Wiley, 2010) as a humble yet always skeptical novice. Since Ichimoku clouds are a price overlay, they clutter charts. Is the clutter worth it?
To enlighten my fellow novices here’s Ichimoku in a nutshell, extracted from Patel’s book. The system is made up of five components: (1) the 9-period average of (highest high + lowest low)/2; (2) the 26-period average of the same formula; (3) the current price shifted back 26 periods; (4) (formula 1 + formula 2)/2 shifted forward in time 26 periods; and (5) the 52-period average of (highest high + highest low)/2 shifted forward by 26 periods. The fourth and fifth indicators combine to make up the Kumo cloud.
The clouds are indications of current and future sentiment and the strength of that sentiment. They also provide support and resistance levels.
In the longest chapter of the book, complete with 135 TradeStation charts, Patel takes the reader through a two-year backtest of trading the EUR/USD cross following a set of bullish and bearish entry and money management rules. There were a total of eight trades. Although the system was profitable, it had a poor risk to reward ratio: the entry risk was 2,249 and the profit was 1,507, not exactly ideal. So Patel shows how one could optimize the strategy.
Patel rounds out his discussion by looking at other Ichimoku strategies (mainly crossovers and breakouts) and time elements in Ichimoku. Patel admits that he uses Gann’s time elements instead of Ichimoku’s.
For anyone interested in Ichimoku trading, this book sets out guiding principles that the systems trader could test, modify, meld into another system—the opportunities are, as always, seemingly infinite. With practice the Kumo clouds might offer up some insights to the discretionary trader as well. I admit I remained unconvinced, but for me this is primarily a question of style.
Perhaps I’m unconvinced in part because Patel has written such a refreshingly honest book. He could easily have cherrypicked his trade to make the strategy look like the holy grail. Instead, he offered up a profitable yet possibly flawed strategy (the sample size was too small to determine whether it was in fact flawed). He’s clearly not trying to sell snake oil.
To enlighten my fellow novices here’s Ichimoku in a nutshell, extracted from Patel’s book. The system is made up of five components: (1) the 9-period average of (highest high + lowest low)/2; (2) the 26-period average of the same formula; (3) the current price shifted back 26 periods; (4) (formula 1 + formula 2)/2 shifted forward in time 26 periods; and (5) the 52-period average of (highest high + highest low)/2 shifted forward by 26 periods. The fourth and fifth indicators combine to make up the Kumo cloud.
The clouds are indications of current and future sentiment and the strength of that sentiment. They also provide support and resistance levels.
In the longest chapter of the book, complete with 135 TradeStation charts, Patel takes the reader through a two-year backtest of trading the EUR/USD cross following a set of bullish and bearish entry and money management rules. There were a total of eight trades. Although the system was profitable, it had a poor risk to reward ratio: the entry risk was 2,249 and the profit was 1,507, not exactly ideal. So Patel shows how one could optimize the strategy.
Patel rounds out his discussion by looking at other Ichimoku strategies (mainly crossovers and breakouts) and time elements in Ichimoku. Patel admits that he uses Gann’s time elements instead of Ichimoku’s.
For anyone interested in Ichimoku trading, this book sets out guiding principles that the systems trader could test, modify, meld into another system—the opportunities are, as always, seemingly infinite. With practice the Kumo clouds might offer up some insights to the discretionary trader as well. I admit I remained unconvinced, but for me this is primarily a question of style.
Perhaps I’m unconvinced in part because Patel has written such a refreshingly honest book. He could easily have cherrypicked his trade to make the strategy look like the holy grail. Instead, he offered up a profitable yet possibly flawed strategy (the sample size was too small to determine whether it was in fact flawed). He’s clearly not trying to sell snake oil.
Sunday, June 27, 2010
Amazon links
At the request of a reader I’m going to start including links to Amazon in my book reviews. I want to assure everyone that I am doing this for my readers’ convenience, not as part of a get rich quick scheme. The non-mandatory disclosure: I get a 4% referral fee when people go to Amazon via a link on my blog and buy something there. Alas, my own Amazon purchases are excluded.
.jpg)
Saturday, June 26, 2010
The bee’s knees
For those of you who have watched the ubiquitous Geico ads (and perhaps have a soft spot for them since, after all, Geico is a subsidiary of Berkshire Hathaway), here is a pedantic footnote. What in the world does the rightfully rejected ad phrase “It’s the bee’s knees” mean?
The folks at phrases.org (UK) help us out. Start with the basic meaning of “excellent—the highest quality.” But then dig deeper, going on a trip to New Zealand, Zane Grey’s rural America, and the roaring 20s.
And perhaps then you’ll decide that I’m writing pollywoppus.
The folks at phrases.org (UK) help us out. Start with the basic meaning of “excellent—the highest quality.” But then dig deeper, going on a trip to New Zealand, Zane Grey’s rural America, and the roaring 20s.
And perhaps then you’ll decide that I’m writing pollywoppus.
Subscribe to:
Posts (Atom)
Posts
