Common Tricks Used To Disguise Earnings

Here are some common tricks use to distort or disguise real earnings performance and how the truth is buried in the financial statements.

The Pro-Forma Pretense:

When two companies merge, a "pro-forma" or "as if" financial statements are issued. The aim is to give investors with an idea of what the merged entity's financial numbers will look like - as if it had been operating as one. In the 1990s, pro-forma statements became a favorite tool of companies to obscure shaky finances. It is especially a popular for the high-tech companies as they discovered that using pro-forma earnings announcements could allow them to selectively exclude many types of expenses that reduce earnings to cover up the fact that they had little or no earnings as defined by GAAP. Other companies in many other industries soon followed suit.

Because pro-forma earnings by its very nature are not GAAP-compliant, few rules dictated what went in, or what stayed out, of a pro-forma statement. But with the passage of Sarbanes-Oxley corporate reform law, the law dictates that all pro-forma earnings must be reconciled to the most directly comparable GAAP financial measure. Some companies excluded restructuring costs under the excuse that they were "unusual" or not part of the company's core operations. Other left out depreciation and amortization expenses, and yet others excluded interest and tax payments. So when a company announces pro-forma earnings, make sure you keep reading until you get to the GAAP number, which you can then see if there're indeed any ugly details that pro-forma excludes.

If used properly, pro-forma numbers can make sense as to which really are unusual and which ain't. But some companies went to ridiculous extent. Take the case of SEC case brought against Trump Hotels & Casino Resorts in January 2002. This case highlights how far companies had bent the rules to get investors to focus on pro-forma results. In October 1999, the company issued a press release announcing the third-quarter pro-forma net income of $14 million, and touted that its positive operating result had beaten analysts' expectations. The release also made clear that the pro-forma results excluded a one-time charge of $81.4 million from closing down a hotel and casino in Atlantic City. But the release did not state that the pro-forma earnings included a $17.2 million, one-time gain, which was the result of some termination of lease. The company had simply chosen to include its pro-forma calculation a one-time event that made its earnings rosier, while selectively excluded a much larger charge that would have made earnings look anemic. Next time you see a pro-forma earnings, be sure you know the assumptions behind the numbers. Read the entire press release and don't jump to conclusions based on a headline. Companies usually want you to focus on the headline and ignore the details so that you won't get to the ugly truth.

The Big Bath:

When companies restructure by selling unprofitable units, laying off workers, or closing production facilities, they often take a one-time charge that bundles the costs of the restructuring. Inherently, there's nothing wrong as long as the management views restructuring charges as a last resort to boost efficiency and restore profitability by writing off only those expenses that directly relate to the restructuring. But some companies use restructuring exercises like a cemetery - to bury all kinds of everyday operating expenses - to clean up its balance sheet. By taking "one big bath" in a single year, companies can pretty up an otherwise desultory earnings into better earnings in the future years. Why would companies want to take restructuring charges that overstate costs even though that makes losses look worse? Because managers and analysts have convinced investors and Wall Street to that one-time loss doesn't matter and look to future earnings. Once Wall Street is convinced, the analysts will tell you that a restructuring charge is all about the past and that it matters little, or nothing, to the company's future prospect. For companies, the beauty of restructuring is that they can front-load several years of expected future expenses into one big package which allows the company to boost future earnings by not offsetting income-producing activities with their associated expenses. Investors who ignore big bath accounting is ignoring at their own perils. Investors should dig out the underlying reasons for the write-off, which may be a signal to sell.

Cookie Jars and Channel Stuffing:

Warren Buffett warns us companies that cannot make the numbers may eventually chose to make up the numbers. Companies can deceive investors with a number of accounting shenanigans. Two of the more common tricks are called "cookie-jar reserves" and "channel stuffing."

• Cookie-jar reserving or accounting occurs when a company intentionally overestimates future liabilities for items such as loan losses (for banks), warranty costs, loss and loss adjustment expenses (for insurance), or sales returns. By doing so, a company can stash money in cookie jars during good times and reach for them when needed in bad times.

• Channel stuffing is the business practice where a company inflates its sales figures by stuffing or forcing more products through a distribution channel and thus loading the channel with more than it is capable of selling. To entice customers to load up with more than they really need, the company often offers discounts, below-market financing, extension of payment terms, or easing of return policy. While such hurry-up sales rob revenue from future quarters, they help cover up a bad quarter so that management can boast that it met analysts' estimates.

Channel stuffing are not without its consequences, by easing the selling policy of the company, the potential for higher default in payments, or return of sales, increases. Besides, it is illegal. In May 2001, Sunbeam Corp. (now part of Jarden Corp.) is alleged by the SEC that the company used both methods in a fraudulent attempt to trick the market into believing that the company was worth more than it really was. According to the allegation, Albert Dunlap, the former CEO and Chairman, was hired by Sunbeam's board in 1996 to restructure the ailing company. As a so-called turnaround specialist, Dunlap set to reorganize the company and promise shareholders quick results. After taking a restructuring charge and reporting huge losses for 1996 - which Dunlap was able to blame on the previous management - the company then reported a record profit of $189 million from continuing operations. But the SEC alleged that the feat was achieved in part by reaching into the cookie jar that was reserved in 1996. In addition, the company is alleged that the record profit was achieved at the expense of future results by inducing customers to buy merchandise they didn't need. Sunbeam had used a scam called "bill and hold," in which it recorded the sale of merchandise but held them in its own warehouses because the customers didn't yet need, or didn't want, the goods. Under GAAP, a bona fide sale takes place only when the customer takes possession of the goods or requests that they be stored. Of that $189 million, the SEC alleged that at least $60 million came from accounting fraud. Because Sunbeam robbed from future results in 1997, it became increasingly desperate to make its numbers in 1998, and was forced to repeat its sins. This time not only did Sunbeam engaged in channel stuffing, but it also deleted certain records to conceal pending returns of merchandise. Now only the sales, and not the returns, appeared on the books. Such case is not unique to Sunbeam, larger companies like Bristol Myers Squibb also engaged in such alleged frauds, though not to the extent of destroying records. In the end, both cases were settled with the SEC without admitting or denying the allegations - which seems a commonality.

There are other ways companies can cook their revenue books by recognizing revenue before the service or product is delivered. For example, a company may sell computers along with a five-year servicing contract along. Under GAAP rules, the service contract must be spread evenly over 5 years as the company "earns" it, or 20% of the service contract value each year. The computer sales however must be recognized immediately once it is delivered. But when the computer and the service contract are sold together for a single "package" price, separating the components can be subject to manipulation. Booking revenues prematurely results in inflated sales figures and misrepresents earnings result - in fact it is similar to "robbing Peter to pay Paul" when companies rob revenues from future periods and recognize it in the current period.

Write-downs and Reversals:

When a company stockpiles on goods it can't sell, and the value of the goods declines below what it will be sold for, accounting rules require that the company writes down the value of the inventory on the balance sheet. In a well-run company, write-downs should be minimal because managers pay proper attention to the supply chain signals of customers and inventory levels and the timing of new product introductions.

In 2001, the telecom and internet-gear companies wrote down massive amounts of equipment because they missed warning signs that their sales forecasts were overly optimistic. Cisco Systems shocked investors when it took one of the biggest such write-downs in April 2001. The company took a over $2 billion of write-down. Instead of liquidating the unnecessary inventory, Cisco kept it in warehouses and denied it ever intended to use or sell the goods in a future quarter. In a press release, instead of proclaiming a loss of $2.7 billion under GAAP, Cisco touted its pro forma earnings of $230 million by burying the $2.2 billion in excess inventory charge. Not only did the managers miscalculated the supply and demand - the crux of their job - they also treated the error as a book keeping exercise by downplaying the loss of real shareholders' wealth because real money were spent.

And by keeping the written-down inventories, the company would be able to report far better results by comparison to its outsized loss in 2001. If a company ends up using or selling the inventory it has written down, the offsetting expenses associated with those sales will be vastly lower, and thus profits can appear healthier than it really is. Eight months after Cisco's write-down, the company did just that and revealed in its 1Q02 earnings report: it had sold or used in production or research $290 million in "excess inventory" that it had previously termed worthless. The upshot was that the net loss of $268 million in the first quarter of 2002 would be much worse without this benefit.

Vendor Financing:

Companies sometimes lend their customers the funds to make purchases in order to boost sales. By doing so, the company is basically buying its own products. Motorola gives a good case that vendor financing can backfire. In February 2000, the company announced that it had sold $1.5 billion of equipment to Turkey's wireless carrier, Telsim. But investors had to wait more than a year to read in Motorola's proxy statement of March 30, 2001, that the company had lent $2.8 billion to customers to finance their purchase of Motorola wireless gear. Of that, $1.7 billion had gone to Telsim alone - a big exposure for such a significant amount lent to a single customer. A little over a month later, Motorola revealed that Telsim's debt was even deeper at $2 billion, out of a total of $2.9 billion in so-called finance receivables, or customer loans. It is also revealed that out of the $2 billion, $728 million was past due. However, the proxy left the strong impression that it had adequate collateral if Telsim failed to repay in 30 days - Telsim had pledged 66% of its stock to Motorola in case of default. In the next quarterly report in July 2001, shareholders got a shock when the entire $2 billion is in default. When Motorola notified Telsim that it was in default, Telsim issued more shares in the Turkish stock market and diluted the Telsim shares that Motorola held as collateral from 66% to 22%. That left Motorola with little recourse but to write off the loan. The following quarter, Motorola took a $1.3 billion charge against earnings.

The lesson is investor must be vigilant. Had an investor been so, they would have spotted clues in Motorola's financial statements. The first hint of any exposure was buried on page 53 (of 104) in Motorola's March 2001 proxy statement. It referred to "one customer in Turkey" responsible for $1.7 billion out of $2.8 billion in long-term finance receivables. In the next three quarters, the company slowly dribbled out information about the Telsim loans, ultimately hitting investors with a two-by-four when it announced the $1.3 billion charge.

Goodwill Games:

Until 2001, accounting rules allowed companies to account for business acquisitions in two ways: Pooling of interests or purchase accounting. When companies evaluate the value of an acquisition, they forecast the cash it expects the acquired company to generate. It also places a price on each of the assets such as equipment, plant and inventory. Assets can also be intangible, i.e., they have no physical form, such as intellectual properties like patents, brand names, quality of personnel and market share. When one company acquires another and pays a premium in excess of the value of its identifiable assets, the premium is called goodwill.

In the past, the far more popular accounting selected to account for acquisition is pooling of interest, in which companies simply combined their assets and liabilities by declaring their combination as a mere uniting of shareholder interest, as if no resources were used up and no goodwill was involved. The other method, purchase accounting is far less popular. Using the purchase method, companies could allocate the amount paid to all the assets acquired, including goodwill: the amount in excess of the identifiable assets is allocated and recognized as goodwill which must be amortized as an expense each year over a period of not more than 40 years. So you can see why companies elected the pooling method over the purchase method because the purchase method reduces reported earnings (though not economic earnings).

However, in 2001, the FASB changed all that when it ended the use of the pooling method. All acquisitions must be accounted under purchase accounting. But, at the same time, it lifted the requirement for companies to amortize goodwill. This means goodwill will no longer have to be expensed and thus no reduction of earnings tied to amortization of goodwill for years to come. Instead, companies must determine on an annual basis if the value of goodwill is impaired, or lost value, since the acquisition took place.

The merger of AOL and Time Warner, at the height of the internet frenzy, is an instructive case. It quickly showed how goodwill accounting changes can affect shareholders' interests, and expose the misjudgment of managers. Upon the combination of the two companies in 2001, it carried $127 billion in goodwill on the balance sheet. The large amount reflected both the inflated stock prices of the era and the excessive prices companies paid for acquisitions. Under the new FASB rule, the company announced that its goodwill is no longer worth $127 billion. As a result, it took the largest write down in history of $54 billion charge, in the 2002 first quarter earnings report. The company downplay the write-down as merely a paper correction, cheered on by most analysts, because it involves no hard cash, and have no effect on future earnings.

But is such huge write-offs really meaningless or pen-pushing events? This shows both companies hugely overvalued themselves and caused shareholders to overpay when the two companies merged. The truth is, goodwill write-offs and not amortizing goodwill allow companies to artificially lift their return of assets and return on equity, two key measures of a company's profitability. For example, AOL, expects to generate as much as $6.8 billion in additional profit in 2002 because it won't have to amortize any of the goodwill it carries on its balance sheet. By not deducting goodwill from earnings, it simply boost future earnings, until one fine day, the company finds it advantageous for them to take one big bath of impairment charges and wave it off as an insignificant event that does not affect cash flow.

Now, you can see, how far companies can bend backwards to use all kinds of accounting tricks to make earnings glossier than it really is. Most companies are not committing frauds even if they resort to smoke and mirrors accounting. Some of the more aggressive accounting path taken may even be legal because GAAP, even at its best, has plenty of built-in flexibility that allows companies to take liberties. And this is the real travesty. Nothing will change corporate managers from doing what they do.

No doubt any company that overplay the numbers game will have to restate earnings and losses will follow for not only the company, but shareholders as well. But for shareholders, it may be too little too late. So to avoid it, we, as investors must change our behaviors: 1) Never follow the herd and grab shares just because the headline suggests so and never sell just because the company falls short of analysts' expectations; 2) Read the footnotes and if you don't, the managers will be happy; 3) It's your responsibility to dig deeper to see what the true economic prospect the company has.

NYT: Warren Buffett's 'Greenback Effect' Warning: A Call to Buy Stocks

The Greenback Effect

Warren Buffett is back with a new piece in the New York Times, but today he's not using the high-profile platform to explicitly urge us all to buy stocks as he did last October. But there's still a big "buy" recommendation implicit in the dollar doomsday scenario he lays out in his latest op-ed. Click here for full article.

The Numbers Game: How To Read Financial Statements (The Cash Flow Statement)

The last part making up the financial statements is the cash flow statement. It simply shows the actual cash flowing into and out of the company. You may now know that the balance sheet reveals a company's assets, liabilities and shareholders' equity at the close of a given period or fiscal year. The income statement shows the changes that have occurred in the balance sheet items, including the promises of money that the company has made or received. The cash flow statement differs in that it reveals the changes in actual cash that the company has generated and raised through creditors and investors. It also shows how the company invested the cash between the start of one fiscal year to the end of another. In other words, the cash flow reflects where the money comes from and goes to.

The cash flow statement comprises of three parts, namely, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.

1. Cash flow from operating activities: It shows the money that comes in from sales of the company's products or services and the money going out to produce those sales. It also includes interest and tax payments. Under GAAP, it allows revenue to be recognized on the income statement before actual cash or payment is received. But not so on the cash flow statement, which lists only revenues actually collected or received. Thus, you may see negative cash flow from operations. On its face, this may seem like a bad omen, but it isn't always a signal to sell. Fast-growing start-ups will tend to show negative cash flow because it consumes more cash than they can generate in the first few years of the business. They cover the shortfall by borrowing money or issuing stock. However, at other times, negative cash flow may indicate a company is in trouble, especially if the company is disposing of assets or selling pieces of the business, because it cannot persuade investors to buy its stock or credit market to lend it money.
2. Cash flow from investing activities: This is where the company reveals the amount of free cash flow and how it's utilizing its excess cash or free cash. Free cash flow is normally defined as cash flow from operations minus the amount of cash consumed to add plants and equipments. Such free cash if available can be used to reinvest in the business by acquiring more business, build more plants, or return to investors through dividend or repurchasing of common stocks. It also shows the amount of cash spent on acquiring businesses, disposal of assets and also acquiring of plants and equipment. If a company lent money to its executives to allow them to buy stock, it is also shown here.
3. Cash flow from financing activities: This part shows how much money a company spends to repurchase its stock and also if the company is raising money by selling its stock or issuance or reduction of debt. A start-up business tends to have more financing activities than a mature business because it has little or no sales, so the cash has to come from somewhere to finance the business. Dividend payment is also indicated here. Remember the company can opt to utilize its free cash to return to investors by either repurchasing stock or paying dividend. Repurchasing of common stocks is usually a more cost-efficient method than in the form of dividend simply because dividend gets tax by Uncle Sam while stock repurchases do not. So the amount of tax saved can be used to repurchase more shares rather than to pay to Uncle Sam.

That's the cash flow statement in a nutshell. You can link the cash flow statement with the balance sheet by looking at the cash amount in the balance sheet and this amount comes from the final cash balance on the cash flow statement.

To sift for clues in the cash flow statement, it may be necessary to examine the cash flow side by side with the income statement, better still over multiple reporting periods. For example, if net earnings on the income statement have surged, but the actual cash received from operations is much lower, that could be a sign that bad debts or obsolete inventories are piling up and the future quarters' earnings could be lower.

A rough way to gauge if a company is playing the numbers game is to compare the rate of growth in net income with the rate growth in operating cash. If net income is growing at 10% but operating cash is growing at 1%, while in previous years, the two numbers grew at a fairly even rate, that could signal that net income isn't as solid as it appears. Or you can, alternatively, divide the net income with the total cash flow from operating activities. The close the ratio is to one, the higher the quality of the earnings.

As you can see, it is far more difficult to manipulate the cash flow statement than the income statement. But it still can be inflated. Again, Enron's cash flow statement is instructive. In its 2000 annual report, Enron showed that cash provided by operating activities came to $4.8 billion. But investors who looked thoroughly at the balance sheet and its footnote would notice that under its liabilities, it held $4.3 billion of customers deposits compared with almost nothing the year before, and hidden under footnote 3 on page 39, it states "At December 31, 2000, Enron held collateral of approximately $5.5 billion....shown as 'Customers' Deposits' on the balance sheet." Without this collateral, Enron's real operating cash flow would be negative $700 million. Furthermore, Enron also reported a onetime asset sales of $1.8 billion on its cash flow statement. With this, Enron's real operating cash flow fell deeper to negative $2.5 billion. Considering that Enron was showing total sales of $101 billion, a negative $2.5 billion cash flow is a sign that something is really fundamentally wrong.

The Numbers Game: How To Read Financial Statements (The Income Statement)

The income statement, also known as the profit and loss statement, is a report on the company's business activities in a given quarter or year. While the balance sheet measures a company's overall health, the income statement measures its performance. It contains two main components: the revenues (money or promises of money flowing in) and the expenses (money or promises of money flowing out).

The first item on most income statement is the revenue, or also sometimes called the top line. When a product or service is sold, the money received or due to receive is called revenue. For start-ups, analysts often consider revenue growth as the most important, rather than earnings. This was a key determinant of stock market value during the internet boom because investors believed revenues showed if a company was gaining market share and customer base. No doubt, revenues are important but it is a mistake to focus just on this top line number. More important, we need to consider the quality of the revenues and the company's entire income statement to gauge its true financial performance.

Under GAAP, there're strict rules for when revenue can be recognized. For example, revenue cannot be counted if the seller must provide a significant amount of services in the future to the buyer. Many companies abused revenue recognition rules in the past.

The next item after revenue is the cost of goods sold, or the amount of paid for the items sold out of inventory - a service company will not have this kind of expense. The income statement also lists other operating expenses such as "selling, general and administrative" costs. This category of expense is important as it measures the efficiency of the management at controlling the overhead costs associated with running its operations.

Another important expense to watch is the cost of research and development. When viewed as a percentage of revenues, R&D expenses can be compared across similar types of companies. If the percentage is unusually high or low, the company may not be managing or investing its R&D dollars wisely. If the percentage is falling, perhaps the company may be cutting its R&D expenses to prop up earnings. It is also important to watch how much of a company's revenue is generated by new products coming out of the R&D pipeline. This provides a good measure of how well the R&D process is being managed.

Gains or losses from discontinued operations and extraordinary gains or losses also appear on the income statement. These extraordinary items must be unrelated to the business normal activities and they must be one-time and highly unusual events. By segregating extraordinary items, one year's income statement can be compared with another's. Another item is restructuring costs. Be careful: many companies have made liberal use of this description for items that are not, in fact, unusual or one-time events.

If a company has determined that one of its operating divisions has experienced lower sales and reduced profitability, it could decide to restructure that division by laying off employees, reducing inventories, and closing plants. Many of the costs associated with this downsizing is called restructuring charges. The expense will be equal to what the management thinks it will incur to pay severance to workers, the other costs, such as ending leases on equipment no longer needed. A restructuring is a signal that the underlying economics of the business have changed - R&D has not been successful in reinvigorating the product line, or revenues are suffering because competitors have gained market share - and can be considered a red flag that the company has long term problems.

The income statement also lists the tax due on the revenues and expenses on the statement. However, this tax figure is only for accounting purposes and may differ from the actual taxes paid, which may cover a different time period and include revenues and expenses not on the statement. Actual taxes owned to the government are determined using arcane rules put out by the Internal Revenue Service. Any difference between taxes based on earnings reported in the income statement and what the company currently owes the IRS is called deferred taxes.

At the end of the in income statement are two important numbers: the net income and earnings per share. Net income, also called the bottom line, is the profit the company shows after subtracting out all expenses and taxes from revenues. This is a GAAP number and differs from so-called pro forma or operating earnings, which are numbers that exclude a lot of noncash charges such as amortization and depreciation, and large expenses such as restructuring costs. Companies go to great extent to pump up their pro forma earnings number - some as far as excluding marketing expenses from the calculation.

While GAAP may not be perfect, at least it forces companies to follow consistent rules for the sake of comparison. Pro forma earnings have to be carefully understood so that investors can see for themselves if the GAAP number of the pro forma number represents the true economics picture of the company. Just be warned: when companies go to great length to exclude all kinds of unwanted charges, the statement for pro forma might as well be called the earnings for everything but the bad stuff.

The other important number at the end of the income statement is the earnings per share (EPS). This number tells how much money the company earned for each share of stock that is outstanding. Again be careful. The better measure of how successful a company has been is the fully diluted EPS number, rather than the basic EPS number. The fully diluted number takes into account stock options issued to managers but not yet exercised. It also includes in bonds, preferred shares, and stock warrants that can be converted to common stock, thus causing a dilution to the basic EPS.

A useful measurement is return on assets (ROA), which also connects the balance sheet to the income statement. Find the net income on the income statement and divide that number by the total assets on the balance sheet. The higher the ROA, the better the management is at using your capital to increase earnings. A healthy company will have an ROA in excess of 5 percent.

The Numbers Game: How To Read Financial Statements (The Balance Sheet)

We have seen how once-high-flying companies were brought down to their knees during the market meltdown beginning in March 2000. No sector lost more money for investors than telecommunications. Some $2 trillion in shareholders' wealth and 400,000 jobs were wiped out in an eighteen-month stretch. One of these companies was Global Crossing, a fiber-optic cable company. As late as November 2001, the CEO was still telling shareholders that he expected the company to improve its operating results as it cut expenses and benefitted from strong growth in certain business lines. Three months later, Global Crossing was the forth-largest bankrupt company in U.S. history.

Were there any danger signs? They were staring right in the investors' face. Global Crossing's had reported eight straight quarters of losses dating back to 1999. Total debt as a percentage of its capital grew from 24 percent in September 2000 to 41 percent the next year. Too many investors were in fact not paying attention to the fundamentals of the business. Reading and understanding 10ks or annual report may appears to be a daunting task. But it isn't as difficult or complicated as you think it is. There are some common accounting tricks that management often play. You can be their own watchdog if you are aware of it.

The 10k or annual report is where company must disclose everything that might affect its future performance, be it a lawsuit, a shrinking market share, or pending expiration of a key patent. The 10k is also where you will find the company's financial statements. Here we will try to examine the various sections of the statements and also some of the commonly used methods companies use to make their accounts more rosier than they are. Many companies, including blue-chip firms, have all played the numbers game. Unfortunately, even investing in high-quality blue-chip firms do not protect you from accounting trickery. It is hard for companies to be completely immune from the pressure from cutting corners. Many on Wall Street or corporations would have you believe that you need an accounting degree to understand financial statements - it is far from the truth. As you will see, with a bit of work, you'll be able to determine by yourself how well a company is really doing and even make an educated guess about its future performance.

All financial statements must contain three sections: the balance sheet; the income statement and; the cash flow statement. Let's start with the balance sheet.

BALANCE SHEET

The balance sheet provides a snapshot of the company's overall financial health - same as a doctor report you will get for a health checkup. It tells you if the company is growing internally or using debt to pump up results. The balance sheet lists the assets such as cash and equipment, and also the liabilities such as obligations like debt and accounts payable, at a specified point in time. The difference between the assets and liabilities is the shareholders' equity. Shareholder's equity includes any investment by the company's owners plus any retained profits that have been reinvested in the business rather than paid out as dividends to the shareholders.

Current assets are listed first on the balance sheet - items include cash, accounts receivable, short-term investments and inventories. Noncurrent assets are listed next. This includes medium and long-term investments, real estates, goodwill, patents, copyrights, plant and equipment. Many of these assets must either be depreciated (for tangible assets such as plant and equipment) or amortized (for intangible assets such as patents and copyrights) to comply with the general accepted accounting principles (or GAAP). Depreciating an assets means allocating its cost as an expense over the period the company uses the asset to generate revenue - a management judgement for the life span of the asset. Depreciable assets are shown on the balance sheet at its original price, offset by the depreciation accumulated over the years. Depreciation has an effect of reducing earnings in the income statement since it is an expense.

Amortization is also similar to depreciation. It recognizes that an intangible asset has a limited useful life and thus a portion of the intangible asset's cost is recorded as an expense each year. GAAP used to require intangible assets to be amortized over a maximum of forty years. However, in 2001, the FASB, which determines GAAP, eliminated any maximum life over which intangible assets must be amortized and instead required companies to write down the assets when they lose value.

Listed after assets are the company's liabilities and then the shareholders' equity. Total assets must be equal to total liabilities and shareholders' equity. Liabilities, like assets, are classified as current and noncurrent. Current liabilities - which generally must be paid within a year - include items such as account payable, short-term notes, the current portion of any long-term debt, and income taxes not yet paid. Noncurrent liabilities include long-term debt, mortgages, and capital leases. Liabilities and equity are listed in the general order in which they are expected to be paid in case of bankruptcy or liquidation. Money owed to suppliers are first in line, while common shareholders are last in line.

An item in the shareholders' equity of interest is retained earnings. This is the amount of a company's earnings that was not distributed to shareholders as dividends. This does not mean that the money is in the bank or available to be distributed back to the shareholders. Instead, the earnings are most likely to be reinvested in the business, for example to expand the company's product line, build a new manufacturing plant or to acquire new businesses.

That's the balance sheet in a nutshell. So, what clues should investors look for? A simple way is to get a feel of the company's health by checking on the inventories and receivables. If either one is growing a lot faster than sales on the income statement, then trouble may be brewing.

• If inventories are rising faster than sales, the company may be having trouble selling as much as it forecasted - i.e. demand is not as rosy as the company thought. Some questions come to mind: If demand is weakening, could it be that the company's products have lost customer acceptance in the marketplace?; Has technology changed and thus make its inventories obsolete?; Has a new competition entered the market?; Is a general economic softness hurting the company?
• If account receivable are growing faster than sales, has the company induced customers to buy more goods than customers really need by offering discounts or easy cancellation terms? Channel stuffing is one such trick used to gross up reportable income. It happens when a company ships products to customers, such as retailers and distributors, loading them up with, or "stuffing," their shelves with excess inventory. This practice is often accompanied by company offers of discounts, below-market financing, and other inducements to get customers to buy products ahead of time. These buyers often delay payment for shipments, thus pushing up the accounts receivable. Rising receivables may signal a change in a company's credit policy. Some firms will lower their credit standards by accepting, say, payment in ninety days rather than sixty days, so as to boost anemic sales. All these help management to cover up a bad quarter so that it meets analyst's expectations, while robbing revenue from future quarters with such hurry-up sales. For example, Bristol-Myers Squibb paid $15o million to settle a SEC charge in August 2004.

When inventories are written down in value, investors should ask what was the root cause: Did the company overestimate what it could sell?; Is this a sign of poor sales forecasting, order management, or production quality controls? Under GAAP, temporary reduction in revenues and profits normally do not result in assets write-down. Instead, write-downs are typically caused by longer-term or permanent reductions in sales value. A write-down means a company does not expect to fully recover the money it invested in the inventories. Companies are required to explain these changes in trends, and their expected effect on the future operations of the company in an important section of the company's financial reports called "Management's discussion and analysis."

Write-off inventory is rarely a onetime event that analysts and corporate executives would want you to believe in. Rather, a write-down could indicate problems with the business strategy, product development, or marketing channels. More importantly, it could be a distress signal about the company's future stock price.

Some companies write off inventories as worthless, without disposing it. Why would a company incur the cost of maintaining and warehousing what it has declared as worthless inventory? One reason is that the company may intend to use the inventory - either by selling it or using it in a production process. As a result, only the lower, written-off cost gets expensed under "cost of sales" in the income statement in the future, thus, making the future earnings appearing rosier than they really are. Dubious it is but unlike channel stuffing which is an accounting fraud, there is no rule that says a company cannot use or sell written off inventories. But written-off inventory has allowed companies to goose up earnings and boost gross margins. Cisco Systems wrote off over $2 billion inventory in 2001, helping to lessen the loss in future quarter - only to report a loss of $268 million which otherwise would be more had it not been for the use of written off inventory in the first quarter of 2002, about 10 months after the write off.

What does a "strong balance sheet" really means? Usually, it refers to the level of debt. By itself debt is not a bad thing. However, if a company cannot generate sufficient income to pay or service its debts, then it's asking for trouble. The reason why so many companies failed is because they took on a mountain of debt. For example, the telecom companies in the late 1990s took on huge debts to finance the building of fiber-optic networks, only to see it failed when the technology bubble burst and demand for network capacity withered. Telecom companies had laid miles and miles of cables but had too few paying customers. This not only affected them but also their equipment suppliers who found that the inventory were piling up in their warehouses. As a result, bankruptcies soon followed as the telecoms and equipment suppliers were unable to meet their debt obligations. On the other hand, companies that had less debt in the high-flying 1990s were able to weather the storm - pretty much like what it is today in the automotive sector.

A way to measure debt is to look at the ratio of long-term debt to the company's total invested capital. In the balance sheet, find the amount of long-term debt. Then, divide that figure by the total amount of capital (capital equals equity plus debt). A ratio of 20 percent is considered high.

If the debt-to-capital ratio seems complicated, a simpler way is to size up the balance sheet. Here's how: Just compare the amount of cash to the amount of debt. Enron's balance sheet is instructive. At the end of 2000, it listed $1.4 billion in cash, while it carried $10.2 billion in debt. Such a wide gap between the two is a strong indicator that something is amiss.

Jamie Dimon's Speech at Harvard Biz School Class Day 2009

Jamie Dimon offered some words of wisdom and advice to members of the Harvard Business School MBA class of 2009 at Class Day this spring. Below are some notes and also the full video recording.

• Importance of lifelong learning and building a reputation - a personal brand - for hard work, integrity and trust.
• A book about each of us is put together as we go through life, and "you can chose the way you want the book to be written."
• Emotional intelligence is as important as brain power because "I.Q. alone won't get you through tough times." A dose of toughness is required as Dimon proposed. People in positions are bound to take some heat along life's way, he quoted Teddy Roosevelt's observation that players are the people who get criticized, not the spectators in the stands.
• Leaders need self-discipline, a work ethic and dedication to continuous improvement.
• Have fortitude and a penchant for action.
• Set high standards of performance. "Compare yourself to the best," he advised, "and treat other people the way you treat your parents. Do the right thing, not the expedient thing."
• Take a hard and honest look at all the facts including "things we're not doing well."
• Willingness to share information with others and us it as the basis for making the right decision. For that to happen, everyone a leader works with should feel free to engage in open, uninhibited conversations and discussions. "Have many truth tellers around you, not just one."
• Respect for everyone at every level and a sense of humility based on the acknowledgement that no one rises to a leadership position without the help of others, beginning with one's parents.
• Have a feel of the firm's morale as organization bureaucracy and politics can cause severe damage.
• Leaders should be able to adjust for the fact that a person tried but ended up being wrong.
• He said, "I shouldn't have to bride you to join us."
• Success is not given. "All good deeds are predicated on the fact that my colleagues and I keep JP Morgan healthy and vibrant."

Bloomberg: Berkshire May Post ‘Blockbuster’ Results by Buffett’s Measure

By Erik Holm

Aug. 6 (Bloomberg) -- Berkshire Hathaway Inc., with a stock portfolio valued at more than $60 billion, may report its best quarter in at least two years using the metric preferred by the firm’s billionaire chairman, Warren Buffett.

About $11 billion in gains in Berkshire’s stocks and a recovery of derivative bets tied to equity markets caused book value, a measure of assets minus liabilities, to reverse after two quarters of declines, according to analysts and investors including Glenn Tongue at T2 Partners LLC. Berkshire is set to report second-quarter results tomorrow.

“It’s going to be a blockbuster,” said Tongue, whose New York-based firm’s largest holding is Berkshire shares. “It may well be the greatest dollar gain in book value in any quarter in the history of the company. Warren Buffett showed extraordinary discipline in the first quarter when all others were losing their heads.”

Buffett, one of the world’s most celebrated stock pickers, this year confessed to investing mistakes that hurt returns over the prior 12 months. Berkshire’s book value per share, the measure highlighted by Buffett in the first sentence of his annual letter to shareholders, has declined in four of the past five quarters, and 2008 marked only the second time since Buffett took over in 1965 that it dropped for a full year.

In his “owner’s manual” for Berkshire shareholders, Buffett says he considers the figure to be an objective substitute for the best measure of the Omaha, Nebraska-based firm’s success: a metric he calls intrinsic value.

Intrinsic Value

“Intrinsic value is an estimate rather than a precise figure,” Buffett wrote in the manual on Berkshire’s Web site. “The percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.”

The value of shares Berkshire reported holding as of March 31 increased 23 percent in the second quarter. Berkshire is the largest shareholder in American Express Co., whose stock rose 71 percent in the three months ending June 30. Buffett’s firm is also the biggest investor in Wells Fargo & Co., which jumped 70 percent, Goldman Sachs Group Inc., which rose 39 percent, andBurlington Northern Santa Fe Corp., up by 22 percent.

Buffett, 78, didn’t respond to a request for comment left with assistant Carrie Kizer. He doesn’t provide a number for intrinsic value in his annual reports or other communications with shareholders.

Berkshire’s book-value decline of 9.6 percent last year beat the 37 percent plunge of the Standard & Poor’s 500 Index, and the firm has outperformed the total return of the index in 38 of the 44 years Buffett has led the company, according to Berkshire’s own calculations. Under Buffett, Berkshire’s book value per share grew 362,319 percent through the end of last year, compared with 4,276 percent for the S&P, the firm said.

Markets Recover

The declines last year and in this year’s first quarter were fueled by drops in Berkshire’s own equity portfolio, and charges on derivatives tied to corporate defaults and stock indexes on three continents.

Since then, markets have reversed, helping both the equity derivatives and Berkshire’s own stock holdings. The gains in the existing stock portfolio, including warrants to buy shares of Goldman Sachs, and the reversal of losses for the equity contracts may have increased book value by 10 percent before results from operating units are factored in, Tongue said.

‘Remarkable Turnaround’

“Some of the stocks had a remarkable turnaround,” said Janet Tavakoli, author of “Dear Mr. Buffett” and founder of Chicago-based advisory firm Tavakoli Structured Finance. “Combine that with the equity puts going up, and this will be a very interesting quarter.”

Berkshire’s own stock rose 3.8 percent in New York Stock Exchange composite trading in the quarter. It reached $100,000 on Aug. 3, the highest since January. Berkshire’s record closing price is $149,200 on Dec. 10, 2007.

Berkshire’s equity puts -- the derivative contracts tied to stock markets -- were sold to undisclosed buyers for $4.9 billion, according to Buffett’s most recent letter to shareholders. Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, four market indexes are below the point where they were when he made the deals. In the meantime, Berkshire can invest the cash and keep any profits.

The four indexes -- the S&P, the U.K.’s FTSE 100 Index, the Dow Jones Euro Stoxx 50 Index and Japan’s Nikkei 225 Stock Average -- would all have to fall to zero for Berkshire to be liable for the entire amount at risk. That figure was $35.5 billion as of March 31 and can move with currency valuations.

Derivative Liabilities

The $10.2 billion in liabilities on the derivatives, which pushed down book value in past quarters, will shrink after the indexes recovered in the second quarter, said Guy Spier, principal at New York-based hedge fund Aquamarine Funds LLC, which owns Berkshire shares. The liabilities are accounting losses, not cash that Berkshire has paid out.

“We’re going to have a huge reversal in the index puts -- just massive,” said Spier. “We can expect to see some substantial non-cash results.”

The S&P rose 15 percent in the quarter, while the Nikkei jumped 23 percent. The FTSE increased by 8.2 percent and the companies in the European Dow rose 16 percent.

Quarter   Book value   Change from
                     prior quarter

1q09      $102.8       -5.9%
4q08      $109.3       -9.1%
3q08      $120.2        1.8%
2q08      $118.0       -1.2%
1q08      $119.4       -1.1%
4q07      $120.7        0.7%
3q07      $119.9        4.0%
2q07      $115.3        4.9%
1q07      $109.9        1.4%

Can David Beat Goliath?

Is there any thing in common between Bill Gates, Warren Buffett, Sam Walton, Ray Kroc, Bill Hewlett, Michael Jordan, Roger Federer and Tiger Woods? It is beyond reasonable doubt they are wired with the correct ability to do what they are good at. But innate ability only serves us in a limited way if we are in the wrong place at the wrong time and if we don't make full use of the ability. But for the rest of us, ordinary folks, can we - the Davids - defeat the Goliath? Yes, we can if we know the ingredients of what it takes to be great. We may not achieve greatness but if we know what goes into the mix for success, we can achieve reasonable success during our lifetime. But I hope this article would help you to do something better than you otherwise think you'd be able to do, rather than to simply focus on defeating Goliath because it can be too tiring. There are basically two major factors: 1) Things we cannot control and; 2) Things we can control.

THINGS WE CANNOT CONTROL

We are all born in different eras and different eras requiring different set of talents. In the Roman or Genghis Khan days, courage, fighting skills and a military-minded person would be the sort of skills needed for greatness. Warren Buffett, if he were born in those days, rather than now, would end up as a nobody. When we are born has an effect on the level of success.

If we work it backwards, both Warren and Gates, besides having the talent, they had the luck to meet the right person and school, who gave them the opportunity to learn and to practice at what they were good at. It also happened that they were born in the golden years for the sectors they were wired for: Warren's case - he was born in 1930 (depression time), by the time he is 20, the world then was ready for a turn in fortune; In Bill's case, he was born in 1954, by the time he had all the required long hours of training, 1975s was the start of the golden years for technology, those who were born in the mid 1950s.

THINGS WE CAN CONTROL

The first rule is if you are lazy, even if you are born with the most talent, you'll languish in mediocrity. But if you are hardworking, seeking for knowledge continuously, and seeking answers to your questions, you are likely to be more successful. David, at times, defeats Goliath because effort can substitute for ability. Reality and history have proven that even the best in the business cannot achieve greatness without putting in lots of time and effort. Malcolm Gladwell in his book, Outliers, claims that you need to put in 10,000 hours of learning before greatness is achieved. You need to put in a lot of hours of practice for example before achieving a certain level of consistency in a golf swing. When we look at Buffett or Gates, we may think they had it easy because they are smart. But fact is they work harder than anyone else. Most of us don't even put in the kind of minimum effort that is needed to touch the boundary of success. Effort and focus are paramount but most of us stop short when we think of the level of work required - main reason why we fail. Then when we look at others' success, sometimes, we rationalize them as "born lucky or smart," but if that is the case, why didn't Chris Langan (one of the smartest man in modern era with IQ of 195) succeed? If we rely on our innate intelligence and luck, yes, success is still possible but that is because these lucky fews are the few monkeys who survive out of millions who participated in a blind-folded dart throwing contest - ultimately, some lucky monkeys will hit the target after each round of elimination but if play long enough, they'd lose it all back too. But if you play the game harder than anyone else, even more so if you know you are not as talented, you'll over time find yourself being even in front of those who have more talents than you because you work harder. If you are playing a basketball match against an all-star team, you can increase your chance of winning or for the matter, reduce the gulf in points difference, by playing full-court press throughout. Fables like the hare and the tortoise are not tales of fantasy. The thing is you never know what you are truly capable of if you don't give it a shot.

The second rule is nobody work by themselves or without the help of others. No matter how intelligent you are, if you do not bounce ideas out of others, or take ideas out from others, it'd be hard, if not close to impossible, to achieve something great. Warren Buffett got his start from Ben Graham, before that he was also a chartist in his youth. Bill Gates had he not been through his high school which had given him all the resources - lots and lots of hours of practice on a dedicated computer, during a time in the 1960s when computers are shared by many - he will not have had the 10,000 hours of practice needed to achieve greatness prior to him developing an operating system.

Find a mentor. It is one of the short cuts to learn faster and pick up the best practices from the best in the class. Do not limit your mentors to those living only. Many best mentors may already be buried six-feet-under but many left behind their work through their writings.

Have passion. Find out what interest you. It is most likely what interest you is what you are best at. Positivity feeds on positivity. When you like something and you do well in it, you find you get more motivated which in turns produces results. Set goals, if big goals are too huge to achieve, set small little dreams. You can try to be a little smarter at the end of the day than at the start. When you accumulate knowledge, even though it may be small, but it all adds up and the effect is you compound your little knowledge after each day, which over a period of time, you find you know a lot more - just like how you compound your return every year in shares.

Ok, these are some advices I picked up from people I admire. There are others but the main ones are here. Whichever path you chose, be it sports, business, or others, the ingredients are the same. There could be others. Maybe, you have some to contribute which please do.

What Do Analysts' Recommendation Really Mean?

Market are often moved - temporarily though - by research analysts' reports and recommendations even when nothing about the company's prospects or fundamentals have recently changed. What does all these really means to investors? Research analysts study publicly traded companies and make recommendations on the securities of those companies - most specialize in a particular sector of the economy. They exert considerable influence in today's marketplace. Some analysts appear regularly through television appearances or through other media. The mere mention of a popular analyst - Henry Blodget, the star Internet analyst, or Meredith Whitney - can cause considerable movement in stock prices.

For investors - especially retail investors - it is important to know the conflicts of interests involve and who these analysts really work for. In 2003, a historical landmark agreement was arrived between 10 of the biggest Wall Street firms and the New York Attorney General and SEC. The regulators dropped year-long investigations into biased research by the biggest, most prestigious Wall Street firms. In exchange, the firms agreed to pay fines totaling $1.4 billion. More importantly, the firms agreed to fundamentally change the way they do business. Research analysts will no long serve as sales arms to investment bankers - the people who arrange stock and bonds offerings to the public. Analysts will not accompany investment bankers to so-called sales pitch meetings where firms sell investment banking services to corporations. Nor will analysts be able to attend road shows in which investment bankers try to find buyers for share placements and offerings. Investment bankers can no longer weigh in on analysts' performance reviews or play any role in analyst's compensation. Any interaction between analysts and investment bankers must be now monitored by the firm's lawyers. And many other new changes.

Why did Wall Street accept such ignominious terms? Simply, the firms violated the basic tenet of their business - that the investors come first. During the investigation, the NY attorney general then, Eliot Spitzer, subpoenaed emails of analysts at the firms. The emails revealed what some had long suspected - analysts often recommend shares of companies that have an investment banking relationship with the firm and yet, privately, analysts deride these same companies. One then famous Internet analysts, in one email referred to a company as "a piece of junk" and others as "dogs" or "crap." And yet he recommended the same company to investors.

Though the firms deny it, the emails seem to show that analysts were using buy recommendation as bait to win business for their firm's investment bankers. The analysts knew they could boost their compensation if they helped snag investment banking deals.

Publicly, the firms maintained the fiction of a so-called Chinese wall that existed between research and investment banking. However, the Chinese wall serves more like a marketing tool than a shield against conflicts. Privately, the two functions are allowed or even encouraged to work closely together. The Street's culture assumed it was acceptable to ignore conflicts that might harm individual investors as long as the IPO business was thriving. Balancing the profit motive with the public interest had long gone out of fashion. Greed in the end prevailed and clouded the business judgment of a lot of smart people. For a few billion dollars in short term profits, brokerage firms tarnished their own brands and trust.

Analysts have always had to wrestle with conflicts of interest. During the tech-boom era, too many analysts had given up any semblance of objectivity about the company they covered and had become outright cheerleaders for an unsustainable technology stock boom. What happened? In the bull market of the 1990s, analysts had become lazy. Instead of going through the laborious task of deciphering company earnings reports, or probing suppliers, customers or competitors for the truth about a company's current performance and future prospects, they were addicted to handouts of inside information from companies. So analysts were no longer asking tough questions that challenge a company's positive spin in a bid to protect their access to inside information. When stock prices came tumbling down, few analysts even warned investors to sell. Investors lost a lot of money but the firms lost their credibility.

When consumers buy a car or computer, they check consumer reports like CNet or Car Magazine. When they buy a house, they have it surveyed and inspected. But when it comes to buying stocks, who do they turn to if analysts are shills for corporations? Analysts are supposed to try to predict the company's future - and its stock price - so that investors know when to buy, sell or hold. There're basically three types of analysts: 1) Buy-side analysts typically work for institutional money managers such as mutual funds, hedge funds, pension funds or insurance companies; 2) Sell-side analysts typically work for full service broker-dealers and make recommendations on the securities they cover. Many of the more popular sell-side analysts work for prominent brokerage firms that also provide investment banking services who help corporate clients to issue stocks and bonds and; 3) Independent analysts typically aren't associated with firms that underwrite the securities they cover. They often sell their research reports on a subscription basis, for example, ValueLine and Morningstar.

SOME HISTORY DRIVING THE CONFLICT OF INTEREST

Analysts by themselves produced no income. Not until 1975 did the center of gravity shifted from focusing on brokerage commission to investment banking revenue. Brokerage commission were the Street's biggest revenue source until SEC deregulated commissions in 1975. The big money no long came from brokerage commission but from institutions such as mutual and pension funds and from investment banking. Under this new model, analysts' loyalties also shifted. Individual investors' interest fell to the bottom of the food chain while powerful institutions and corporate clients rose to the top. Quickly, analysts learned to carry their load by grafting themselves onto the investment banking team. They refrain from writing anything negative about current or potential clients and corporate managers began picking underwriters on the basis of how well the bank's analysts treated them. A sell recommendation on a company is basically a kiss-of-death when competing for the company's business. By the 1990s, the ties between analysts and corporate clients deepened. Company's executives now knew how to keep analysts on a tight leash by occasionally leaking important information, such as a sales figure or "guidance" on quarterly earnings. Companies also massaged their earnings to come as close as possible to the consensus numbers that analysts were peddling, preferably beating them by a cent. To normal investors, analysts seemed prescient. Some were worshiped. With a brief appearance on a financial news show or column, they could push a company's share price to the stratosphere. Analysts had all stopped making sell recommendation for unwilling to bite the hand that feeds them. Investors began to rely more and more on financial news as the stock market went higher and higher. Wall Street analysts would wave their magic hand by taking to the airwave to wax poetic stories about one company after another. On shows, analysts were asked to name his "top 5" stocks but viewers were never told that the analyst's employer likely was the investment banker for most, if not all, of the companies on his list of hot stocks.

Seldom do individual investors are aware of analysts' conflict of interest. Conflicts of interest are aplenty. While insiders know about how Wall Street really works, most individual investors don't. Analysts often use a variety of terms such as "market perform," or "neutral," to indicate to sophisticated investors and mutual funds that it's time to unload a stock. Those in-the-know understand the code; most individual investors do not. At the height of the tech mania in 2000, optimism from analysts resulted in 92 buy recommendations for every sell recommendation. By the end of July 2001, when the S&P500 fell by 12% and Nasdaq fell by 59%, analysts were still issuing 65% buy recommendations. Statistically, only half of all stocks can perform better than the median - a fact that many individual investors again do not understand.

Analysts cannot serve two masters. The joke analysts gave was that they work 75% of their time for investors and 75% of their time for corporate clients. But unbeknown to most individual investors, corporate clients has won out. It is common for analysts to offer to "provide coverage" - code for positive coverage - in exchange for corporate financing deal. Corporate clients naturally want their stock up and analyst's recommendation can only aid them. A positive report leads to a higher share price which in turn pleases shareholders, and increases the value of the management's stock options, make the company less vulnerable to a takeover, and allow management to use the company's shares as currency for acquisitions. A glowing report also helps to boost the price of the shares the investment banks get for underwriting, or managing the IPO. It increases the value of the investment bank's private equity stake in the company as well. And if a favorable report induces retail investors to purchase more shares, the brokerage side of the business also earns more commission.

Fund managers can easily discourage analysts from issuing sell recommendations - until the fund has disposed of the shares - because they can punish analysts who fail to heed this unwritten rule by refusing to use the analyst's brokerage firm to execute trades. Buy-side analysts play this game too. By taking to the airwave, they can talk up a share price either to dress up quarterly returns or to unload shares on an unsuspecting public.

Now as you can see, everyone knew the rules except the small investors. Practically, everyone's back get scratched - except the retail investor. And analysts played the game well. In 1980, analysts' pay were $100 grand. By 2000, their pay can top $10 to $15 million a year. Many are paid according to their share of the investment banking deals they help to attract. Compensation indeed dictates behavior. Celebrity analysts too became indispensable to the investment banking team. Moreover, when analyst's recommendation are clouded, not only do small investors get toast, but more importantly, this distortion shifts capital away from worthy companies to those able to purchase positive research reports with their investment banking dollars. Over time, this could undermine the efficient allocation of capital, which is the reason why stock markets were set up in the first place. Retail investors when reading analysts' reports must understand that while you may never have to write a check to pay for it, that research report is never free because there is a hidden cost and individuals have to pay for it one way or another. This is one reason why the loyalty of analysts shifted from brokerage commission to investment banking in the first place. Brokerage commissions don't produce enough revenue to support the research function. Individual investors don't want to pay much which deprives analysts of a revenue source. So guess who they give their attention to in order to get paid?

Loopholes are still plenty even though with the new disclosure rules approved in 2002. It's the individual investor's responsibility to know more than what is recommended by analysts or in the grapevine. Sure you could read analysts' reports but it should not be the deciding factor in whether you buy or sell a stock. Reports are a good way to start your research, for you to understand what you buy, use it intelligently and simply, just consider them as one more piece of the information you need to piece the jigsaw puzzle together. Compensation certainly determines behavior. So it'd serve you well to know the conflicts of interest, namely: 1) Investment banking relationships of the analyst's company with the corporate clients - analyst's firm may be underwriting the IPO, client companies prefer favorable research reports and positive reports attract new clients ; 2) Brokerage commissions; 3) Analyst compensation structure; 4) Private equity interest in the recommended company.

Bill Gross August 09 Investment Outlook Notes

Here are notes from Bill Gross's Aug 09 Investment Outlook article:

• Investment managers like the infamous Madame Rue sells hope instead of love but very few are able to seal the deal with performance anywhere close to compensating for the generous fees managers command.
• Hope has a legitimate price even if its promises are never fulfilled. It is why we put donation into the collection plate on Sunday mornings and why we risk money at the blackjack table. When promises are not fulfilled, we rationalize it as insurance in the former case and entertainment in the latter.
• Industry as a whole cannot outperform the market because they are the market and yet investors are willing to pay the generous fees to fund managers.
• Based on the new normal of 6% return that PIMCO envisioned, a 1% management fees paid by investors to funds equate to a 15% extraction of investors' income.
• Investors looking for hope in a deleveraging and reregulation economy must focus on some macro-oriented events rather than focus on typical news-dominated details.
• Common sense tells us that consumer spending growth comes from highly employed, well-compensated labor, and we are far-far from even approaching that elemental condition. In reality, near double-digit unemployment has resulted from numerous business models that are now broken: autos, home construction, commercial real estate development, finance and retail sales.
• Reflecting nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.
• Nominal GDP over the last 15 years increased 5-7%.
• 5% was the number capitalists rely on to justify employment hiring, investment spending plans and also serve as a close proxy for the return on capital that they should expect.
• Nominal GDP is in fact a decent proxy for a national economy's return on capital which serves to estimate the present value of cash flows, and price investment and related assets accordingly.
• Businesses' growth in demand, expenses and return on the economy's capital would mimic this 5% consistency. Debt was issued with yields that reflected the ability to service those payments through 5% growth in both real and inflationary terms, and stocks were issued and priced as well with the same foundation. So are pension obligations and similar liabilities, as well as government spending programs forecasting tax revenues and benefits.
• However, things have changed. Nominal GDP sunk below 5%. If this continues, a portion of the U.S. production capacity - massively overcapacity now as it is catered for 5% growth - and labor market will have to be permanently laid off.
• Economy may head towards a new normal where unemployment averages 8 instead of 5%, housing starts total 1.5 instead of 2 million, domestic auto sales 12 instead of 16 million annual units, if nominal GDP does not grow close to 5% so that long-term balance is to be maintained.
• Debts are haircutted via corporate defaults and home foreclosures and equity P/Es are cut based upon increase risk and substantially lower growth expectations, during the readjustment process.
• A modern capitalism economy based on levered financing and asset appreciation cannot thrive if its "return on capital" or nominal GDP suffers such a significant shock.
• Government interventions - low interest rates, quantitative easing, $1.5 trillion deficits - are not likely to successfully reflate to 5% nominal GDP growth. Substitution of government-backed vs private-leverage works against the possibility.
• Low rates financing provided by the TALF, TLGP, etc., comes with quality constraints (larger collateral haircuts and mortgage down payments, to name a few) that inhibit the "new normal" lenders from approaching the standards of the 5% nominal-based shadow banking system.
• "New normal" will likely be closer to 3%, for at least a few years. Diminished capitalistic risk taking and constrained policymaker releveraging will lead to this conclusion.
• A 3% nominal GDP "new normal" means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalism model.
• A readjustment to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.
• Steady income-producing bond and equity investments in companies with strong balance sheets and high dividend yields is recommended for this new environment.

Understanding a bank financial statements and its operations

Analyzing and understanding a bank's financial statement can be a daunting task. I have taken the past few months to learn more on the basics of banking operation. Bank's financial statements are vastly different from that of manufacturing or service companies. As a result, analyzing a bank's financial statement requires a different approach to decipher its unique risk.

HOW BANKS MAKE MONEY?

Primarily, banks acts as an intermediary between savers and borrowers by taking in deposits from savers and making out loans to borrowers. The bank makes a "spread" between the interest paid out to the depositors and interest received from the borrowers. This spread is known as the Net Interest Income (NII). As a result, banks as financial intermediaries, has inherently two kinds of risks: 1) interest rate risk - managing the spread between the interest paid on deposits and the interest received from loans; 2) credit risk - the probability that a borrower will default on its loan or lease. So, banks have to provide for a provision for loans and credit losses, which take a portion off the net interest income. Banks also makes a constellation of fees from services like credit cards fees, asset management and insurance business - known as Non-Interest Income. Banks also need to pay for employees salaries and benefits, rentals, office equipments, operating cost, etc. - these are non-interest related expenses and known as Non-Interest Expense. In summary, the following table depicts how a typical bank makes its money.

+ Interest income	Bank makes loans
- Interest expense	Bank receive deposits, debt financing and commercial papers
= net interest income	The spread between interest received and interest paid
- Provision for loan and credit losses	Bank takes risk for lending out
+ Non interest income	Sell investments, insurance, and other services
- Interest expense	Bank needs people, system, space and equipments
= Net operating income	Bank keeps what is left
- Tax expense	The country takes her share
= Net income	Bank's goal

INTEREST RATE

One of the avenue banks can grow its revenue is by widening the net interest margin. The size of this spread or margin determines the profit generated by a bank. Consider, a difference in 1% of net interest margin on $100 billion is $1 billion. Interest rates are important to banks because it determines the rate at which money is bought (garnering of deposits) and sold (extension of loans). But interest rates present its own risk. Interest rate risk is affected by the shape of the yield curve. Net interest income varies due to the changing of rates, the timing of accrual changes and also the yield curve relationship. Banks assume financial risk by making loans at an interest rate that differ from rates paid on deposit. Because deposit often have shorter maturities than loans and adjust to market rates changes faster than loans, it causes a mismatch in the balance sheet between assets (loans) and liabilities (deposits). An upward sloping yield curve - the steeper it is, the wider the spread - is favorable to a bank as the bulk of its deposits are short term while its loans are longer in term. This mismatch of maturities generates the net interest income banks enjoy. When the yield curve reverse or flattens, this mismatch causes the spread to diminish.

BALANCE SHEET

A bank's balance sheet is unlike that of a typical company. There's no inventory, account receivable, or account payable. Instead, you will find securities, investments and loans on the asset side and deposits, and borrowings on the liability side. On all bank's financial reports, you can find two kinds of balance sheet: 1) the ending period balance sheet and; 2) the average balances with the yield rates indicated. For a better understanding, it is better to use the "average balances" to explain. Below is an example.

AVERAGE BALANCES, YIELDS & RATES PAID
(In millions)	2008			2009
	Average balance	Yields/rates	Interest income/expense	Average balance	Yields/rates	Interest income/expense
EARNING ASSETS
Federal funds sold & securities	5293	1.70%	90	4468	4.99%	223
Trading assets	4971	3.80%	189	4291	4.38%	188
Debt securities available for sale	86345	6.46%	5577	57023	6.28%	3582
Mortgages held for sale	25656	6.13%	1573	33066	6.50%	2150
Loans held for sale	837	5.73%	48	896	7.81%	70
Loans	398460	6.94%	27651	344775	8.43%	29057
Other	1920	4.74%	91	1402	5.06%	71
Total earning assets	523482	6.73%	35219	445921	7.93%	35341
NONINTEREST EARNING ASSETS
Cash & due from banks	11175			11806
Goodwill	13353			11957
Other	56386			51068
Total noninterest earning assets	80914			74831
TOTAL ASSETS	604396			520752
INTEREST BEARING LIABILITIES
Deposits	266056	1.70%	4521	239178	3.41%	8152
Short term borrowings	65826	2.25%	1478	25854	4.82%	1245
Long term debt	102283	3.70%	3789	93193	5.18%	4824
Total interest bearing liabilities	434165	2.25%	9788	358225	3.97%	14221
NONINTEREST BEARING LIABILITIES & SOURCES
Deposits	87820			88907
Other liabilities	28939			26557
Preferred stockholders equity	4051			0
Common stockholders equity	49421			47063
Total noninterest bearing sources	170231			162527
TOTAL LIABILITIES AND EQUITY	604396			520752
NET INTEREST INCOME			25431			21120
GROSS INTEREST MARGIN		4.47%			3.96%
As percentage of earning assets:
Interest income		6.73%			7.93%
Interest expense		1.87%			3.19%
Net interest income		4.86%			4.74%

The numbers in the balance sheet is an average balance for each line item, rather than the balance at the end of the period. At the side of each line item, you will find there is a corresponding interest-related income or expense item, and the average yield or rate for the period. In this case, you can also see the slight steepening of the yield curve - caution: provided the bank reflects the market which may not be all the time because some banks manage interest rates better than others.

Let's start with the net interest income. The bank generated a higher net interest income even though its interest revenue was flat and interest rate was lower. This is because correspondingly, the bank managed to reduce its interest expense at a slightly higher rate and reducing its interest rate paid out. The reason for this could be either: 1) the yield curve had steepened or; 2) the bank manage its interest margin more efficiently. If the yield curve had steepened, the interest rate the bank pays on shorter term deposits tends to decrease faster than the rates it can earn from its loan during a period when interest rates are falling. This causes the net interest margin to widen, as you can draw from the table.

The bulk of a bank's assets are loans. Loans are the life blood because it can typically earn a higher interest rate. However, loans have its danger. If a bank makes bad loans, the bank can face credit problems when borrowers default on their loans. So it is also important to know the composition of the loans and also who the bank lends out to.

CREDIT RISK

When banks make loans, there's always a risk of defaults. The key is to manage the credit risk of the bank's loan portfolio. Credit risk is the potential that a borrower or counterparty will fail to meet its obligations in accordance with the agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to the customer. An allowance for loan and lease losses is maintained by the banks to absorb such losses. In order for the allowance to be accurate to absorb actual losses, banks have to estimate the amount of probable losses in its loan portfolio.

Actual losses will be written off from the allowance for loan losses account in the balance sheet. As it is written off, banks need to replenish it. It is replenished via the income statement through the item "provision for loan and lease or credit losses." Some times banks replenish more than it write loans off. This happens when banks anticipate credit quality or probable loan losses is likely to increase in the coming quarters. In such cases when provision is more than write-offs, banks are building its loan-loss allowance. At other times, provision for loan losses could be lower than actual write-offs which in turn reduces the amount in the allowance for loan losses account. While this by itself may not necessarily means a problem, but if it is coupled with a flattening of the yield curve (long term rate converging with short term rate), then it may be suspect because it indicates there is a slow-down in economy or economy is in uncertainty and thus push marginal borrowers to the blink of default.

Providing a provision for loan losses is an art as well as a science. It involves a high degree of judgment and evaluation on the part of the management for approximating a loss reserve probability. Since it is a management judgment, the provision is a good source to manage a bank's earnings. In a given quarter where banks need to meet market's expectation and if its earnings fall short, banks can opt to under-provide for that quarter to hit the expectation. On the other hand, banks can also over-provide - not that it is a bad thing - but by overproviding, it ties up capital which otherwise can be deployed to generate more revenue.

The most concerning factor an investor should worry of is when banks isn't reserving sufficient allowance to cover its probably future loan and credit losses. If a bank under-reserves, they will have to face up to reality when more borrowers default on the loans. When the time comes, such banks must provide for loan and credit losses that not only covers actual write-offs but also build on the allowance. Thus the provision for loan losses will spike tremendously which often cause the bank to report a loss in income. When that happens, it depletes shareholder equity and if equity falls below and fails to meet regulatory requirements, regulators will take corrective action such as issuing additional capital, and in worst case, seize the bank, thus wiping out all shareholders' equity. Neither of these situations benefit investors.

WRAP UP

Analyzing banks are one of the most convoluted among other businesses. Moreover, banks are highly leveraged in order to generate the higher return on equity, and thus, a loss on any assets, also magnify the loss on shareholder's equity. So a real careful review and understanding of a bank financial statements is required because it can highlight the key factors that must be considered before making an investing decision. The yield curve as well as the business cycle have a major impact on the economic performance of banks. Credit risk must always be the most important factor when banks manage its loans portfolio because that is the life-blood of a bank. Running a stress-test for adverse economic conditions to evaluate how much losses banks can absorb before eating into capital is one way to evaluate the strength of the bank. Lastly, if you were to hand over money to others, you'd want a honest and trustworthy fellow to be the steward of your money. Same here, you want a good and honest banker who do not manipulate earnings for the short term.