Enron balance sheetI'd suggest that companies can play games with almost any metric for a few quarters– and companies try to present their results in a manner which fits the current favored meme. For a while, Wall Street was enamored of EBITDA and not paying taxes– and companies responded to this fixation with leverage and buybacks at the expense of their balance sheets. And no one cared about earnings. Comcast was a poster child for this. Then, Wall Street became enamored of growth rates and margins, and companies fired workers, and sold businesses and restructured continuously– taking "one time charges" which wiped out the profitably of multiple years in one fell swoop (and Wall Street rejoiced). Other companies engaged in "slow-motion" leveraged buy-outs– showing no organic growth, but showing steady earnings growth, and Wall Street said Hallelujah. (IBM was a poster child for this.) For a while, the fad was "click throughs" for internet companies with no earnings and no revenues! And the list of fads and fancies goes on and on.

I agree with The Chair that sales as a sole metric is meaningless, however, I disagree with him on ease-of-manipulation– I actually think it's quite difficult to manipulate sales over a multi-quarter period because it doesn't hit the balance sheet. (For example, it only took a couple of quarters of "channel-stuffing" to cut down Chainsaw Al Dunlap at Sunbeam…) Whereas goodwill, depreciation, merger reserves, one time charges, etc are much more prone to manipulation– which can be buried on the balance sheet and disappear for years and years. For example, the really big cons (Enron, Worldcom, Cendant, Healthsouth) all had warning signs on their balance sheets– more so than on their income statements.

I try (often unsuccessfully) to be an investor who owns the "company" (as distinct from renting the stock), and I try to look past the shenanigans that management play to meet/beat the quarterly performance. I keep things simple. I want to see a decent return on capital over the cycle; a strong balance sheet; reasonably consistent profit margins; and serious investment in innovation and human capital; and aggressive interactions with competitors, regulators and taxing authorities. But I also want to see some revenue growth too. Because (absent deflation), without sales growth, it's impossible to have long-term profit growth– unless a more sinister game is being played.

Niederhoffer comments:

Might one say that Mr. Humbert's post is one of the most sapient things I've ever seen about markets, and that it should be required reading for every business student and investor. It is appropriate to be bested by a deep thing of this nature.

Rocky's post about changing styles in reaction to earnings and the coevolution of companies to give investors what they want would be a good subject for a very useful book, and would make Mr. Bacon take a turn around the turf with Clocker Lawton in the morning workouts.


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