Monday, April 11, 2005

Few accept slower growth gracefully

April 11 2005 - Financial Times
Most of the latest accounting scandals have taken place with successful and highly regarded companies, not the John Does of the corporate world, but the icons of corporate America. Is that a coincidence? Not at all. We live in a finite world where infinite supernormal growth of earnings is not possible, at some point even the most successful company will reach a size at which a supernormal growth rate is not possible. The law of large numbers is as inevitable as gravity, setting in slowly but surely. Many companies defy the law of large numbers by constantly going after new markets or branching out into new industries. However, the inevitable can only be postponed but not escaped, the longer and the faster past growth lasted, the more difficult it is to repeat. Most companies facing the music of slower growth are thrown into a spiral of denial. Few have the courage to face the new reality and lower their growth expectations, since stock will pay the price of price/earnings multiple contraction. On a behavioral level, admission of inability to deliver the past growth will disappoint shareholders expectations that were anchored on past growth, and are difficult for corporate managers as they often look at it as personal failure. Often sub-par performance has to last for awhile, several generations of management changes need to take place, and a lot of capital needs to be wasted to "reinvigorate the company" before the more realistic growth rate is set. It took Coca-Cola more than seven years and several management changes for the company to set a more realistic and achievable growth rate target and to admit that the past growth rate is not repeatable. The latest darlings that joined the club of financial statement offenders are AIG and MBIA. Both are the largest players in their industries, both exhibited consistent, respectable earnings growth and had the highest debt rating possible (AIG got downgraded last week). Though it appears the size of restatements is insignificant in relation to their enormous net incomes, the risk profile of both companies just went off the charts for the following reasons. It is hard to know if the discovered offences are the exceptions or just the tip of the iceberg. In the absence of other information, the fact that restatements dated back to late 1990s, raises the likelihood of discovering an Everest-size iceberg. The degree of assumptions used to create financial statements varies from industry to industry. To create financial statements as insurance companies, AIG and MBIA have to make a large number of assumptions from the size, probability and timing of the future liabilities to the expected rate of return received on investments far into the future. Their financial statements are complex, and to makes things worse, net income is extremely sensitive to those assumptions. Investors have to have faith that assumptions made to construct financial statements reflect economic reality. It is hard to have that confidence, since the same management that was involved in accounting tricks is in charge of making those assumptions. In general, companies resort to illegal shenanigans after all legal avenues for maintaining growth have failed. The fact that AIG and MBIA may have intentionally succumbed to illegal accounting and business a warning sign that true earnings growth rate is likely to be slower in the future, resulting in a permanent contraction in p/e multiple. As is often the case with corporate hallmarks, they trade at a premium valuation to their industry peers. That certainly was the case with AIG, it always commanded a higher valuation to other insurance companies. Debt downgrade by credit agencies will result in a higher cost of funds for AIG thus reducing its profitability. Though debt downgrades are unpleasant, AIG should be able to survive a series of small downgrades. However, that may or may not be the case with MBIA. MBIA's business model is heavily dependent on its ability to use its AAA-rated balance sheet to cosign [insure, act as guarantor of] bonds issued by municipalities. A loss of trust in MBIA's financial strength could result in MBIA's demise. Again, it is impossible to assign probability to that event, but it is clear that probability is higher now than ever before. Bear (as well as bull) markets tend to be great educators for those who are willing to learn. The recent one taught investors an important lesson: in the event of even the slightest appearance of intentional financial or business shenanigans sell first and think later, as bad news hates loneliness and never travels alone. Vitaliy N. Katsenelson, CFA Copyright Fincial Times 2005


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