Accounting irregularities = sell.
For six years, that simple equation ruled my thinking about stocks. In fact, ever since I lost $17 million in one hour after Cendant revealed the depths of its accounting fraud, the biggest of all time until the $12 billion WorldCom debacle, I’ve kept a yellow Post-it with those three words glued to the top of my Bloomberg quote machine, lest I forget the pain that phony bookkeeping always seemed to inflict on my portfolio.
Until now. This week I ripped down the Post-it, because instead of saving me money, it’s been costing me a fortune in missed opportunities. Because in these post-Cendant-WorldCom-Enron-Tyco days, the books simply aren’t as fraudulent as they used to be. The average set of public-company books used to be airbrushed of blemishes, if not augmented by an Earl Scheib paint job.
“Selling on each niggling exposé costs too much in missed opportunities.”
Now you get the whole nasty portrait right down to the crow’s feet in the income statement and blackheads on the balance sheet. Companies used to make up whole revenue streams and constantly capitalize items that should have been expensed for fear of missing Wall Street estimates. Now they play it the way you were taught in accounting before the alchemists took charge of bookkeeping. The result is dramatic. In the bad old days, accounting problems surfaced only when the creativity gave way and the fiction became too obvious for the outside auditors to condone. Now honesty’s the only policy.
These days, companies come clean immediately for every little infraction and overestimation. Selling the stock on each niggling exposé renders too harsh a judgment and costs too much in missed opportunities when the stock soars right back after the minor nature of the infraction comes to light.
I am not saying that companies still don’t try to “manage” earnings. You still see Wall Street estimates beaten “by a penny.” The massage game still gets played; CFOs let Wall Street analysts know what they should be carrying for estimates, and then they methodically work to beat those standards by just enough to fool us in the media into saying “better than expected” about a quarter. But these days the media’s more at fault than the accountants. They take the bait too easily.
What happened to make me so confident about the books of corporate America? Why can I ignore a rule that I held as cardinal after my Cendant disaster—a rule that I saw as so important that I routinely sold shares of any company I owned down two or three bucks from the last purchase price after even a whiff of accounting legerdemain?
Three changes made the difference. First, and by far the most important, the government shut down Arthur Andersen. That stunning decision scared the bejesus out of every suit in the land. The idea that the most powerful accounting concern on earth, with 80,000 workers, could disappear overnight through an indictment—not even a conviction—by the Feds changed everything. How big a deal was it? New York State Attorney General Eliot Spitzer, the alleged barometer of so-called tough-guy regulation, has criticized the decision as too extreme for his tastes. Now, that’s saying something.
Secondly, Sarbanes-Oxley, the law hastily drawn to eliminate a national white-collar crime wave, actually worked, because it forced the CEO generals to haul in their lieutenants and say, “Come clean now; I am not going to jail for you.” It also re-instilled an adversarial relationship between auditors and insiders, particularly the CFO. Pre-Sarbox, accountants spent a tremendous amount of time pitching consulting businesses. For many companies, the quid pro quo became rote: You do consulting with us, we show you the best ways to mask your flaws and take on-balance-sheet debt and shift it to where the analysts and credit agencies can’t find it. Some industries, particularly those connected with telecom and energy, experienced epidemics of this kind of corruption, chiefly courtesy of a couple of sharp partners at Andersen. Those shell games don’t get played anymore because the accountants don’t have an incentive to look the other way. Auditors now catch errors instead of condoning them. They out off-balance-sheet hide-and-seek games instead of inventing them.
Third, we’ve drastically changed the penalties for white-collar perps. This past week, for instance, a former high-ranking finance executive at Dynegy, a disgusting sham of an energy company in the late nineties, got 24 years, the equivalent of life in prison, practically (he’s 38), after pleading guilty to charges of book-cooking. Such a crime five years ago might not even have been prosecuted because the Feds didn’t have much savvy in bringing the cases, and the penalties hardly made it worthwhile for the government to pursue the bad guys. Not anymore. It’s no coincidence that two crooked CFOs, Enron’s Andy Fastow and WorldCom’s Scott Sullivan, both agreed to plea bargains of at least ten years, perhaps even to be served in Oz-like pens, not country clubs, provided they cooperate fully in nailing their bosses in those men’s upcoming trials. My sources in Justice indicate that both Fastow and Sullivan were facing certain life imprisonment for their crimes if they had been found guilty.
The result of all of these changes? White-collar crime gets treated almost exactly like every other type, or even harsher; the pen’s truly mightier than the sword when it comes to stealing, these days. It all makes sense when you think about it, given the speed with which companies can be wrecked and pensions looted. With these kinds of incentives, you’ve built a tremendous amount of honesty into the system that didn’t exist before. That’s why, when I hear about accounting irregularities, I now jump not from them but toward them, buying the decline that’s based on the knee-jerk selling by others who haven’t yet figured out that the financial world, indeed, is a cleaner and better place.
Of course, others are still operating by the old rules, bolting from any accounting impropriety. These are the traders who sold Freddie Mac down from $55 to $43 last year, only to watch it soar to $60 recently when it came out that the company was actually hiding bigger earnings. These same people crushed down Take-Two Interactive, the maker of the ludicrously popular game Grand Theft Auto, to $28 on an SEC-mandated restatement early in February only to watch it fly back to the thirties when the company simply trimmed a couple of pennies off previous quarters. And how about the gains made from the accounting panic over Omnicom? The advertising giant fell from $70 to $46 over accounting problems in 2002, then doubled when it all turned out to be much ado about nothing.
How emboldened do I feel? I just bought a ton of Nortel right in the teeth of restatement fears that took the stock to the $5 level from $8. I think we’ll look back a year from now and laugh that the stock got so hammered off something so minor as a restatement of accruals from the telecom heyday.
Perhaps Nortel will be an exception to the new rule. But I can’t bet that way. Not after the stunning gains that have slipped through my grasp now that the books are no longer cooked—but, at last, clean, open, and downright honest.
James J. Cramer is co-founder of TheStreet.com. At the time of publication, he owned stock in Nortel. He often buys and sells securities that are the subject of his columns and articles, both before and after they are published, and the positions he takes may change at any time.