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Book Learning

Bookkeeping problems used to mark a stock as a must-sell. Today, when a company comes clean about creative accounting, it can signal an attractive bargain.

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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.


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