Mafia Buzz Issue 3

Finance Week

Ethics should be an essential component of the syllabus at varsity for every discipline. The emphasis must be on what is right rather than teaching the bare necessities. (4^th, page 32)

Preference shares should be considered as part of the portfolio of a retiree once the tax on interest kicks in. (4^th, page 47)

Mr Mike Lomas, CEO of Group 5, says that the establishment costs of the expanded Everite factory are being amortised over five to 15 years. (I thought that establishment costs couldn’t be capitalised in terms of the statement on intangible assets. An investigation is needed by the JSE into this matter. Maybe they are just using the wrong terminology. I do not have the financials so cannot check.) (11^th, page 10)

Deon Basson says that Group 5’s establishment costs should not have been capitalised (see the previous info-byte). He states that R63 million is shown on the balance sheet as deferred closure costs! (If this is true, then Group 5’s managers have some explaining to do.) (11^th, page 42)

Should one allocate investments based on risk profiling (group clients into low-risk, medium-risk or high-risk categories) or based on the investor’s lifestyle goals? (Surely the answer is to get a balance between the two, e.g. if you are already retired and have only R1 million, you cannot afford to take risk on board so must adapt your lifestyle.) (11^th, page 46)

Investors who have been in equity markets over the past three years now want out. This is due to impatience and unrealistic short-term expectations. Greed and fear are often the driving emotions behind a belief that markets can be timed and often result in investors getting it horribly wrong. It is more important to be in a market than to time the market. Volatility needs to be managed to obtain superior returns over time. Stick to your strategy and stick to your plan. (11^th, page 51)

Sir Isaac Newton said that he could predict the motion of planets but not the madness of crowds. The market emotion cycle goes something like this: Optimism, excitement, thrill, euphoria (peak) anxiety, denial, fear, depression, panic, capitulation despondency (trough) depression, hope, relief, optimism (go to start). (11^th, Page 57)

The major argument against expensing options is that they are almost impossible to value accurately (GAAP does not require accurate). The Black-Scholes model is dependent on inputs, which are themselves estimates and will overstate the charge to the income statement. (Not true – the Black-Scholes model can be modified to apply to options with vesting rights. The only major estimate in the model is the volatility factor. This is a small part of the total value of an option.) A major problem is that the cost will be expensed even if the options are deeply out of the money and there is no chance that they will be taken up. (This would only happen if the price of the shares has fallen after the award and the expense is being spread over the vesting period. If they were awarded deeply out of the money, they would have little value.) (16^th, Page 32)

Freddie Mac, a giant mortgage company in the US has restated its earnings for the past three years by $1,5 billion. The difference here is that the restatement increases the earnings! But the next few years will see earnings lower by $1,5 billion. (30^th, page 6)

Fortune

The newly formed PCAOB in the US will soon be a 300 people powerhouse. Its first goal is to investigate and transform virtually every aspect of auditing. Only firms registered with this body will be eligible to perform audits of public companies. The PCAOB will determine how auditors are paid for their services, will set auditing standards and will evaluate audit procedures undertaken by the firms to audit the companies. (Who wants to be an auditor?) (9^th, page 19)

Who should be penalised for corporate fraud: the company or the executive who committed the crime? Was it fair to destroy a firm like Arthur Andersen (thousands of innocent employees lost heir jobs and thousands of partners who knew nothing about the crime lost their nest eggs they had been building for years) because of the deeds of a few executives? Why should the company pay, as in the case of WorldCom, a $500 million fine, thereby penalising its shareholders for the misdeeds perpetrated by its executives? Surely the perpetrators should be the ones to pay – sit in jail for 20 years will be a better deterrent to others contemplating fraud. (9^th, page 21)

PwC has advised Amerco, the parent of U-Haul, that the special purpose entities that were created seven years before did not meet the criteria for off-balance sheet accounting. PwC had advised the company on these structures and, according to the article, took the entire blame for the mistake. PwC tried to help the company rectify the mistake but things went terribly wrong during this process and PwC is now facing a $2,5 billion lawsuit. (Who wants to be married to an auditor?) (23^rd, page 49)

Very skilled, very careful investors can consistently beat the market. They don’t try to hit home runs. They hit lots of singles. They don’t follow hunches; they follow computer models. They don’t believe that markets are efficient but they don’t believe that they are very inefficient either. (23^rd, page 58)

The greatest insight into new finance is that investment returns are in part a reward for taking risks. Risk means the possibility that a share or a portfolio will go down more than the overall market. If you earn a higher return by taking a higher risk than the market risk, you haven’t necessarily beaten the market. Since the costs of active trading are more than the cost of the buying and passively holding shares, someone who simply buys the market will invariably do better than the average active investor. (23^rd, page 59)

If you don’t read the notes in a company’s financial statements, you are not getting the whole story. Most of the critical details are buried in these notes. Examples:

1. 
   Growth in earnings may be attributable to acquisitions and not organic growth. Find this clue in the notes.
   
2. 
   Read the note on related party transactions carefully.
   
3. 
   Study the accounting policy notes carefully, e.g. if a company recognises revenue when goods are shipped, there could be a “stuffing of the channel” problem (goods are ending up in stock of the customers and not being consumed). (23^rd, page 78)