Cooking the books can only last 2 years

Interesting article in The Economist "How companies massage their profits to beat market forecasts", some snippets:


Executives have every incentive to match or beat forecasts as the market punishes those that fail to do so. That, in turn, hurts the value of the share options which are the best hope of making the executives rich.

A recent academic paper looks in detail at this process (The Valuation Premium for a String of Positive Earnings Surprises: The Role of Earnings Manipulation by Jenny Chu, Patricia Dechow, Kai Wai Hui and Annika Yu Wang). As the authors point out, it is hard to know whether the ability of the corporate sector to beat forecasts is due to good management, a growing economy or outright manipulation. So they focus on companies that the SEC has identified as indulging in manipulation.

Sure enough they find that 53% of such firms have a record of four straight quarters of beating forecasts, compared with just 43% of all firms. Secondly, they find that firms tend to indulge in earnings manipulation when they already have a high stock market multiple; they are trying to prop up their share price, not inflate it. The average price-earnings ratio during the manipulation period is 35.

Third, they find that 42% of manipulating firms beat profits for eight quarters, compared with 32% of all firms. After that, the difference is not statistically significant. So two years seems to be the limit for cooking the books. And fourth, they find that executives focus more on beating forecasts than on beating last year's numbers.


The link to the research paper can be found here.

AirAsia: A turbulent patch

Well balanced article in The Economist about AirAsia. One snippet:


"..... AirAsia may never manage to grab more than a smallish slice of the Indonesian market, by far the region’s largest, reckons Shukor Yusof of Endau Analytics, a consulting firm. That would be a bitter blow to its ambitions. It might also mean that LionAir—which has plans to increase its fleet by two-thirds before 2018—overtakes it as the region’s biggest carrier. AirAsia’s “rocket-ship trajectory” is over, confirms CAPA’s Mr Sobie. But a steadier airline may result."

Got ’em, Gotham

Good article in The Economist about the Gowex fraud, some snippets:


Gowex’s dramatic collapse marks one of the biggest victories for a relatively new breed of company-accounts “detectives”: small, independent research-and-investment outfits that revel in unearthing alleged book-cooking. Having focused largely on China’s fraud-filled market until now, they are branching out.

Gotham’s approach is to short and shout: it takes a negative investment position, then noisily publicises its findings. It is cut from the same cloth as Muddy Waters, which is run by Carson Block, a former self-storage entrepreneur. His biggest scalp to date is Sino-Forest, which went bust in 2012 after Muddy Waters accused it of overstating its forest holdings in China. Another such outfit is Citron Research, whose leader, Andrew Left, prides himself on never having been successfully sued for defamation.

Gotham spent eight months studying Gowex, amassing far better information than investment-bank analysts, most of whom were still recommending the shares when it buckled. Gotham spotted that Gowex used a little-known auditor (a classic red flag: see the Bernard Madoff case), whose fees were unusually low, as if they were based on revenue far smaller than Gowex’s books stated. Often, the sleuths comb the books for ratios that are hard to manipulate. Gotham also noted, for instance, that Gowex’s revenue per employee was implausible compared with rivals’—while the revenue could be inflated, it was harder to fake the headcount.

..... market regulators often eye them [short sellers] with suspicion: Spain’s at first reacted to Gotham’s report by investigating its publisher, not Gowex. China has cracked down on shorts, even imprisoning the writer of one negative report.

.... perhaps two-thirds of cases involve improper revenue recognition. New global accounting rules announced in May seek to curb one common ruse, booking sales prematurely, for instance on long-term contracts. But sometimes the revenues are simply invented, often by getting a related party to pose as a customer. Sometimes very closely related: Gotham said in its report on Gowex that it had evidence the firm’s biggest customer “was really itself.”


In the Malaysian context, no case of short sellers "attacking" a company has happened, nor do I expect that in the near future, despite Malaysia having its fair share of accounting frauds. It would be interesting though if something like the above would happen, given the "shoot the messenger" mentality. How would the company, the regulators and the press react?

The Bitcoin Bubble

The Economist published today an article "The Bitcoin Bibble":

"Bitcoin is booming. Investors are piling into the digital currency, which is not issued by a central bank but is conjured into being by cryptographic software running on a network of volunteers’ computers. This week the price of a Bitcoin soared to above $1,000, from less than $15 in January.

Having long been favoured by libertarians, gold bugs and drug dealers, Bitcoin is attracting some surprising new fans. Germany has recognised it as a “unit of account”. Ben Bernanke, chairman of the Federal Reserve, told a Senate committee on virtual currencies that the idea “may hold long-term promise”. A small but growing band of shops and firms accept payments in Bitcoin. Some like the way it allows funds to be transferred directly between users, without middlemen. Others are attracted by the potential for anonymous transfers, or by the fact that the number of Bitcoins in circulation has a fixed upper limit—so there is no way a central bank can inflate their value away by issuing more.

But the recent price surge, driven by Chinese investors stashing money offshore, looks like a classic bubble. Hoarding means that Bitcoin is currently more of a speculative asset than a currency. And a crash is not the only risk Bitcoin users face. As the price rises, Bitcoin theft is increasing, both from individuals and from online exchanges that store the coins and convert them into other currencies. Around $1m in Bitcoins was recently stolen from BIPS, a European exchange. GBL, a Chinese Bitcoin exchange, abruptly vanished in October, taking $4.1m-worth of deposits with it."


The article ends with:


"... if you are lucky or clever enough to have owned an asset whose price has risen 60-fold in a year, it might be time to sell."

To be honest, I don't understand much of Bitcoins, to me it does resemble a classic pyramid scheme, including some rationale concepts (like the mining), which tries to give it some credibility (in itself very normal for these kind of schemes).

The price of Bitcoins fluctuates very much (sometimes 20% in a day), which makes it not very suitable being a currency.

Using Bitcoins for cross border payments would make live me easy, however, how can central banks check that the purpose of the payments was legal?

David Webb wrote an insightful article "The hole in Bitcoin", concluding:


"...here is the biggest flaw: the economics of it. For Bitcoin to succeed, it has to become a transaction currency, widely-accepted by the real world for goods and services. With a cap of 21 million Bitcoins, the accepted wisdom driving prices is that spreading the limited supply of Bitcoins over all these real-world transactions, even with fractional reserve banking, would necessitate a high valuation per Bitcoin.

Unfortunately, most of the people getting into Bitcoin, either with cash, goods and services or by buying and running mining rigs, are just hoarding the Bitcoins, either expecting the price to go up because they believe in this transactional utility, or expecting the price to go up because other people will - people like the  Winklevoss twins, who proposed setting up an ETF to hoard Bitcoins (SEC filing), rather like the SPDR Gold Trust.

The flaw then is that most Bitcoin owners are hoarding something which they expect to become a widely-used transaction currency, and if everyone holds on to their Bitcoins, then it won't become a transaction currency.

....


Even if we are wrong and Bitcoin becomes a widely-accepted transaction currency, the second flaw in Bitcoin is this: when the rate of coin production is reduced towards zero, the only economic incentive the nodes will have to convert electricity into blocks (and heat and noise) is the transaction fees. So far, these are very low, but if the people who control the Bitcoin specification don't increase the fees to a commercial level then the amount of machines running the algorithm will plunge for lack of reward, and it will become much less expensive to take control of the network by holding more than 50% of the hashing power. However, if fees become a significant part of transaction values, then a lot of users (not seeking illegal goods and services) will wonder why they don't just use traditional payment networks denominated in real currencies. So there's the conundrum: charge too little, and someone will put in enough capital to take over the network and turn it, in effect, into just another MasterCard, Paypal or Visa. Charge too much, and people will use other payment networks."


Marc Faber in an interview on CNBC:

a "massive speculative bubble" has encroached on everything from stocks and bonds to bitcoin and farmland. He attributed the vast bubble to "symptoms of excess liquidity."

Faber said the markets, which have reached record highs, could still rise before the bubble bursts, if stimulus programs such as the Federal Reserve's massive monthly bond purchases and super-low interest rates continue.

"Now can the market go up another 20 percent before it tumbles?" Faber said on"Squawk Box". "Yeah, it can go up even more, if you print money."

Warning investors that they could see disappointing long-term returns in equities, Faber said he thought a correction in equities was overdue when the S&P 500index crossed 1,600 points. The benchmark index surpassed 1,808 points this week.

Faber pointed to a high Shiller price-to-earnings ratio, a market indicator named after Yale University professor and Nobel Prize winner Robert Shiller, which relies on 10 years of adjusted inflation, as an indicator of the bubble. He said a high Shiller P/E ratio suggests low returns in the future.

Faber also referred to the rapid rise of bitcoin, the digital currency that crossed $1,200 early Friday, as an area affected by excess liquidity.

"Farmland is up 10 times over the last 10 years," Faber said. "And bitcoins are up now and who knows what next will go up."