After enthralling readers with a wonderful treatise on how good corporate governance need to be practiced at firms in his 2002 letter to shareholders, Warren Buffett rounded off the discussion with three suggestions that could go a long way in helping an investor avoid firms with management of dubious intentions. What are these suggestions and what do they imply? Let us find out.
The 3 that count
The master says, "First, beware of companies displaying weak accounting.There is seldom just one cockroach in the kitchen." If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.
On the second suggestion he says, "Unintelligible footnotes usually indicate untrustworthy management. If you can't understand a footnote or other managerial explanation, its usually because the CEO doesn't want you to."
And so far the final suggestion is concerned, he concludes, "Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers)."
Attention to detail
From the above suggestions, it is clear that the master is taking the age-old adage, 'Action speak louder than words', rather seriously. And why not! Since it is virtually impossible for a small investor to get access to top management on a regular basis, it becomes important that in order to unravel the latter's conduct of business; its actions need to be scrutinized closely. And what better way to do that than to go through the various filings of the company (annual reports and quarterly results) and get a first hand feel of what the management is saying and what it is doing with the company's accounts. Honest management usually does not play around with words and tries to present a realistic picture of the company. It is the one with dubious intentions that would try to insert complex footnotes and make fanciful assumptions about the company's future.
We would like to draw curtains on the master's 2002 letter to shareholders by putting up the following quote that dispels the myth that manager ought to know the future and hence predict it with great accuracy. Nothing could be further from the truth.
CEOs don't have a crystal ball
The master has said, "Charlie and I not only don't know today what our businesses will earn next year; we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to 'make the numbers' will at some point be tempted to make up the numbers."
Hence, next time you come across a management that continues to give profit guidance year after year and even meets them, it is time for some alarm bells.
http://www.equitymaster.com/p-detail.asp?date=8/20/2008&story=2
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