Clear Indexes Ideas

Seeking Only Good Companies

The media has focused a lot of attention on the number of companies going private via the private equity community compared to the number of firms going public. This is best measured in number of companies and in total market cap. This ratio of going private and public runs in cycles and there is no doubt that private equity is affecting the marketplace. However, at its current pace, it would take years for private equity to reduce the number of public companies to the point that investors become concerned at a lack of good opportunities. We are aware that this topic makes for dramatic headlines. It also screams that the private equity market believes that the public market is under-priced, and that bodes well for the stock market.

What is of concern to us is the very short memory of certain lawmakers and, even more concerning, the SEC. They want to cut back on or even repeal the 2002 Sarbanes-Oxley Act which has cleaned up balance sheets, installed new reporting processes, greatly improved corporate governance, and has been the catalyst behind most of the restatements by public companies during the last five years. No law is perfect, but from an investor perspective, this one rocks.

A frightening battle cry of the law makers and public servants trying to repeal or water down Sarbanes-Oxley is that too many firms are publicly listing their shares in London and other exchanges simply to avoid the cost and hassle of complying with Sarbanes-Oxley.

Late in April Greg Ip of Dow Jones published a report in the Wall Street Journal after reviewing raw data and academic analysis.

In a new study, they [three academics] conclude there is no evidence the much-criticized 2002 Sarbanes-Oxley Act, which beefed up corporate accounting and financial disclosures, among other things, increased London appeal to foreign companies at New York expense. The study looked at thousands of companies that either listed, or did not list, their stocks on various U.S. and London markets from 1990 to 2005.

The research also found that investors are still willing to pay a sizable premium for foreign-company shares listed in the U.S., in return for meeting tough U.S. regulatory standards. Foreign-company stocks in London receive no similar premium, they said.

The first implication from the study cited above is that a frequently made argument, that Sarbanes-Oxley has decreased the competitiveness of the U.S. in world financial markets, does not hold true.

The second implication from this study is perhaps more important: meeting tough regulatory standards is good for stock valuations. After the scandal-plagued market meltdown from 2000 through 2002, the regulatory environment from Sarbanes-Oxley has greatly improved transparency and trustworthiness. This in turn has helped drive the investment environment over the past four years of consistently strong stock returns with low volatility. After all, when companies are required to be more upfront about their financials, it logically follows that there are fewer and less severe negative surprises. The conclusion is clear: far from being a burden on Corporate America, Sarbanes-Oxley is actually a benefit to U.S. companies.

The article goes further and discusses the cyclical nature of new listings.

The researchers also say the decline in new foreign listings on U.S. stock markets since 2001 is not due to regulatory overkill. Rather, today there are simply fewer foreign companies that fit the historic profile for listing abroad: namely, larger, faster growing and less indebted companies from countries with stronger legal protections. Relative to historical patterns, the U.S. attracted more foreign companies since 2001 than would have been predicted, while London attracted slightly fewer.

All of our evidence is consistent with the theory that there is a distinct governance benefit for firms that list on the U.S. exchanges, say the authors, Andrew Karolyi and Rene Stulz of Ohio State University and Craig Doidge of the University of Toronto. There is no evidence this benefit has weakened over time.

Our hats are off to these researchers for confirming with their data what we as investors have believed to be true all along: that Sarbanes-Oxley has been a source of benefit, not loss, to the U.S. economy.

The biggest proponent to loosening Sarbanes-Oxley is Christopher Cox of the SEC. He should know better and is not serving investors or the U.S. markets. For now, as stewards to institutional investors we will watch and chime in before we find ourselves once again in an Enron/Worldcom world.

In conclusion, there are plenty of good firms to purchase in the public markets. In fact the best firms do not mind complying with the laws that protect investors, and they trade at a premium for doing so.

As money managers utilizing multifactor models, we believe the cleaner the data into our models, the more accurate the results. So our affection for the law is both self serving and investor protection friendly.

It’s Not Funny

Today’s NY Times Business section features an article titled: Warning: Auditor Jokes Are Being Told. The well written piece by Floyd Norris essentially expresses the frustration of the people who work in the accounting and finance departments of public companies and the power of their outside auditors. The powers feels to some as if its moved from the client side, the public companies, to the service side, the auditors who guide, judge and therefore can change at anytime the methodologies and processes concerning disclosures compiling with the Sarbanes-Oxley Act.

It quotes some very cutting remarks:

We are at the mercy of our independent auditor, which may abruptly change its views regarding proper accounting practices and blame us for it. This could adversely affect us.

We were required to restate our prior financial statements because our independent auditor told us we were incorrectly accounting for (insert your issue here). There is risk that any of our other accounting practices, which our auditor has been reviewing and finding acceptable for years, may suddenly become unacceptable.

There is also substantial risk that our auditor will disavow any knowledge of our operations, our accounting practices, or our very existence prior to the date of the filing in which we disclose that what it told us earlier was wrong. It may insist that any suggestion of a prior relationship between us and our auditor be excised from our documents.

Our auditor may also require us to characterize an industry standard interpretation of generally accepted accounting practices, which it later determines to be incorrect, as a material weakness in our internal control over financial reporting.

It may require us to emblazon, in bright red letters, ‘We had a material financial weakness in our internal control over financial reporting’ on everything we send to the Securities and Exchange Commission or other government agencies, including on our employees’ personal tax returns, and on T-shirts that our employees may then be required to wear to work for the next 12 months.

Buying and printing such T-shirts for all of our employees could be expensive.

Even if we acquiesce to all of our independent auditor’s demands, we may still be unable to file timely reports with the S.E.C. because anything local auditors do must be cleared with our guy at the national office. Our guy is very busy and may not be able to get back to us.

OK we get it. This is what seems to be arduous work. There is still interpretation and some of it is still a moving target with different firms seeing issues differently. Much of the work at many firms seems not yet to be routine.>

My opinion is that these are all signs that Sarbox is working. Last year it was restatements. This year options issues have been “outed” to the SEC and the media. Only now, thanks to government action after tremendous thievery and scandals, the stakes are much higher for accuracy. Arthur Anderson is gone. Jeff Skilling looks like he will spend much of the next 24 years at a Federal Prison facility in N.C. for fraud, conspiracy, insider trading and lying to auditors.

In addition to more consistent disclosure, company financials are signed by management and its auditors before they are filed with the SEC and through Reg FD sent to stockholders, Wall Street and the public.

All good things come at a cost. I hate to say this, but with all the hoopla about how hard Sarbox is to comply with, my big fear is the Republican controlled congress may want to “cut and run” from this one.

I say bitch and moan all you want. Tonight, I’ll be raising a glass for good governance and shareholder rights.

Why does SarBox Rock?

Back in April, I wrote a piece for our clients: ”Earning Season in a Sarbox World” and have edited and updated it to share with a broader audience.

The Sarbanes Oxley Act of 2002 is often portrayed by public companies and the media as a burden. In practice, the Act has increased the quantity and quality of published fundamental data about public companies. Discussing it recently with a big four accounting firm, they initially feared it and now the reality is it carries more reward than risk for them. This year, many firms are reporting more than one set of financial data, reflecting new rules requiring the inclusion of the impact of stock compensation in company results. This has created career changing (an frequently ending) events making headlines. I want to focus on the original intent of the law and what I believe are the longer-term effects.

The number of companies filing restatements of earnings (according to a press release from San Francisco based Glass Lewis & Co.) and other material financial data in 2002 was 330 and increased in 2003 to 514, 2004 to 619 and 1,195 companies in 2005. Overseas companies that do business in the U.S.also experienced an increase in the number of restatements from 37 in 2004 to 100 in 2005. These companies trade on U.S.exchanges as ADRs.

Of the reasons for financial restatements in 2005, expense-recognition mistakes ranked number one. Misclassifying accounting items was the second most frequent mistake, followed by equity-related errors, such as improper valuations for stock-based compensation.

The consulting firm is quoted as stating: Over time, as companies continue to improve their internal controls, we expect the number of restatements eventually will decline, perhaps this year.

I agree with this supposition. We just do not agree that it will be this year.

The options back dating scandals are reaching a peak. The next thing SarBox will ferret out is still unknown. What we do know is that there are still more cob webs to be cleaned out of public companies, and it won’t be completed by Halloween or even this year.

We believe and hope that as more companies clean up their act and tighten their controls, their CEOs and CFOs will sign off on financials with confidence and pride. And that investors, employees and the country will benefit.

This issue is very material to me. As a quantitative, investment manager, the more accurate the information, the better (in theory) our algorithms (mathematical formulas) will work.

Beyond my work life, I believe this is a place where government can work effectively by insuring fair disclosure and an even playing field. This does not provide or elevate anyone to a competitive, unfair or subsidized advantage. It is simply playing the necessary role of cop in an imperfect world.