Near-zero interest rates for more than a decade, passive indexing, the rise of machine learning, and no accounting crash since Enron are the main reasons for investors’ waning interest in financial reporting. The way forward could be to make quantitative models smarter by incorporating micro-insights that a good analyst can extract from financial reports.
Neon Electric Corp.’s Todd Norris, left, watches the E on one of the last remaining Enrons … [+]
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“Who else reads 10-K?”
I’m often asked this question when teaching deep fundamental analysis of financial statements in my class. I was speaking to chief investment officers of state pension funds the other day and asked which of them routinely reads a 10-K. About 10% of the approximately 60 assembled officials raised their hands. This is worrying. Here are a few hypotheses as to why investor interest is lukewarm.
“Free” money after 2008 due to quantitative easing
When interest rates are close to zero, the realization of gains next year is almost the same as say 10 years from now. Lower interest rates also encourage investments in speculative assets like cryptocurrencies or meme stocks like AMC. As my senior colleague Trevor Harris points out, “without a discount rate, fundamentals may be less relevant.” One could argue that growth stocks tend to do well when interest rates are low relative to value stocks. But even with growth stocks, the analyst must assess the company’s barriers to entry, competitive advantage, and pricing power based on the financial statements.
No interest in the passives
Footnote 38 of the SEC’s proposed climate rules lists the multi-trillion dollar investor groups pushing for such rules. The list includes Blackrock, which had $9 trillion in assets under management (AUM) as of June 11, 2021, when the rule was proposed, and CERES, which represents a climate risk and sustainability investor network, which had an AUM of $37 trillion represents, CII or Council of Institutional Investors with $4 trillion under management, Investment Adviser Association with $25 trillion under management, Investment Company Institute with $30.8 trillion, PIMCO with one $2 trillion in assets, Securities Industry and Financial Markets (SIFMA) with $45 trillion in assets under management, State Street Global Advisors with $3.9 trillion in AUM, and Vanguard Group with $7 trillion in AUM -Dollar.
This is an impressive amount of firepower. When was the last time so much firepower was collectively advocated for specific disclosure and reporting issues in a 10-K?
Changing FASB and SEC Priorities?
Jack Ciesielski, owner of RG Associates, a research and portfolio management firm, has argued that the FASB has been concerned with simplifying accounting standards rather than prioritizing improving financial reporting for the benefit of investors, particularly as companies have become more complex and larger and invest more in intangible assets.
The number of AAERs (Accounting and Auditing Enforcement Releases) that focus on financial reporting and disclosure issues issued by the SEC has also steadily decreased since the Enron days. A detailed dataset maintained by Patty Dechow at the University of Southern California suggests that the number of AAERs for reporting and disclosure peaked in 2004 at 237. In 2012, the number of AAERs dropped to 65. In 2018, the most recent year for which data was reported, the SEC reported 73 AAERs issued. It has been suggested that after Enron and the passage of the Dodd-Frank Act, the SEC’s enforcement priorities had shifted to monitoring terrorist financing and then to the post-2008 mortgage crisis. Commissioner Clayton was known to focus on “retail fraud” during his 2016-2020 tenure. The focus now appears to be on ESG and crypto-related issues.
Of course, there are other concurrent developments that analysts have blamed for such a low level of AAER-related coverage. Has the introduction of the PCAOB reduced the number of accounting and reporting irregularities? This is difficult to investigate in part because the PCAOB does not publicly disclose the names of companies with unsatisfactory audits.
Does the decline in the number of public companies have anything to do with this? Michael Mauboussin, Dan Callahan and Darius Majd of Credit Suisse First Boston (CSFB) note that the number of public companies has almost halved from 7,322 in 1996 to 3,671 in 2016. I’m not sure if this declining trend can explain the lower number of AAERs. In one of my studies, Chief Financial Officers (CFOs) suggested that, at any given time, about 20% of companies manage profits to misrepresent economic performance. Even if half of it is scams, regulators may still have a lot more to do.
Not a major accounting crash since Enron
Jack Ciesielski points out, “There were fewer accounting tragedies. Self-interest related to detecting and preventing tragedy is now low. Also, I’ve often found that investors were more interested in financial accounting when the FASB was active/proactive. Investors, and especially sell-side analysts, were interested in how accounting changes would affect their earnings models. Not only has the FASB gone deep into “simplification,” it hasn’t taken on projects that aren’t as dramatic, such as income taxes in SFAS 109, or OPEBs at 106, or fair value in SFAS 157. The FASB soft pedals theirs projects now.”
The rise of quantitative investing
“Investors have become monochromatic (e.g. value/growth based on M/B or market-to-book ratios and P/E or price-to-earnings ratios) and only worry about accounting when it’s too late,” says Jack Ciesielski. For example, a relatively large body of literature has pointed out the bias in M/B and P/E due to mispricing of intangible assets. Large sums of money are managed using quantitative models, which can be quite simplistic.
Adds Ciesielski, “A lot of people I know rely on Beneish’s M-score or Sloan’s backlog to reassure them that there are no chicanery and no reason to go any further.” Both Dan Baneish and Richard Sloan, the academics who came up with the M-Score and the Accrual Anomaly are dear colleagues who I greatly respect and admire. You’ll probably admit yourself that summary metrics like beneish score and reserves miss the nuances of a company’s business. For example, income accumulating provisions can represent either a misrepresentation of a company’s earnings or natural growth, which is reflected in higher working capital provisions. The quant may attempt to base such demarcations on noisy proxies, such as those that rely on corporate governance, but such attempts to identify management opportunism are usually not very satisfactory.
Pranav Ghai, CEO of Calcbench says: “We are seeing increased demand for our machine-extracted financial data, but it is automated demand. 25 years ago the users were people like Mary Meeker (or her team) and/or Dan Reingold from Credit Suisse. Today’s users are Aladdin, Blackrock’s portfolio management software.”
As a result, perhaps, Aladdin is likely to care less about the SEC’s or FASB’s pronouncements, or lack thereof, regarding financial reporting. Even with Larry Fink, the CEO, taking care of the nuances of financial reporting, would that interest carry over to the channels that exist within Blackrock? And what about the other quant shops like Citadel, Worldquant or AQR?
The rise of machine learning
We live in a world where complexity is mainly handled by machine learning applications. Machines have no sense of the limitations of the underlying accounting measures. Nor can such a machine learning application ask strategic questions that an analyst might be able to ask about a company’s financial sustainability. A research group at one of the largest passive index managers routinely performs NLPs (natural language processing) on 10Ks and proxy statements (and press releases, conference call transcripts and more). However, micro-work associated with understanding the mosaic of information reflected in financial statements does not scale well and is therefore very expensive to implement for 5000+ stocks.
lack of patient capital
Unless an analyst can show that a fundamentals-based strategy can deliver alpha quickly, hedge funds aren’t usually that interested. Trading has become relatively free as the technology underlying trading systems and exchanges continues to advance. Trevor Harris says: “I think the patient capital issue isn’t new, it’s just that ETFs and mutual funds have grown a lot. Virtually no transaction costs have made investment “free”, so trade and short-term activity have greatly increased.”
diversification
“Investors hear all the time that they should diversify. The more diversified they are, the lower the importance of individual company-specific topics such as accounting. This is just one of many risks they diversify,” said Vahan Janjigian, Greenwich Wealth Management, LLC’s chief investment officer.
What, if anything, can be done about such lukewarm interest?
“I think the only thing that can be done is keep the faith. At some point there will be an “accounting tragedy” that will once again show how important it is to look behind the numbers,” says Jack Ciesielski.
We may also need a way to make machine-based models smarter for microanalysis, which many of us enjoy working on when looking at 10Ks and proxy statements. ESG is a whole new opportunity to bring the micro-skills that analysts are developing with financial reporting into an area that badly needs measurement and reporting discipline.
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