Monday, March 1, 2010

Book Review: The Number*

The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
Alex Berenson

New York Times reporter Alex Berenson tells the story of how a single number, rather a single variable, has come to dominate Wall Street investment. That number is the quarterly profit that the 14,000 some publically traded companies are required to report to the federal Securities and Exchange Commission.

The problem is how this 3-month ritual has become an obsession for ever higher profits leading to a variety of accounting schemes to maximize the number.

Berenson beings his story with the Senate hearings in the aftermath of the Great Depression that created the Securities and Exchange Commission. At that time accounting standards were virtually non-existent, with accountants willing to help companies portray their financial situation however the companies saw fit. The early SEC called for annual reporting of sales and profits.

Between 1951 and the early 60's, the number of financial analysts grew from 3,000 to 11,000. This is where Berenson identifies the beginning of the obsession with quarterly profits.

Ironically, the next phase came when corporations generally turned away from paying dividends. This started in the early 1990's after the junk bond market collapsed and Michael Milkin went to prison. During the 1970's and 80's corporate raiders, financed by the likes of Milkin, often used a company's profit to finance a leveraged buyout of that same company. (If this doesn't make any sense to you, it doesn't to me either, but this is the sort of corporate shenanigans occupying much of those decades.) So in the 90's, companies started avoiding paying dividends in order to look less appealing to the raiders.

Throughout, Berenson never loses sight that he is writing as a journalist-historian and not just an economist. To that end, he includes a number of juicy quotations, such as one relevant here. One investment advisor opined, "On Wall Street there is a rule that every good idea must be driven into the ground like a tomato stake. Junk bonds were good ideas that became dangerous ones."

A third phase in the history of the number came when averages of analyst predictions became widely available. Whereas individual analysts often give a range of expected profits, the averages give a precise number, to the penny of what a corporation's quarterly profits are expected to be. This precision has generated added pressure for companies to meet or exceed expectations. In 1994, Chicago Tribune reporter, Bill Barnhart observed, "When you boil down the entirety of a corporate enterprise to a few pennies (of profit per share), the chances for error, misunderstanding and mischief are immense."

The story continues today...

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