by Near-zero interest rates for more than a decade, passive indexing, the rise of machine learning, and no accounting crash since Enron are key reasons for declining investor interest in financial reporting. The way forward could be to make quantitative models smarter by incorporating micro insights that a good analyst can glean from financial statements.
Todd Norris of Neon Electric Corp., left, watches as the E on one of the last remaining Enrons … [+]
“Who reads a 10-K the most?”
I am asked this question very often when I teach deep fundamental analysis of financial statements in my class. I spoke to the investment managers of the state pension funds the other day and asked them which of them usually reads a 10-K. About 10% of the gathering of around 60 officers raised their hands. This is worrying. Here are some hypotheses related to the interest of lukewarm investors.
Post-2008 “Free” Money Due to Quantitative Easing
When interest rates are close to zero, making a profit next year relative to, say, 10 years from now is about the same. Lower rates also encourage investment in speculative investments, such as cryptocurrencies or meme stocks like AMC. My senior colleague, Trevor Harris, points out that “without a discount rate, fundamentals are potentially less relevant.” One could argue that growth stocks tend to do well when interest rates are low relative to value stocks. However, even for growth stocks, the analyst must assess the company’s barriers to entry, competitive advantage, and pricing power from the financial statements.
No interest between liabilities
Footnote 38 of the SEC’s proposed weather rules lists the billionaire investor groups that are pushing for such rules. The list includes Blackrock, with assets under management (AUM) of $9 trillion as of June 11, 2021, when the rule was proposed, and CERES, which represents a network of investors on climate risk and sustainability representing AUM of $37 trillion, IIC or Council of Institutional Investors with AUM of $4 billion, Investment Adviser Association with AUM of $25 billion, Investment Company Institute with AUM of $30.8 billion, PIMCO with AUM of $2 billion, SIFMA (Securities Industry and Financial Markets) with AUM of $45 billion, State Street Global Advisors with AUM of $3.9 billion and Vanguard Group with AUM of $7 billion.
This is an impressive amount of firepower. When was the last time so much firepower collectively advocated for issues around targeted disclosure and reporting in a 10-K?
Did the priorities of the FASB and SEC change?
Jack Ciesielski, owner of RG Associates, a portfolio management and research firm, has argued that the FASB has been concerned with simplifying accounting standards, rather than prioritizing improving financial reporting for the benefit of investors, especially as businesses have become more complex. and larger, and place more investments in intangible assets.
The number of AAERs (accounting and auditing compliance publications) focused on financial reporting and disclosure issues issued by the SEC has also steadily declined since the days of Enron. A detailed data set maintained by Patty Dechow at the University of Southern California suggests that reporting and disclosure AAERs peaked at 237 in 2004. In 2012, the number of AAERs dropped to 65. In 2018, the last year from which data was reported, the SEC issued 73 AAERs. It has been suggested that the SEC’s enforcement priorities after Enron and the passage of the Dodd-Frank Act had shifted to policing terrorist financing and then the post-2008 mortgage crash. Commissioner Clayton, during his tenure, was known to which spanned from 2016 to 2020, focus on “retail fraud”. The emphasis now seems to be on issues related to ESG and crypto.
Of course, there are other simultaneous developments that analysts have blamed for such a small number of reporting-related AAERs. Has the advent of the PCAOB reduced the number of accounting and reporting irregularities? That’s hard to investigate in part because the PCAOB doesn’t publicly release the names of companies with unsatisfactory audits.
Does the drop 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) find that the number of publicly traded companies nearly halved from 7,322 in 1996 to 3,671 in 2016. I’m not sure this upward trend low can explain the lower amount of AAER. In one of my studies, chief financial officers (CFOs) suggested that in any given period, about 20% of companies manage earnings to misrepresent economic performance. Even if half of these are frauds, regulators potentially have a lot more work to do.
No major accounting crash since Enron
Jack Ciesielski notes, “There have been fewer accounting tragedies. The self-interest associated with detecting and preventing tragedies is now low. Also, I often found that there was a higher degree of interest in financial accounting among investors when the FASB was active/proactive. Investors and, in particular, sell-side analysts were interested in how the accounting changes would affect their earnings models. The FASB has not only delved into “simplification” but also hasn’t taken on projects that aren’t as dramatic as, say, income taxes at SFAS 109, or OPEBs at 106, or fair value at SFAS 157. The FASB is loosening its bills now.”
The Quant Investing Rise
“Investors have gone monochromatic (eg, value/growth based on M/B or market-to-book ratios and P/E or price-earnings ratios) and worry about accounting only when it’s too late” says Jack Ciesielski. For example, a relatively large literature has pointed to the distortion of M/B and P/E due to the incorrect measurement of intangible assets. Large sums of money are run through quantitative models that can be quite simplistic.
Ciesielski adds that “many I know rely on Beneish’s M-score or Sloan stacks to convince themselves that there is no cheating and no need to go any further.” Both Dan Baneish and Richard Sloan, the academics who achieved the M score and the accumulation anomaly respectively, are dear colleagues whom I greatly respect and admire. They themselves will probably admit that summary measures like the Beneish rating and accruals miss the nuances associated with running a company’s business. For example, accruals that increase revenue may represent a misrepresentation of a company’s earnings or natural growth, as reflected in higher working capital accruals. The quant can test and condition such accumulations on noisy intermediaries such as those that depend on corporate governance, but such attempts to identify managerial opportunism are generally not very successful.
Pranav Ghai, CEO of Calcbench, says: “We see increased demand for our finances pulled from machines, but it is automated demand. Twenty-five years ago, the users were people like Mary Meeker (or her team) and/or Dan Reingold at Credit Suisse. Today’s users are Aladdin, Blackrock’s portfolio management software.”
Perhaps it follows that Aladdin is less likely to care about the SEC’s or FASB’s pronouncements or lack thereof in relation to financial reporting. Even if Larry Fink, the CEO, cares about the nuances of financial statements, would that interest translate into the channels that exist within Blackrock? And the other quant stores like Citadel, Worldquant or AQR?
The rise of machine learning
We live in a world where complexity is primarily dealt with through machine learning applications. The machines have no idea of the limitations of the underlying accounting measures. Such a machine learning application also cannot ask strategic questions that an analyst can potentially ask about the financial sustainability of a business. A research group at one of the largest passive index managers routinely runs NLP (natural language processing) on 10K and proxy statements (and press releases, conference call transcripts, and more). However, the 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 more than 5,000 actions.
Shortage of patient capital
Unless an analyst can show that a fundamentals-based strategy can generate alpha quickly, hedge funds are generally not that interested. Trading has become relatively free as the technology underlying trading systems and exchanges advances. Trevor Harris says: “I think the problem of patient capital is not new, it’s just that ETFs and mutual funds have proliferated. Near-zero transaction costs have made investment “no cost,” so short-term trade and activity has proliferated.”
Diversification
“Investors constantly hear that they need to diversify. The more diversified they are, the lesser the importance of any company-specific subject, such as accounting. This is just one of the many risks they diversify,” says Vahan Janjigian, chief investment officer at Greenwich Wealth Management, LLC.
What, if anything, can be done with such tepid interest?
“I think the only thing to do is keep the faith. At some point, there will be an “accounting tragedy” that reinforces the importance of looking behind the numbers,” says Jack Ciesielski.
Perhaps we also need a way to make machine-based models smarter about the microanalysis that many of us love to work on when looking at 10K and proxy statements. ESG is a whole new opportunity to bring the micro-skills that analysts develop with financial statements to an area that needs discipline in measurement and reporting.
