Way back in 1997, I wrote these words in a Fortune article:
General Electric, a company whose name invariably comes up when you ask Wall Streeters about earnings management, says it does what it does because the stock market demands it. “We think consistency of earnings and no surprises is very important for us,” says Dennis Dammerman, the company’s CFO. “We’re a very complex, diverse company that no one from the outside looking in can reasonably be expected to understand in complete detail; so our story to the investing world is, we have a lot of diverse businesses, and when you put them all together they produce consistent, reliable earnings growth.” And if something inconsistent comes along–say, a one-time gain from selling off a factory–”we have a pretty consistent record of saying, ‘Okay, we’re going to take these large gains and offset them with discretionary decisions, with restructurings.’”
These tactics have helped GE meet or beat expectations every quarter but one in the past five years, and they certainly haven’t hurt it among investors, even skeptical ones. “They are using all sorts of techniques to smooth earnings,” says Howard Schilit, whose Center for Financial Research and Analysis keeps institutional investors posted on companies whose earnings numbers may be hiding business troubles. “If I wrote that to my clients, there would be a big yawn.”
Everybody’s stopped yawning now. GE’s stock is selling for $6 a share (down from $24 in 1997 and a peak of almost $60 in 2000). And antipodean hedgie John Hempton, in another of the brilliant blog posts for which he by now ought to be famous, offers a pretty plausible explanation why. It’s not that the company has managed itself into a ditch. It’s that in trying too hard to keep earnings consistent and reliable it has lost the trust of investors:
GE was still – even on my adjusted numbers – profitable last year. I have seen some bear-case estimates of the loss on the ground in various GE businesses and they look high to me. These are guys who estimate losses by looking at accounts – and the losses GE will take are – in my view – substantially less than market because – on the ground – I have seen them operating in a lower-risk manner than their competitors.
The problem of course is you do not know. Summary: mostly good behaviour – bad accounts.
Then he sums up an entire nation’s predicament in one sweeping conclusion:
America has plenty to recommend it – and if I did not love Australia so much you would see me on the plane yesterday.
But the accounting sucks. It sucked when the broker certified the taxi driver’s income at $350 thousand for the purpose of the no-doc loan and it sucks when Immelt certifies the reserves in GE’s accounts.
It sucked when the Bush administration regularly and systemically misestimated the US budget deficit and it sucked when the SEC went after truth-telling short sellers rather than easily provable frauds by powerful people.
But beyond all that accounting when the mess is cleaned up the good stuff about America will probably still be there.
Will GE will still be there? Well I think it will probably will – but without a huge run through the accounts and without your lie-detector running full blast – well it is very difficult to know.