Don’t believe everything the CEO says

Is there anything more important than profit, when it comes to judging a company’s performance and prospects?

It is, at the end of the day, what’s left over for shareholders. And the higher the better, thank you very much!

Even those companies currently burning cash are aiming for a profitable future, as are their shareholders.

If money makes the world go ‘round, profits make the journey much more satisfying!

Accounting might be the language of business, but profits are its love language.

The financial statements are English, but earnings are pure French!

Aren’t they?

Of course they are.

But, what if…

What if those profits are just some selective – creative? – accounting?

You know, throw in some depreciation, a decent whack of amortisation, perhaps the reversal of some previous provisions for bad debts and capitalise some IT spending…

It reminds me of the old joke about the accountants going for the job. When asked ‘What’s two plus two?’, most answered ‘Four’. The guy who got the job replied “What do you want it to be?”

That’s a little unfair, of course. Most companies are on the level.

But there’s still a good chunk of – let’s call it ‘discretion’ – when it comes to deciding what numbers go where in the Profit & Loss Statement.

So, it’s worth being careful.

“Ah”, you say,” I already knew that. Cash is king!”

And you’re right.

Sort of.

Let’s take a company that spends up big every 10 years to replace some really expensive machinery.

In that 10th year, there’s a massive cash deficit. In the other 9, a good cash surplus.

So which number should you rely on?

Some sort of mix of both?

Then congratulations – we’ve just re-invented ‘accrual accounting’ and we’re back at the same problem I just mentioned when it comes to profits.

Why am I telling you all this?

Well, because it’s ‘earnings season’, and we’re in the middle of an onslaught of results from almost every ASX-listed company.

And because forewarned is forearmed.

See, we’re already seeing – and we’ll see a lot more – companies telling us what happened over the last 6 or 12 months.

And they’re telling us what they want us to hear.

Profit.

Underlying earnings.

Normalised earnings.

Cash profit.

And then there’s the acronyms:

EBIT, EBITDA, NPAT, NOPAT, EPS…

You’d almost be forgiven for thinking they just want us to be so bamboozled that we swallow whatever they want us to hear, huh?

Now, I’ve had some fun with it.

But I’m serious.

I’m no cynic – I’m a believer in the power of democratic capitalism, and the mechanism of the market as the best (or least worst) way for companies to raise capital, and for us all to share in the march of progress.

But I also think it pays to be sceptical.

Many CEOs and boards are on the level – telling it how it is, and treating shareholders as owners and partners.

But some… well, let’s just say the incentives and self-delusion are powerful at the pointy end of capitalism.

No CEO gets there without a very significant helping of self-confidence and self-belief.

No investor relations flack gets a bonus by telling the boss to stop spinning the results.

Few board members want to ‘fess up to bad news, preferring to tell us all about the exciting plans for the future.

And so it goes.

A tiny, tiny minority are outright crooks.

A few are suspending their own disbelief in the crusade for the holy grail.

Some are trying to get the share price up, believing that’s what shareholders want (and they’re often right!), despite the reality of their businesses.

Some are going to call it straight – telling us, in Warren Buffett’s words, what they’d want to know if our positions were reversed.

The hard part?

Think about this: The CEO gilding the lily (to one extent or another) is often more persuasive than the person telling the unvarnished truth.

Why?

Because that’s how they get the job in the first place. The board falls for the charismatic executive with a silver tongue and big plans.

And hey, it’s not a lie if you believe it, I guess…

That’s the challenge of analysing management, when it comes to investing.

It’s something that our investment team spends a lot of time thinking and talking about.

Some people love meeting management teams. It feels good to have access and to ask the hard questions. It can convince you that you’re more informed than you were before.

But, again, few CEOs are poor salespeople. And they almost all believe fervently in their mission.

So it’s a rare analyst or investor who leaves a meeting with management less impressed than when they went in.

Which doesn’t mean it’s necessarily a bad thing – just that you need to be mentally and emotionally prepared.

Most CEOs are likeable. They tell a good story. A convincing story. Usually (almost always) because they believe it themselves.

But history shows that some of the most confident company bosses still deliver terrible – or just mediocre – results.

In other words… be careful of who and what you listen to.

Weigh it appropriately. Discount it, knowing you’ll be prone to believing what you hear.

And look for a few things:

Candour with good and bad news.

Alignment with shareholders.

Track record.

That’s not a fail-safe formula. You’ll still be disappointed in the results, sometimes.

No-one is perfect, and your investment may not work out – for any number of reasons.

But remember, investing is a probabilistic pursuit.

You want to be right as often as possible, of course, but your measurement is the overall portfolio result – not an arithmetic ‘strike rate’.

After all, I’d rather be right six times out of ten, and earn 15% per annum, overall, than be right 9 times out of 10 and earn 6.5% p.a.

I hope you would too.

One of the best ways to do that? Keep the, ahem, BS filter finely tuned.

Especially during earnings season.

Fool on!

The post Don’t believe everything the CEO says appeared first on The Motley Fool Australia.

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Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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