Trust, but Verify

November 9, 2006 by  


By Bob Wood

Do you remember the Reagan era phrase “Trust, but verify”? I think the basic idea behind that phrase was: “Of course we trust you, and, since we do, you won’t mind if we verify what you’re telling us, right?” I can think of no better concept for investors to remember when preparing to make buy or sell decisions in the markets. But I fear that they do much more trusting than verifying.

What inspired my line of thinking for today’s article is last week’s announcement of the government’s monthly jobs report, where we learned how many new jobs were created in October. The number was a small disappointment to the markets, but did you hear any news about the large revisions to two previous months’ numbers?

These large revisions mean that investors who made buying and selling decisions in September and October based on those jobs numbers were far off the mark! And when these large revisions to data from previous months occur, we should question how viable October’s jobs number will prove to be. But even amid that uncertainty, investors appear willing to alter their investment allocations according to the announced number.

Rarely factored into investor decisions is the Bureau of Labor’s use of a method called “the birth/death model.” This number assumes the creation of more jobs for the month than were actually identified. Of the 92,000 new jobs announced last week, 73,000 were not really identified and counted; the BLS merely assumes they were created. But then, how could they possibly announce that only 19,000 jobs were created in October?

Yet how many investors quickly reacted to these and other data without taking time to verify their worthiness? I fear the answer is, “Too many.” And though we all remember what happened to investors loading up on technology stocks and mutual funds in the late 1990s, based largely on happy talk generated with straight faces by financial media promoters, too few really learned a lesson. Many still read into these “headline numbers” too much meaning–without seeking verification of their value.

We also see from this example how quickly investors can be shaken from their current allocations, based on news that is subject to change in a few short weeks. How convinced were those investors of the value of their current portfolio allocations when they found small changes in monthly numbers meaningful enough to alter their risk exposure?

The need to verify what you hear from Wall Street–and the media that sells its wares–seems obvious. But too few seem to take the time, and that befuddles me. Very seldom do weekly releases of data make any difference at all to my clients’ allocations. In fact, I don’t remember the last time data concerning job creation, GDP growth, inflation or productivity moved me to act on them at all.

Those small data points, subject to revision and statistical machinations, add nothing of value to my research. And the exercise of trying to verify the credibility of those numbers also keeps me from acting on them. Just checking the birth/death model and the job creation it assumes in creating payroll growth numbers shows me the “real” worth of those headline numbers.

As for inflation, simply looking at the growth of commodity based investments–like oil, natural gas, wheat, copper and gold–tells me all I need to know about the true rate of inflation. And that’s worth far more to me than government declarations that inflation is benign, hovering between 2 and 3%.

Hearing the Bush administration boast about cutting the Federal budget deficit in half was certainly something worth verifying. After taking a closer look, I could easily see where the case made to prove this point was as false as the case for Saddam’s WMDs. Bush’s touting the reduced deficit has much to do with his previous over-estimation of the deficit in 2004. It also ignores how excess contributions into the Social Security trust account are used as regular revenues and then are spent, leaving the Social Security liability growing uncontrolled. A fast look at national debt growth also belies any claims about doing “big things” with the annual deficits.

Of course, Bush’s tax cuts are credited with all sorts of financial “wonder-working.” And remember, electing any Democratic candidate into office will surely cause your tax bills to rise, or so they say. But most Democrats appear to favor tax breaks for the middle class and poor–meaning most Americans. And as we are scared into voting for Republicans to keep our taxes low, I wonder how many of you actually benefited from tax savings over the past five years. Have you verified the impact on your finances?

The mutual fund market could use some verification, too. I wonder how many investors were attracted to Bill Miller’s Legg Mason Value Trust mutual fund based on the word “value” used so prominently in the name. And have investors bothered to check that this so-called value fund holds shares in companies like Yahoo, Google, Amazon.com or Ebay?

Speaking of Amazon, last week, when the company announced quarterly earnings, the market reacted with a sense of urgency by buying up the cost of shares by nearly 10%. Yes, the company made more for the period than the market expected, so investors shoveled a lot of money into Amazon shares based on the headline number. Some investors are a little calmer at times like this–and with good reason. One apparently looked before leaping and offered this critique, posted as a reader’s e-mail submission to Bill Fleckenstein’s web site–Fleckensteincapital.com.

“Here we have a stock apparently worth $34 just prior to the release of Q2 earnings 3 months ago. Now apparently the stock is worth $38 (couple of billion $’s more). What has happened in the interim to force the re-valuation?

“Well, Q2 earnings came in below expectations, and they lowered revenue and operating income guidance by 20% for the remainder of year when Q2 was reported. Magically, Q3 revenue and EPS came in just ahead of the dramatically lowered bar ($0.03 was the EPS expectation and actuals were reported at $0.05–really $0.045 but who’s counting).

“How did they beat?” you may ask? Primarily by producing $4 mm (1 cent) of unexpected “other income” (non-operating) and by accelerating their share repurchase program (good for more than half a cent). And I’m giving them the benefit of the doubt for not manipulating the COGS (cost of goods sold) line (inventories were up 61% y/y).

And if you back out Q3 numbers from updated guidance, they actually LOWERED Q4 guidance.

Well, the bulls will say, revenue growth was very strong at 23%. That’s great, except that every other operating line on the income statement grew faster. Marketing expense was up 50%, tech & content spending up 40%, fulfillment up 27% and SG&A up over 50%.

And for these great fundamentals you can buy the stock for 90x this year’s EPS and 50x next year (oh, but they refused to give guidance for next year, so who knows whether 50 is the right number).’’

Do you think this analysis would have been helpful to an investor suddenly rushing to buy shares in Amazon? But we heard none of this on CNBC, right? Of course, among those impressed by the headline number were the “Dubious Duo” Kudlow and Cramer.

A little verification of the value of their opinions might have served investors well. In the book, Bull! by Greg Eckler and L.M. MacDonald, Cramer is quoted as saying on February 10, 2000 that “Enron is certainly for real,’’ and on March 6, 2002, Kudlow predicted “A sizable stock market bounce yet to come,’’ shortly in advance of a 20% drop to the eventual cycle bottom a few months later.

Investors looking at announced earnings for their favorite technology companies should note how many of them announce earnings without offering pertinent information such as balance sheets or income statements. It seems that about 100 companies, many of them in the tech arena, are embroiled in the options backdating scandal and cannot verify their true financial conditions.

Knowing a company’s financial condition does seem to be rather important, doesn’t it? Yet another technology company executive was sentenced to 12 years in prison last week for falsifying his company’s financials in 1999 and 2000. Sanjay Kumar of Computer Associates joins Bernie Ebbers, Jeff Skilling and John Rigas (Adelphia), who are now paying the price for lying to investors about their companies’ performance.

Without verification, it is, and always will be, the investor who loses the most. Whether the numbers we hear relate to earnings, balance sheet manipulation, the true rate of inflation or Federal budget deficits, those in charge seem to have no aversion to rewriting much of the story so they look like great stewards of their companies–-or our national economy. Isn’t it a leap of faith–of epic proportions–that so many investors willingly accept these pieces of data and the added risk based on them?

When it comes to investing for clients, I maintain a healthy respect for how hard they worked to earn investment money and the sacrifices made to save that money–rather than spend it on fun stuff. And that respect requires a large dose of skepticism before I invest their money for them.

When I invest, what always comes to mind is a quote from Steven Levitt, co-author of Freakonomics. His motto is “Don’t trust, just verify.” He explains better than I when he says, “So much of what we hear and what we’re taught turns out to be false on closer scrutiny. Whether it is expert advice, what you read in the paper, or what your mother told you, if it is important, take the time to figure out for yourself whether it is really true.”

The prolific writer Noam Chomsky offers a similar warning. When hearing virtually anything that passes as news coming from big media. “The first thing you should always ask is, ‘Is it true?’”

I can’t think of any better advice for investors in today’s America.

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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