Peter Eavis
Classical alchemy never worked. The financial variety, by contrast, has made some people very rich over the past few years. But this dark science was dealt a serious blow in 2001, due mainly to the accounting controversies that prompted Enron's (ENE Quote - Cramer on ENE - Stock Picks) dramatic collapse.
Now, Detox isn't predicting an imminent end to the accounting abuses that proliferated in the '90s bull market; companies will always deploy them to mislead investors. But 2001 will go down as the year when it became impossible for anyone to say that book-cooking was a marginal issue. For that, blame Enron, which had been a giant in its sector and a corporate icon before its decline. How can accounting shenanigans qualify as alchemy? How can something worthless get turned into gold? For this to happen, society must lose its critical faculties. In recent years, when gains were easy to come by, the need for independent fundamental research was reduced. In that emaciated intellectual environment, the majority of stock analysts essentially became off-balance-sheet marketers for corporations, repackaging managements' views into reports with a wafer-thin veneer of objectivity. On the whole, mutual fund managers -- and, yes, the millions of individual investors who thought themselves geniuses for making 100%-plus returns on their tech-heavy portfolios -- were just as softheaded. As a result, when companies resorted to numbers games to produce profits, few people had the mental capacity or motivation to notice. No surprise, then, that many stocks rose on phantom profits. When the stocks had appreciated, they could be sold for hard cash. The alchemistic process was completed.
Necco
Of course, there are rules against counterfeiting of profits. But in some cases, the accounting guidelines are easy to abuse, and in others they are outright broken. Let's swing back to Enron. In the energy trading business, companies often do trades based on prices that don't come from a liquid and transparent market but from their own models. Who knows where natural gas prices are going to 10 years from now? The cash market won't tell you much. But if a company has a contract to supply natural gas that far in the future, it has to make a fairly arbitrary guess at the price that far out to help give its contract a value. By plugging in the right numbers, an immediate noncash gain can be booked. It's not clear how much "marking to model" Enron did because it gave out hardly any detail about its trading profits. But weak operating-cash flows suggest the company was struggling to turn paper gains into hard cash. But we shouldn't isolate Enron. A Detox account of a recent deal Dynegy (DYN Quote - Cramer on DYN - Stock Picks) did with Enron shows that Dynegy may also have been overly enthusiastic to book gains on long-dated trades.Nilla
Lending is another industry in which accounting rules make advancement of profits easy. Finance companies that sell their loans by packaging them in bonds can use an accounting method called "gain on sale" to accelerate profits. Again, however, the size of the gain partly depends on assumptions made by the company about factors such as credit losses. When those assumptions prove too optimistic, losses have to be booked. Conseco (CNC Quote - Cramer on CNC - Stock Picks) has had to book hundreds of millions of dollars in gain-on-sale-related writedowns, but in that company's inimitable style, it has recently excluded those losses from operating profits. It's cute moves like that which have dragged Conseco's stock down 80% from its 52-week high. Alas, there are more Conseco-like companies out there. A heavy user of gain on sale is an auto-loan maker, AmeriCredit (ACF Quote - Cramer on ACF - Stock Picks), which has recently been experiencing a worrisome deterioration in credit quality. It can't be long before these guys start having to take losses from revising their bullish preconceptions. The fact that this company projects earnings growth of 40%, yet trades at a price-to-earnings ratio
of only 8, indicates the market doesn't trust this accounting method or management.
Plenty of other companies have benefited from twistable accounting rules in 2001. Among those Detox has looked at are Calpine (CPN Quote - Cramer on CPN - Stock Picks), with its trading profits and capitalized interest, and Qwest
(Q Quote - Cramer on Q - Stock Picks), with its optical capacity deals. Both stocks were leveled in 2001 as investors lost patience.
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