Avoiding bullsh**ers

I try to avoid management teams that deceive their investors or make excuses for their performance.  Usually, it is because:

  1. Management is trying to promote the stock.
  2. Management is not very good at their job and don’t want to be fired.  Or, the CEO earned his position due to skill in office politics rather than operational skill.
  3. Management is delusional.
  4. Management knows that the future is not bright but doesn’t want to admit it.

Whatever the reason, the underlying cause tends to hurt shareholder return.  Here are some signs of BS.

Taking credit for things outside their control

In a commodity industry, management may try to take credit for rising commodity prices.  For example, Exxon Mobil points out its excellent returns on equity.  Their returns on equity largely have to do with leverage and rising commodity prices rather than things that management control (e.g. being the low-cost operator, low F&D costs, low corporate overhead, etc.).  Exxon’s hedging program suggests that management doesn’t want to take commodity price risk.  At the same time, management is taking credit for rising commodity prices.  Management is trying to have it both ways.  I want to see management rate itself based on how well they are operating the business and not how much leverage the company uses or what commodity prices are.

Conversely, management may blame bad performance on factors outside their control.  One example is Crocs, which is one of my investing mistakes.  The CEO appeared on CNBC saying that the business was “recession-proof” (see my original flawed writeup on CROX).  Meanwhile, Crocs’s 10-K blamed poor performance in Europe on “macroeconomic” factors.  Later on, Crocs came out with bad earnings and the CEO was fired.  I should have simply paid attention to his excuses and avoided the stock.  He probably knew that he wasn’t very good at his job and would soon be in danger of getting fired.

Blaming the weather

If there is a storm that knocks out power for a few days, then the weather is a reasonable excuse for weak sales.  Otherwise, this is not a good excuse.  Good management teams will own up to their mistakes and admit them rather than blaming the weather.

Management is very promotional in pointing out that their stock trades below NAV/cash

They point out that the stock is supposedly “undervalued”.  At the same time, management has no intention of buying back shares.  Their actions do not match their words.

In the case of QXM/XING (one of my investing mistakes), management was trying to fleece stock market investors.  Later on, the CEO ran off with all the cash and the businesses.

In the case of Pinetree Capital, management issues monthly press releases on the company’s net asset value.  Management is trying to grow its AUM and to collect fees on its AUM.  The CEO Sheldon Inwentash does not particularly care about creating shareholder value.

Rates of return that are too good to be true

In the oil and gas space, it is unlikely that somebody will generate 20%+ unleveraged rates of return unless they are really, really good at exploration.  When multiple shale companies say that they will generate 40-60% rates of return on their wells… they are trying to trick investors.

Commodity price predictions

Most of the shareholders in any given commodity stock own the stock because they are bullish on that particular commodity.  The CEOs of a commodity company may provide information to “help” investors predict future commodity prices.  Usually the CEO is trying to promote the stock.

In general, you want the CEO to be focusing on things under his/her control.  The CEO should focus on areas of value creation such as keeping overhead down and being really good at finding reserves.  Conversely, it is hard for them to create value by predicting commodity prices because they likely do not have any skill at it.

Intentionally misleading press releases

The blogger “Quoth the Raven” put out an excellent piece on Why Herbalife’s CEO “Personal Share Increase” is a PR Stunt that Insults Your Intelligence.

Similarly, some companies put out press releases about increasing the size of their buyback programs.  Then, they don’t buy back any shares.  Or, they will buy back a small number of shares and then stop buying back shares when the share price is lower.  Most companies that do this are simply trying to get their share price higher.  This is especially common among Canadian junior mining stocks.

Another press release shenanigan is to bury information in the middle.

Strategic alternatives

A company that announces that it is exploring its strategic alternatives is basically saying that it has no plan.  That is not something that should inspire confidence among investors.  The CEO might as well come out and say: “I don’t know what to do.”

There may be some adverse selection at work.  Sometimes management teams know that the future will not be kind to their company (e.g. imminent bankruptcy, the status quo leading to bankruptcy in several years, etc.).  In some of those cases, all of the options may suck.  So, the company may hire outside advisors in the hope that they will come up with a plan that doesn’t suck.

Exploring strategic alternatives doesn’t always mean that the company faces imminent bankruptcy.  However, it is almost always a sign that something is wrong.

Non-GAAP (Adjusted) EBITDA

Adjusted EBITDA can be a useful metric for measuring the operating performance of a company between different time periods.  I don’t have a problem with that.

I have a problem when management teams use adjusted EBITDA as a substitute for GAAP earnings.  Maintenance capex and stock-based compensation are very real expenses that should be taken into account.  Some management teams would like shareholders to believe otherwise.  I also find it troubling whenever management makes adjustments for “one-time” events every quarter… as if every single quarter had some extraordinary event that distorts earnings.

*To be fair, stock-based compensation can cause lumpiness to earnings due to the accounting.

On the other hand…

Sometimes a company will be promotional for public relations purposes.  They want the mainstream media to write about the company in a positive light since positive PR should help the company sell its consumer products.  They don’t want articles about how the company “missed” earnings.  The company’s investor relations department may try to get analysts to lower their estimates so that the company always meets or exceeds analyst estimates.  A press release may be promotional simply because it was written with the mainstream press in mind.

For companies that sell consumer products, shareholders should tolerate some level of marketing/public relations BS because management has to try to sell the company’s products.

In industries where most products will be failures (e.g. movies, technology), I would not expect management to spend too much time or effort admitting mistakes or dissecting them.  Failure is a natural part of the process.  The real failure is not finding hit products.

Putting it together

The best management teams are the ones who BS the least.  Honest people do not try to deceive shareholders.  Skilled and honest operators generally do not BS their investors because they don’t have to.

Exxon Mobil’s BS is very mild and tame.  Virtually all of their peers behave similarly (if not worse).  I’m not a fan of their practices but it isn’t particularly egregious.

The worst management teams are the ones who distort the truth that most.  Herbalife’s press release for example borders on the egregious.  The reality is almost the complete opposite.  It’s a tell that there is something seriously wrong with the company.  I don’t know what the fatal flaw is (e.g. the MLM business is about to collapse naturally like Tupperware, the capitalization of “computer” expenses is unsustainable, etc.).  However, I believe that management teams do not behave this egregiously unless they know that something is very wrong.

Looking at how much a company does or doesn’t BS investors can be a useful shortcut/heuristic for screening companies without spending too much time.

*Disclosure:  No position in the stocks mentioned in this post (XOM, CROX, QXM/XING, PNP.TO, HLF).


12 thoughts on “Avoiding bullsh**ers

  1. A useful follow-up post : examples of CEOs / companies that use conservative
    assumptions / accounting, and over-deliver on shareholder value.

  2. Thanks for the article. The weather was an especially convenient scapegoat this past year given the mild winter. Can’t even count the number of earnings calls that cited the weather as a reason for poor operating performance during 4Q13 and 1Q14. Really makes you re-consider faith in management

  3. Glenn,

    I think you really missed the boat on this post. Using Exxon to illustrate BS, even if ‘mild and tame’ really doesn’t make sense.

    Point 1: “Exxon Mobil points out its excellent returns on equity. Their returns on equity largely have to do with leverage and rising commodity prices rather than things that management control (e.g. being the low-cost operator, low F&D costs, low corporate overhead, etc.)”

    2013 Year End LT Debt of Exxon = $6.9Bn
    2013 YE Notes and Loans payable = $ 15.8Bn
    Conservatively sum these two, assuming both are functionally debt: $22.7Bn
    # we could include pension in here to if you want, but it doesn’t really matter in XOM’s case
    Book Value of Equity 2013 YE: $180.5Bn
    That gives you a debt:cap of ~90%. (If you include Postretirement benefits, you get ~80%)

    Coming at it from a different angle: I don’t understand how anyone can complain about leverage distorting ROE when Exxon has been AAA since at least 1995, and it still has its AAA even now, in a world environment where not even BRK is a AAA. (What’s the current total– like 5 AAA companies, globally?)

    Furthermore, you can look at Exxon’s ROE and ROIC over the last two decades and see that both have consistently been excellent in many different commodity price environments which makes it rather unique in the oil and gas space. (Even more baffling to long-time observers has been the profitability of Exxon’s downstream segment over a long time period.) Sure, I prefer ROIC for non-financial businesses but that doesn’t mean that ROE for an extremely lightly leveraged company is a problem or ‘BS’.

    Point 2: “Exxon’s hedging program suggests that management doesn’t want to take commodity price risk.”

    What hedging program are you referring to? Exxon is well known in the industry for doing essentially zero hedging of commodity price risk. If you want corroboration take a look at note 13 in the 2013 10-K. Exxon did pick up some hedges (and assumed debt) when it bought XTO but those were not particularly large compared to XOM’s firm value, and XOM let the hedges roll off and discontinued XTO’s hedging program.

    Point 3: As I recall, Munger at one point in the 2000s referred to Exxon as (approximate quote) “the best managed big company, ever.” One way to evaluate that is to look at Exxon’s ROE and ROIC over very large time horizons — and see how so called peers did during those time periods. Something to think about.

    • Wow, great comments.

      1- I am mistaken about Exxon hedging.

      2- Regarding leverage: Yes you’re right that Exxon uses very little leverage. In other situations, I think ROE versus ROIC makes a difference.

      3- What I find slightly misleading about Exxon’s current ROIC is that it reflects the past- rising commodity prices, different CEOs, etc. And it partly has to due with successful efforts accounting. Going forward, I don’t think that it will be able to invest capital at ~20% or very high rates of return. Its capex has been going up while the number of barrels produced have stayed flat.
      They are probably getting killed on shale. Rex Tillerson commented that they are losing their shirts.

      3b- I do agree with you that Exxon has historically been far better managed than its peers. However, I don’t think that past performance should be extrapolated into the future if the CEO has changed.

      Thanks again for the comments.

  4. Exxon reports return on capital (and I believe was the first of the oil majors to focus the market on this metric) for the exact opposite reason to what you are suggesting.

    They believed their peers were focusing on metrics like revenue and profit growth which were influenced predominantly by commodity prices and that the long term return on the money deployed by the business is the most relevant KPI for the company.

    One of the key reasons for this KPI is to provide a comparison with peers which generally have a level playing field when it comes to commodity prices.

    • What I really want to see is management measuring their performance with good metrics. Admittedly, this is difficult in the oil and gas industry. You may not know how good your capex decisions were until 5, 10, 20 years out. But… you can look at things like F&D costs, overhead levels (e.g. revenue per employee), days to complete a well, etc. etc. You can measure yourself based on how accurate your reserve estimations are.

      ROE and ROIC are influenced by things like accounting, reserve estimation, commodity prices, etc. etc. To Exxon’s credit, their accounting is fairly conservative (e.g. very little interest capitalized).

      • Think you’d find this recent interview with the CEO of ExxonMobil worth watching. Some of the errors in what you said have already been pointed out and you quickly fixed them. In the video he talks about not hedging, not even attempting to predict oil prices, and focusing on efficiency. http://video.cnbc.com/gallery/?video=3000336112

        I still think you should cross out “In a commodity industry, management may try to take credit for rising commodity prices. For example, Exxon Mobil points out its excellent returns on equity. Their returns on equity largely have to do with leverage and rising commodity prices rather than things that management control (e.g. being the low-cost operator, low F&D costs, low corporate overhead, etc.).” They publish ROIC which adjusts for the effect of debt enhancing returns. They compare to competitors individually so you can see Shell, BP, etc. They don’t show this number in isolation. Being the low-cost operator, low F&D costs, low corporate overhead lead to industry leading ROICs. They do show some other metrics in the Summary Annual Report such as energy intensity of their refineries compared to the industry which energy costs are something like half of the cost of a refinery so this is a metric for determine low cost operator. Also ROIC when comparing across the industry rules out commodity pricing effects.

  5. Pingback: Egregious accounting fraud in retail | Glenn Chan's Random Notes on Investing

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