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Why bother....(says Terry Smith)

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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Why bother....(says Terry Smith)

#193020

Postby TheMotorcycleBoy » January 12th, 2019, 3:01 pm

This is from the FT, it is a slightly old (2015) interview with Terry Smith. I found it interesting, and hopefully people won't mind me posting it here. The original can be found by googling "why bother cooking the books". Should be the first hit.

In August 1992, my book Accounting for Growth was published. It exposed how companies used accounting trickery to flatter their reported performance. Nowadays, there are brokers such as Muddy Waters and Iceberg who specialise in revealing these practices, but in 1992 such research was most unusual so it caused quite a stir.

My then employer tried to stop its publication, which of course only made people want to read it, sending it to the top of the non-fiction charts. I was fired, which sent my career off in a more entrepreneurial direction, and several of the companies named in the book got into serious difficulty or simply went bust.

A second edition was published in 1996 and I’ve often been asked to reprise the subject with another book.

One of the reasons I haven’t is that publication of the book roughly coincided with the start of a successful campaign by the Accounting Standards Board, led by Sir David Tweedie, to stamp out many of the abuses in company accounting.

Another is that I am not sure many investors or analysts study company accounts any longer. Instead, they seem to rely upon management presentations using “adjusted”, “core” or “underlying” earnings or profits.

One sector in which my Fundsmith Equity Fund does not own any stocks is pharmaceuticals. This seems to surprise some commentators, who think that drug companies would represent exactly the sort of dependable returns we seek. After all, such stocks benefit from seemingly inexorable growth in demand for healthcare, especially among the ageing populations of the developed world, and margins that are shielded from competition by patents.

One reason we don’t own them is that the sector has become rated on the basis of “underlying” earnings. Beginning in about 2010, many major pharmaceutical companies started a switch to reporting what they term “core” earnings. This switch was allegedly to smooth out exceptional items from reported earnings and make trends more recognisable.

So what is excluded from earnings based on generally accepted accounting principles (GAAP) to get to “core” earnings?

1. Restructuring costs, although they seem to be a recurring item in the accounts of a number of companies. GlaxoSmithKline, for example, has not had a quarter without any since 2008.

2. “Exceptional” legal charges. Once again, given the nature of the industry involving patents, patent disputes, regulation and product liability, it seems inevitable that significant legal expenses will be a more or less constant feature of a pharmaceutical company’s profit & loss (P&L) account. So it is hard to see how they are by nature exceptional.

3. Intangible asset amortisation and impairment. When pharmaceutical companies buy a drug from another company or buy another drug company — and they have been doing a lot of that — they create intangible assets that represent the amount they paid over and above the tangible or hard assets acquired. This is usually the vast majority, if not all, of the cost and GAAP requires it to be both amortised by a charge to the profit and loss account, usually over the life of the drug patents, and written off in the event that a drug fails its trials — a not infrequent event.

Some will argue that it is acceptable to exclude these intangible charges as they are “non cash”, but doing so turns the P&L account into a hybrid of accrual accounting and cash flows. If you are interested in a company’s cash flow, and you should be, the place to gauge that is in the cash flow statement, not a doctored P&L account which excludes some non-cash items. AstraZeneca, for example, has over £16bn of these intangibles on its balance sheet which would cause an annual charge of some £1.6bn, but this is not reflected in its “core” earnings.

Moreover, excluding these intangible items means that the cost of acquiring new drugs and biotech companies does not appear anywhere in these “core” earnings. In light of this, is it any surprise that the pharmaceutical sector has been on a binge of buying biotech companies, spending $80bn in 2014 alone?

All of the adjustments have one thing in common — they make the reported “core” earnings higher.

Faced with this opportunity to flatter the earnings it is also no wonder that management incentives have been remodelled to take advantage, with some or all of management remuneration in the sector based on “core” earnings.

Unsurprisingly, since 2010 the GAAP earnings per share (EPS) in the sector have decreased significantly as a percentage of “core” EPS — in the case of AstraZeneca from 84 per cent to just 23 per cent by 2014. In other words, as their pay has come to depend upon “core” earnings, more and more bad stuff has been excluded from the calculation.

For example, AstraZeneca reported GAAP EPS of $5.60 in 2010 but courtesy of “core” earnings this became EPS of $6.17. By 2014 the GAAP EPS of just $0.98 had become “core” EPS of $4.28.

The net result of all this is that the ratings which many pharmaceutical stocks appear to trade on bear little resemblance to reality based on their GAAP earnings:



In my view, if you are an investor in pharmaceutical stocks this should worry you a lot. If you want to know more, broker Baden Hill Sanlam recently published a critical — and in my view good — research report on “Big Pharma”. The irony is that in order to discover what is really going on you do not need to be a sophisticated financial analyst. All you need to do is get the GAAP EPS number from the accounts.

Hence my view that there is no point in companies engaging in any form of accounting chicanery, when their legerdemain seems to have the entire market looking somewhere other than the accounts.


Matt

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Re: Why bother....(says Terry Smith)

#193033

Postby Charlottesquare » January 12th, 2019, 3:48 pm

It has been ever thus.

Not sure if it was his book or A N Other but I had one such in the early 1990s, it had 2+2=5 on the cover and covered various nefarious activities like profit smoothing with pension fund valuations, exceptional and extraordinary costs etc, it likely lurks somewhere in the house or my office , certainly have not spotted it for a good few years.

The problem is that business, especially multinational business, is far more complex and also rules based these days, the catch with this latter is some smart cookie then works out ways to play the system, (Its allowed, honest) we just need to think of off balance sheet finance re Enron but there have been plenty of others such examples.

In my view, rather than throw our hand up in horror and give up, we have to approach accounts viewing them as a "maybe view" of underlying reality, I tend to try to concentrate more on cashflows than profits as the former are trickier to distort in the long term, the catch is I doubt I could actually describe my approach, a large part is gut feeling, and I have made mistakes with some right lemons over the years, hence why these days I tend more to geographic and sector investment decisions (where and what at a macro level) and let the fund managers chose the individual stocks. (Though Shell and Unilever do remain as long standing friends)

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Re: Why bother....(says Terry Smith)

#193040

Postby monabri » January 12th, 2019, 4:05 pm

I used to own shares in GSK but sold them. Reason - as an income investor I realised that I could get a (i) slightly higher yield with an IT that (2) would likely grow by a few percent p.a. wheras the uncovered divi , debt heavy GSK has frozen their dividend.

TheMotorcycleBoy
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Re: Why bother....(says Terry Smith)

#193058

Postby TheMotorcycleBoy » January 12th, 2019, 4:55 pm

This is the second edition

https://www.abebooks.co.uk/servlet/Book ... 0147212523

(going to start buying books from non-amazon from now - New Year's resolution)

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Re: Why bother....(says Terry Smith)

#193060

Postby kempiejon » January 12th, 2019, 5:00 pm

TheMotorcycleBoy wrote:This is the second edition

https://www.abebooks.co.uk/servlet/Book ... 0147212523

(going to start buying books from non-amazon from now - New Year's resolution)


Unfortunately Abe Books is an amazon company https://en.wikipedia.org/wiki/AbeBooks On August 1, 2008, Amazon acquired AbeBooks

TheMotorcycleBoy
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Re: Why bother....(says Terry Smith)

#193062

Postby TheMotorcycleBoy » January 12th, 2019, 5:09 pm

kempiejon wrote:
TheMotorcycleBoy wrote:This is the second edition

https://www.abebooks.co.uk/servlet/Book ... 0147212523

(going to start buying books from non-amazon from now - New Year's resolution)


Unfortunately Abe Books is an amazon company https://en.wikipedia.org/wiki/AbeBooks On August 1, 2008, Amazon acquired AbeBooks

Arrgghh!!! How sneaky......do you happen to know a decent alt. online book merchant?

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Re: Why bother....(says Terry Smith)

#193066

Postby kempiejon » January 12th, 2019, 5:18 pm

I like real life so use WHSmith and Waterstones and a local independent (I think) however a quick google https://www.waterstones.com/book/accoun ... 0712675949

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Re: Why bother....(says Terry Smith)

#193085

Postby Dod101 » January 12th, 2019, 6:59 pm

On the subject of book suppliers, many independents use abebooks for online sales so it is difficult indeed to get away from Amazon.

Terry Smith is as usual very much on the button although GAAP has pretty well been abandoned for IFRS as far as I know and that seems to take us further from reality than ever.

Dod

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Re: Why bother....(says Terry Smith)

#193086

Postby bluedonkey » January 12th, 2019, 7:12 pm

Very interesting. It made me look closer at Astra Zeneca's EPS. There's a summary here of the last several years.
https://www.hl.co.uk/shares/shares-sear ... nd-reports
It's clear that adjusted EPS has been consistently massaged. Given the recent rise, I'm tempted to sell. I rarely do but I might.

GSK has a similar phenomenon with its EPS.

No wonder their dividends have been static. They're uncovered most years.

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Re: Why bother....(says Terry Smith)

#193091

Postby TheMotorcycleBoy » January 12th, 2019, 7:38 pm

kempiejon wrote:I like real life so use WHSmith and Waterstones...

Me too! But I live in the rural Fens, no WHS or WS for miles :( And my day-job necessitates 300+ miles/week on East Anglia's worst road....so in my free time the car stays parked in the drive!

TheMotorcycleBoy
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Re: Why bother....(says Terry Smith)

#193094

Postby TheMotorcycleBoy » January 12th, 2019, 7:43 pm

bluedonkey wrote:Very interesting. It made me look closer at Astra Zeneca's EPS. There's a summary here of the last several years.
https://www.hl.co.uk/shares/shares-sear ... nd-reports
It's clear that adjusted EPS has been consistently massaged. Given the recent rise, I'm tempted to sell. I rarely do but I might.

GSK has a similar phenomenon with its EPS.

No wonder their dividends have been static. They're uncovered most years.

FWIW I downloaded GSK accounts a few months ago (the last 4-5 years worth) and I put my slide rule over them, and I really couldn't fathom out where the FCF for the dividend comes from exactly. Just didn't seem to add up...I didn't bother with making a purchase on that basis.

Incidentally, the reason I posted this thread, was because in this earlier one, Howard posted this and the book cooking link (IIRC) was embedded in the Tesco/AZN/FT article in Howard's link.

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Re: Why bother....(says Terry Smith)

#194341

Postby monabri » January 17th, 2019, 6:04 pm

Article by John Kingham on "why he sold GSK"

https://t.co/Ntks9DmICF?amp=1

TheMotorcycleBoy
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Re: Why bother....(says Terry Smith)

#194355

Postby TheMotorcycleBoy » January 17th, 2019, 7:08 pm

monabri wrote:Article by John Kingham on "why he sold GSK"

https://t.co/Ntks9DmICF?amp=1

An interesting read. From reading JKs article and reflecting on the recent past, it seems the big R&D spend (to find next Advair) was, maybe, wasted money, and internal growth prospects didn't materialise, hence recent move to acquire Tesaro. Growth by acquistion, always more risky than organic growth, in my naive opinion.

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Re: Why bother....(says Terry Smith)

#194405

Postby 77ss » January 17th, 2019, 11:12 pm

TheMotorcycleBoy wrote:[.....hence recent move to acquire Tesaro. Growth by acquistion, always more risky than organic growth, in my naive opinion.


Debatable.

However, it is pretty common practice in 'big pharma'. Buying pipeline.

Which might lead one to think (hope?) that investing in the smaller companies (such as Tesaro) can but pay off. There are investment trusts that enable one to do just that.

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Re: Why bother....(says Terry Smith)

#194431

Postby monabri » January 18th, 2019, 8:16 am

77ss wrote:
Which might lead one to think (hope?) that investing in the smaller companies (such as Tesaro) can but pay off. There are investment trusts that enable one to do just that.


Any ones in particular that come to mind pharma specific ?

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Re: Why bother....(says Terry Smith)

#194461

Postby 77ss » January 18th, 2019, 10:21 am

monabri wrote:
77ss wrote:
Which might lead one to think (hope?) that investing in the smaller companies (such as Tesaro) can but pay off. There are investment trusts that enable one to do just that.


Any ones in particular that come to mind pharma specific ?


The one I hold is Worldwide Healthcare Trust (WWH). It is not, however, purely pharma specific. If I remember rightly, healthcare ITs generally spread their investments more broadly than that. Suits me. Check out trustnet and the aic site.

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Re: Why bother....(says Terry Smith)

#194464

Postby bluedonkey » January 18th, 2019, 10:26 am

Further to my post of 12.1.19, I sold my holding of AZN. Proceeds went 50% into VAPX (Vanguard Developed Asia ex-Japan) and the other 50% into HYP usual suspects: IMB, BP, RIO.

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Re: Why bother....(says Terry Smith)

#195194

Postby ADrunkenMarcus » January 21st, 2019, 9:28 am

I plan to trim AZN somewhat, reducing the proportion of portfolio income it provides.

Best wishes

Mark.


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