Numbers are a necessary tool and a vital one, but they are a means and not an end; a condition necessary to measure corporate success, but not a condition sufficient, writes John C. Bogle in ‘Don’t Count on It!’ (www.wiley.com). To believe that numbers – in the absence of the more valuable albeit immeasurable qualities of experience, judgment, and character – are all that illuminate the truth is one of the great failings of our contemporary financial and economic system, he rues.
It pains the author to see too many so-called industrial companies become financial companies – companies that count rather than make. He finds a parallel in a children’s game, in which rock breaks scissors, scissors cut paper, and paper covers rock. “In manias, as prices lose touch with values, paper indeed covers rock. ‘Paper’ companies that count have acquired ‘rock’ companies that make, and the results have been devastating.”
At the firm level, what anguishes Bogle is that even otherwise sound companies dwell too heavily on what can be measured – market share, productivity, efficiency, product quality, costs – and set internal goals to achieve them. But when measures become objectives, they are often counterproductive and self-defeating, he cautions.
“Most measurements are inherently short-term in nature, but far more durable qualities drive a corporation’s success over the long-term. While they cannot be measured, character, integrity, enthusiasm, conviction, and passion are every bit as important to a firm’s success as precise measurements.”
The author frets that loose accounting standards have made it possible to create, out of thin air, what passes for earnings. He mentions, as example, the popular method of making an acquisition and then taking giant charges described as ‘non-recurring,’ only to be reversed in later years when needed to bolster sagging operating results.
Other examples of ‘breakdown in accounting standards’ listed in the book include cavalierly classifying large items as ‘immaterial’; hyping the assumed future returns of pension plans; counting as sales those made to customers who borrowed the money from the seller to make the purchases; and making special deals to force out extra sales at quarter’s end.
In a section titled ‘the worship of hard numbers,’ Bogle warns investors about the peril of believing that the momentary precision reflected in the price of a stock is more important than the eternal imprecision in measuring the intrinsic value of a corporation. Investors seem to be perfectly happy to take the risk of being precisely wrong rather than roughly right, he laments.
A top peril, according to the author, is the bias towards optimism; that is, investors wearing rose-coloured glasses when appraising the past or looking to the future. By focusing on theoretical market returns rather than actual investor returns, we grossly overstate the returns that equity investing can provide, he alerts.
Reported vs operating earnings
The author is unhappy about a trend that has attracted too little notice – the change in the definition of earnings. While reported earnings had been the standard since Standard & Poor’s first began to collect the data all those years ago, in recent years the standard has changed to operating earnings, he explains. “Operating earnings, essentially, are reported earnings bereft of all those messy charges like capital write-offs, often the result of unwise investments and mergers of earlier years. They’re considered ‘non-recurring,’ though for corporations as a group they recur with remarkable consistency.”
Bogle also notes that pro forma earnings (‘ghastly formulation that makes new abuse of a once-respectable term’) reporting corporate results net of unpleasant developments, is simply a further step in the wrong direction.
Instructive read for investors.