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Introduction: Raw Greed and Red Flags > Far from an Exact Science

Far from an Exact Science

There are no absolutes in this game. Experts say in the chapter on boards that it is best to avoid those dominated by families and those with long-serving, elderly directors who have business dealings with the companies on whose boards they serve. And yet, this applies to Warren Buffett’s Berkshire Hathaway Inc., widely regarded as one of the most successful American companies of the past 40 years. The seven-member Berkshire board includes Chairman and CEO Buffett, his wife Susan, his son Howard, and Buffett’s long-time managerial colleague, Vice Chairman Charlie Munger. Some of the other board members have long-term business links to the company. The majority are either more than 70 years old or about to reach that age.

Despite these and other warning signals, Buffett is seen as a key figure driving recent reforms in the American boardroom and trying to get the accounting profession back on track. Buffett is no Rigas. He has pushed hard for companies to expense stock options, which has been one of the major controversies of recent years, and he has condemned excessive compensation of executives. He is also widely regarded as one of the few at the top of the heap who really tells it as it is, admits mistakes, doesn’t seek to spin or hype, and doesn’t drive Berkshire’s short-term profits and share price. Buffett, who says he considers the ice cream produced by Berkshire’s Dairy Queen company to be one of his favorite treats, has taken just a $100,000 annual salary for 21 years. There is no reckless or wasteful extravagance. It is one of those exceptions to the rule.

In this book, I do not just focus on executives who looted companies; I also examine corporate leaders with a record of hyping their business prospects, a poor history of disclosure, or a habit of ignoring shareholders’ interests. These are hardly crimes. They will not be hauled off in handcuffs at dawn for being tardy about filing a document or for downplaying a major debt problem. However, I argue that anyone who deliberately misleads investors by telling them that a product is going to be a hit when he or she knows it could easily flop, who buries a threat to the health of a corporation, who ignores the wishes of the owners of a company, or who manipulates a board to get more than a fair share of a company’s profits deserves his or her own place in a rogues’ gallery.

This book has distinct elements. Most of the chapters have an introductory essay on the particular topic being addressed and a second section that details the relevant red alerts. There is also a glossary at the back of the book that explains some of the colorful vocabulary used in this era of corporate skullduggery.

There are two extreme attitudes in investing: one is to put all your trust in reputable chief executives to deliver on their promises and thereby avoid spending time looking beyond the headline earnings numbers. Many investors did this for years by buying into some large successful companies. If GE said earnings would grow at least 15 percent, that’s what they did, and there was no need to worry about debt levels, cash flow, pension costs, derivatives, or anything complicated like that. Indeed, GE encouraged this attitude by disclosing only what it had to.

Then there is the other extreme, exemplified by 61-year-old money manager Robert Olstein, who trusted management once early in his career, was lied to, and saw the investments of friends, family, and clients crash. He vowed never again to listen to CEO spin. “We don’t talk to management and we don’t care what management does,” Olstein told Reuters. “No management has ever told us that something is wrong with the company and we should bail out,” said the manager of the $1.5 billion Olstein Financial Alert Fund, which has succeeded by focusing on tearing apart financial statements and has therefore avoided investing in many horror stories.

This book tries to take a path between these two views. It starts by looking at some simple investment wisdom that, if followed, might keep even a fool and his or her money united, and it then heads straight into an examination of disclosure policies, the executive suite, and the boardroom—before we shake down the accounts. I have focused as much on how to avoid high-risk CEOs, uncritical boards, dubious fads, and corrupt Wall Street practices as I have on detecting accounting fraud in financial statements. For the Main Street investor lacking the time and expertise to comb through the footnotes of financial documents, the earliest signals of bad news often come from a pattern of behavior by executives rather than a detailed look at a cash-flow statement. Some go so far as to say that looking at the latter for shenanigans can be a waste of time. “You are not going to find financial fraud looking at the numbers—if it got past the auditors it is probably going to get past you,” said Michael Young, the outside legal counsel to the American Institute of Certified Public Accountants and the author of a book on accounting fraud. “Often there will be very logical explanations to numerical anomalies,” Young continued.

Certainly, when a fraud involves the transfer of large amounts of money from one part of the accounts to another, as was the case with much of the alleged $9 billion-plus fraud at telecommunications company WorldCom, it becomes very difficult to spot from outside. A much earlier alert to ditch the stock would have been the disclosure in the company’s annual financial statements filed in March 2001 that the board had agreed to loan then CEO Bernie Ebbers up to $100 million and guarantee loans for even more to help cover a margin call he was facing over purchases of the company’s stock. It should have been clear to shareholders at that stage that this was a company prepared to act recklessly, in this case by bailing out its top executive.

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