Beyond The Headlines


August 5, 2020 | François Sicart
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Some years ago, I advised my clients: “Never invest in something where you can’t lose money”. This was the time when investors were beginning to mistake market volatility for risk, (which has now become a habit) and financial marketing departments were obliging the hungry crowd with a multitude of mathematicians-created products that promised to make you money whether the market went up or down. Face you win, tails you don’t lose.

The problem with the accounting approach to auditing

There were a number of problems with buying these complex products. The most prevalent was that very few people were capable to understand or deconstruct them. Another was that many people did not have the common sense to know that there is no such thing as a profitable but riskless proposition in investing.

Then, there was a minority of intelligent and educated investors, who assumed that they were smart enough to understand everything. By definition, they were incapable to admit: “I don’t understand”. By refusing to acknowledge their limitations, they often wound up losing just as much as the supposedly ignorant ones.

Some of these same people were caught in the Enron scandal (publicized in October 2001), which was the largest bankruptcy in American history at that time, and perhaps also the biggest audit failure, leading to the de facto dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world.

Enron, a self-described new-era energy company, had for several years reported stellar profits. However, they had done so, it was discovered, by using accounting loopholes, special purpose entities, and questionable financial reporting, and were able to hide billions of dollars in debt from failed deals and projects.

Two of my partners at the time, who were extremely knowledgeable about energy, went to visit the company twice. Both times, they came back saying: “We just don’t understand”. This is why we never bought the stock in spite of growing pressure from younger clients seduced by the company’s glamourous aura and its officers’ very public contempt for those who dared question them…

This should serve as a reminder to be wary of the “accounting” approach to auditing, which aims to make sure that the reported figures match mathematically, but forgets to understand how these results are generated. In doing so, they ignore the precept that John Maynard Keynes apparently borrowed from a less-famous 18th century author: “It’s better to be approximately right than exactly wrong”.

(After graduating from business school and assisting for a year two tenured professors, I did a stint for a year teaching accounting to candidates to the French equivalent of the CPA. Since I soon realized that they knew the required “entries” better than me, I decided to teach them the “philosophy of accounting’. I don’t know how they did at their exams, but it made me very popular with my class… and perhaps helped some students become better auditors.)

More recent and perhaps more extreme was the Madoff scandal. Bernie Madoff had been, among other things, a market maker and former non-executive Chairman of the NASDAQ until Bernard L. Madoff Investment Securities, which he created and chaired, was convicted of operating a massive Ponzi scheme, in December 2008.

The Madoff investment scandal defrauded thousands of investors of billions of dollars over more than twenty years. The irony is that the outstanding returns his firm reported were never actually achieved. His small staff created false trading reports, based on the price performance of stocks chosen after the fact. One of the back-office workers would then enter a false trade report with a previous date and enter a false closing trade in the amount required to produce the profit demanded by Madoff. The figures matched, but the trades were phantom.

I don’t think I would have been tempted to invest with him, but I was fortunate never to have heard of Madoff before the scandal burst into the open. After it was discovered, a few investment bankers I knew admitted to have oriented many of their clients to him but they all claimed that they had performed all the necessary due diligence before doing so.

Only one felt guilty enough to commit suicide. But, for all, the “due diligence” consisted in checking the reported numbers without checking how they were arrived at. Only a small team, whose board I had joined at the time, had not invested with Madoff because they had tried to virtually replicate the system Madoff claimed to follow, and concluded it was impossible to produce such superior results with such unfailing regularity.

This, I am afraid, is the kind of accounting-based due diligence that most fiduciaries and consultants still perform today.


Eliminating the risk in investing

What led me to write this paper was an article that my partner Bogumil Baranowski forwarded to me, which asked what money managers should do if the Federal Reserve, in order to fight the deep recession induced by the current pandemic, started to buy every security in sight.

After broadening its original mandate from trading Treasury bills and notes to buying other fixed-income securities and, most recently, even high-yield (junk) bonds, the article wondered if the “Fed” might go further and start buying common stocks as the Bank of Japan has started experimenting.

Already, the routine of announcing and implementing a policy of near-zero interest rates eliminated the risk of losses for bond buyers should interest rates rise.

Now, buying junk bonds, usually issued by financial “zombie” companies eliminated a new risk layer from the panoply of instruments money managers can buy or sell. If the Fed started buying a portion of the stock market, there would be almost no instrument left where you could lose money.

You may ask why it should be bad to eliminate risk from financial markets? One of the essential roles of the stock and bond markets, for example, is “price discovery”. This is the process through which the interaction of buyers and sellers in the marketplace determines the price at which an asset will change hands. If the central bank substitutes for one of the participants, price discovery will be potentially dictated by the government and the odds for an investor of beating “the market” will be distorted.

The original advice I offered my clients concerned individual investment products. But if the Fed decides the price at which stocks should trade, the true performance game will be over for money managers and then I will probably retire.


François Sicart – August 5, 2020



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