December 5, 2012
A day before Hewlett-Packard (HPQ) announced an astonishing $8.8 billion writedown associated with its acquisition of Autonomy, the governance analysts at GMI Ratings released their first “Black Swan Risk List.” Right there on the roster of companies that GMI believed to offer a disproportionate risk of something going very wrong in the near future – a so-called Black Swan event – was Hewlett-Packard’s name.
GMI has since produced a second list of 40 companies with a market capitalization north of $5 billion that it believes have extraordinarily aggressive accounting practices. “Inclusion in this list,” said GMI CEO James A. Kaplan, “signifies an elevated risk of adverse events that can materially affect share prices.” Translated, that means these are companies that investors should run away from screaming as loudly as the victims in horror movies.
Some of the companies on the second list of 40 potential Black Swans – all of which GMI believes may see a stock price decline of 50 percent or more in the next six months because of their accounting policies and the problems that these have created – have already been in the headlines for all the wrong reasons.
Chesapeake Energy (CHK), for instance, has been trying to resolve its ongoing business and governance woes in a very public fashion for much of the year. Western Union (WU) is struggling to come to grips with changes in the payments business that have brought about new kinds of competition and shrinking profit margins.
Other names, however, may well raise your eyebrows. Mastercard (MA) makes the list, as does Tiffany & Co. (TIF). The former has been one of the outperformers in 2012, rising 32 percent so far this year. While Tiffany’s stock price has flagged, market chatter has linked that more with questions about high-end retailers rather than company-specific accounting woes. Among financial stocks, Bank of New York Mellon (BK) makes the list, but the megabanks that investors love to loathe, such as Citigroup (C) or Bank of America Merrill Lynch (BAC). Indeed, the banking universe is under-represented on the GMI list relative to its weighting among large-cap stocks.
GMI may have gone out on a limb, but its success in giving investors a very early warning (dating back to 2009) about problems that could weigh on Hewlett-Packard’s stock price mean that this is the moment it can trumpet the value of forensic accounting in general and the need to constantly question the validity of reported financial statements.
In the wake of the Bernie Madoff Ponzi scheme, the misleading accounting of companies like Enron, WorldCom and Tyco, one might be forgiven for thinking that this is a lesson investors already have learned. Evidently not, or Hewlett-Packard’s writedown amid allegations that Autonomy hid or failed to disclose accounting improprieties wouldn’t have come as such a bolt from the blue. After all, Hewlett-Packard had ranked high on GMI’s risk model for more than three years, long before the vast majority of investors suggested there might be anything amiss.
Some of the names on the Black Swan list are clearly there for a reason; others may or may not prove to have similarly acute accounting problems. Still, the list is a reminder that even at venerable blue-chip companies, things can go very wrong. The causes of the debacles vary, but there are some familiar factors across the 40 companies.
Half of them offer incentives that may lead chairmen, CEOs and CFOs to disregard warning signs; nearly two-thirds have a chairman who also serves as a CEO. (The latter has long been a major source of contention between governance activists and corporate boards.) By far the largest reason why a company may end up on the list, however, is because of its track record of mergers and acquisitions.
As for the accounting issues that pop up as reasons for GMI waving a red flag, well, investors may do well to devote some extra scrutiny to factors such as asset turnover, the ratio of cost of goods sold to the company’s revenue, the valuation of intangible assets and accounting policies on such items as goodwill and depreciation expenses.
Only about 5 percent of the companies that GMI monitors end up earning a failing grade, the rating agency says. They just happen to be the ones that GMI makes the most noise about, because investors really care – and rightly so. To be a successful investor, first and foremost you have to figure out how to avoid losses; to lose 10 percent in a year is bad enough, but in order to get back to where you started you have to earn more than 11percent. It’s simple math. If a company earns good grades on the transparency of its accounting and the more intangible measures of good governance, the odds that it is hiding something nasty in the woodshed are going to be lower; then you simply need to worry about the more obvious issues of business risk.
GMI may not be correct in predicting gargantuan losses for all 40 names on its Black Swan list, but the company is right to remind us that these issues matter, however difficult they may be to understand. Over and over again, investors have shown that they don’t really internalize the messages of past crises. The events of 2001-2002 may have sparked a brief surge in interest in forensic accounting, but it hasn’t stuck around. Hewlett-Packard and the other Black Swans should serve as a wakeup call for us all.