Canada’s book cooks

In a recent article, The Economist reported that the Canadian budget uses the accrual basis of accounting for its revenues, and the cash basis for reporting its more detailed spending.

Accounting like that provides a government with the opportunity to cook the books, Enron style. The Public Sector Accounting and Auditing Board (PSAAB) of the Canadian Institute of Chartered Accountants provides recommendations for how Canadian governments should account, but has no authority to enforce their recommendations.

In a speech given in 1982 by PSAAB’s first Chairman, N.G. Ross, he posed the following question to a group of legislators – why might governments “cook the books”? The answer – because governments, like any organization, do not like to report bad news. Bad financial news can constrain policy and spending initiatives that a government wants to introduce.

In 2003 a Liberal finance minister changed the budget to full accrual accounting. But the more detailed spending estimates were still accounted for on a cash basis. So, Canada’s anticipated expeditures do not follow the matching concept, one of four founding principles of accounting.

And the government no longer reconciles the figures, the most basic accounting control mechanism.

To forensic accountants these are signs that things are amiss.

And it suggests that one of the world’s leading democracies isn’t.

More at:
Something doesn’t add up
Perspectives on Accrual Accounting

More money than sense

Cropped Thinking 500x144Daniel Kahneman, the 2002 Noble laureate in economic sciences, proved that value is a relative concept1. Marketers of luxury goods are very successful at using Kahneman’s ideas. In the stores that cater for people with more money than sense, you will find at least one item that even the wealthiest won’t buy. Those highly overpriced items are there to establish the relative value, so that a $12,000 handbag, is a good deal in relation to the one placed ostentatiously in the center of the store, priced at $37,000. They make huge profits using that technique.

That’s until Oprah, believing she is the world’s wealthiest woman, wants to buy the $37,000 handbag. The store assistant has been told not to sell that bag – it makes the store a lot of money just sitting there – but she can’t tell Oprah that, so she says it’s not good value, and that Oprah can’t afford it.

Actually, the wealthiest woman in the world is the Queen of England, who is also a very astute businesswoman. It also helps that for most of her life she was not liable for tax. She only appeared on Forbes’ list of wealthiest people once in the 1990s, and immediately afterwards ‘arranged’ her affairs so that she never appeared on the list again. She certainly would not buy a handbag costing $37,000.

Perhaps that’s because she has more sense than money.

More at:
Daniel Kahneman, Thinking Fast and Slow
Oprah Winfrey ‘racism row’ a ‘misunderstanding’

  1. Daniel Kahneman, Thinking Fast and Slow chapter 16 []

What were you thinking, man

Hindsight is 20/20 vision, but sometimes so is foresight. Investment is simply a numbers game, and the mathematics of compound interest form the foundation of how well the investment performs. Often using the magic of compound interest, and the history of past performance, investment sales people offer the promise of fantastic wealth extrapolating from an often selective history.

Right from the outset the extrapolation is dangerous, but when one takes account of the twenty and twenty fee structures that hedge funds charge, the wealth becomes illusory.

Just playing a little bit the spreadsheet makes this obvious.

if you want to invest in equities, the lowest cost options are index linked funds. These are funds that aren’t managed, but have a portfolio made up of the shares that comprise a specific index, say S&P, or Dow Jones. Usually for an index linked fund the fee runs at 0.2% of the capital invested. A hedge fund would need to outperform the index linked fund after deducting its higher expenses.20121222 FNC667

Plugging the figures into the spreadsheet makes it apparent how difficult that is. If the index is growing at 7%, which over an extended periodis considered to be very good, the hedge fund would need to be earning 12% just to break even with the index linked fund, after expenses.

Playing a little bit more with the numbers, the reality hits home. Taking economic growth of 3% over an extended period, together with the 7% return used earlier, a $100 billion hedge fund, which is small to medium-sized fund in relation to the $2 trillion hedge fund market, after 40 years would be the market. And that’s just assuming that the fund makes returns that break even with an index linked fund. If, after fees, it outperforms the indexed linked funds, as they promise, then it gets to be the market quite a bit sooner.

Perhaps that explains why the hedge fund market is shrinking now, quite rapidly.

More at:
Going nowhere fast
Rich managers, poor clients
And the winner is…
Hedge funds for beginners
Index Fund Understanding

How to make money

People in the finance industry are very good at making money – for themselves.

Take a look at the hedge funds, which have a fee structure called “two and twenty”. The two is 2% of the capital invested, and the twenty is 20% of the profits. When one does the maths, it works out that, as a client, it’s quite difficult to make money. If the return on investment is 5%, then the “twenty” gives the hedge fund 1 of the 5% and the “two” gives them another 2 of the five, which is 60% of the return. And it appears that’s a generous example. An insider, with access to the data, calculates that hedge fund managers have kept 84% of the returns, and their clients have got the other 16%. It’s a good deal for the managers.

Of course, it’s the clients who carry all the risk. It’s really not a very good deal for the clients.

Now the funny thing is that it’s not really all that complicated making money on the stock market. One of the best books on the subject “Security Analysis” has been around since 1934. Its most successful proponents is Warren Buffett. Another is Seth Klarman who, like Buffett, has made extraordinary returns for his investors. Klarman is also the author of the book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” which is now also considered to be an investment classic.

Value investment is the term given to the strategy. Briefly summarized, it’s proponents argue that it makes sense to buy something worth a dollar, if you can find it at 40 cents. They argue that the markets often react emotionally, and then sometimes going against the market makes sense, especially if you know that there is something special about the business. That’s how one finds the dollar for 40 cents.

Let’s use the example of Olympus. Last year there was a lot of bad news about the company. It had been hiding losses, and the share price crashed from a peak of ¥2,773 on 08/1/2011 to a low of ¥424.00 on 11/11/2011.

Olympus makes cameras. The camera market has become quite challenging as phones have captured the point and shoot market. So the market is shrinking to the professionals and dedicated amateurs.

Olympus has just introduced a new model that is changing that market. The new model replaces it’s clunky SLR predecessors. The new camera matched to similarly svelte high quality lenses is going to give the dominant players, Nikon and Canon, something to worry about.

If Olympus was only about cameras, buying their shares would be a great value investment, even with the market as it is. Unfortunately, they make a lot of other products, and not knowing enough about those makes the investment less certain.

Certainly worth investigating though.

Legal note: This article does not constitute financial advice. If you follow any of the suggestions contained herein, losses are for your own account. Profits are to be shared on 1% and 20% basis.

More at:
Olympus Corp (7733:Tokyo)
The Superinvestors of Graham and Doddsville
Notes to Ben Graham’s Security Analysis
Security Analysis – What did Benjamin Graham really say?
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
Security Analysis: Sixth Edition, Foreword by Warren Buffett
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
Hedge funds
Masterclass
Mastered by the universe
The Oracle of Boston
Figuring it out