13. BUT WHAT DO THE NUMBERS MEAN?

You can see that there are a lot of numbers floating around Wall Street, that the Game is played with numbers, and that with computers more people can play with more numbers in more combinations than anyone would have dreamed possible in the old, archaic pre-computer days BC in 1960. But what are the base numbers? They are the figures reported by the subject companies as sales and earnings, and earnings, in anybody’s systems, are one of the most important factors.

But what are earnings?

It really ought to be easy. You pick up the paper, and Zilch Consolidated says its net profit for the year just ended was $1 million or $1 a share. When Zilch Consolidated puts out its annual report, the report will say the company earned $1 million or $1 a share. The report will be signed by an accounting firm, which says that it has examined the records of Zilch and “in our opinion, the accompanying balance sheet and statement of income and retained earnings present fairly the financial position of Zilch. Our examination of these statements was made in accordance with generally accepted accounting principles.”

The last four words are the key. The translation of “generally accepted accounting principles” is “Zilch could have earned anywhere from fifty cents a share to $1.25 a share. If you will look at our notes 1 through 16 in the back, you will see that Zilch’s earnings can be played like a guitar, depending on what we count or don’t count. We picked $1. That is consistent with what other accountants are doing this year. We’ll let next year take care of itself.”

Numbers imply precision, so it is a bit hard to get used to the idea that a company’s net profit could vary by 100 percent depending on which bunch of accountants you call in, especially when the market is going to take that earnings number and create trends, growth rates, and little flashing lights in computers from it. And all this without any kind of skulduggery you could get sent to jail for.

How can this be?

Let’s say you are an airline, and you buy a brand-new, freshly painted Boeing 727. Let’s say the airplane costs you $5 million. At some point in the future the airplane is going to be worth 0, because its useful life will be over. So you must charge your income each year with a fraction of the cost of your airplane. What is the life of your airplane? You say the useful life of the airplane is ten years, so on a straight-line basis you will charge your income $500,000, or 10 percent of the cost, this year. If your net income from ferrying passengers and cargo is $1 million, it will drop by half when you apply this depreciation charge. Obviously the year you buy the airplane your earnings are going to look worse than they are next year, when you have the full use of the airplane and it is shuttling back and forth all the time. Your profits will certainly look better if you are still running that airplane in eleven years, because that year there will be no charge at all for depreciation; it will have been written off.

But that is only the beginning of the complications. Right next door at the airport is another airline. It has also bought a brand-new, freshly painted Boeing 727. So you and your competitor can be compared side by side when you both report your earnings on the same day. Right?

Hardly. The airline next door says it can run an airplane twelve years. So it is depreciating its airplane over twelve years, and its depreciation charge this year is 1/12, not 1/10, so it has only penalized its earnings $416,666 instead of $500,000, and for this year on that basis it has made more money than you have.

Don’t the accountants make everybody charge the same thing for the same airplane? No, they don’t. It just makes another little bit of work for the security analysts, who have to adjust the varying depreciation rates to constants. Accountants are not some kind of super-authority, they are professionals employed by clients. If you say the life of your airplane is twelve years, you must know your business; the life is twelve years. Delta Airlines depreciates a 727 in ten years; United in sixteen.

The airplane example is, of course, a very simple one. But what about two second-generation computers, say a Honeywell H200 and something in the IBM 1400 series? Do they have the same life? They may, as far as usage is concerned, but if you are going to sell or trade up it may be easier on the IBM. Then there is an investment credit available on new equipment, a tax assist passed to encourage capital expenditures. Is the investment credit “flowed through,” as the jargon says, right to the earnings the first year? Or is the investment credit spread through the whole life of the equipment?

If everybody used the same depreciation method but with different periods of use, life would be tough enough. But equipment is not always depreciated straight-line, an equal percentage for each year. Some companies use heavy charges at the beginning, say 150 percent declining. Some use a method with the charming appellation “sum-of-the-years-digits.” If you really want to go into details, call up your accountant and ask him for definitions.

This is only the beginning. Look at inventories: Some companies value their inventories last-in, first-out. Some companies charge their research costs as they incur them, some amortize them over several years. Some companies amortize their unfunded pension costs; some do not amortize them at all. Some companies make provisions for the taxes on the profits of subsidiaries as these profits are earned; some make no provision until the subsidiary remits a dividend to the parent.

When companies purchase other companies, the accounting gets even more arcane. The acquisition can be a purchase, a pooling of interests, or a combination of the two. Good will can be amortized or not amortized. The base of depreciation can vary wildly.

In short, there is not a company anywhere whose income statement and profits cannot be changed, by the management and the accountants, by counting things one way instead of another. Not too long ago Price Waterhouse did a study captioned with the rhetorical question, “Is Generally Accepted Accounting for Income Taxes Possibly Misleading Investors?”

Generally—but not always—a real sleuth of an analyst who doesn’t have to spend time answering his own phone, talking to customers, selling stock to pension funds, and attending meetings, can crack an income statement and balance sheet in a couple of days. This means real donkey work, digging out notes, making comparisons, finding the tunnels, and in general unpainting the carefully painted picture. But most analysts do have to answer their own phones, sell stocks, attend meetings—and still cover all the developments in their areas. So there are not many who can do the job. Even if every analyst could do this job, there are ten times as many brokers as analysts, and 200 times as many eager customers as brokers, so you can see the odds against Truth at any given instant, when your phone rings and a voice says, “Zilch is earning one dollar and selling at only twelve times earnings.” On the other hand, as we have learned, Truth will not make Zilch go up, but the Crowd’s general feeling about Zilch just might.

Most accountants are honorable men, trying to do a job. But they are hired by corporations, not by investors. Not only are they professionals hired by the corporations, but they are frequently further involved in company affairs as tax and management consultants.

For years, Wall Street accepted with religious faith an accountant’s certification as the Good Housekeeping Seal of Approval, especially those of the great national accounting firms, Price Waterhouse, Haskins & Sells, Arthur Andersen, and so on. Then came a couple of cases in which corporations reported profits, had their reports audited and certified, only to come back several years later and say that the original certified reports were, for one reason or another, off by a very wide mark. In the famous and well-publicized instance of Yale Express, the corporation reported profits for the years it was sliding into bankruptcy. (It is now being reorganized under Chapter X of the bankruptcy laws.) The angry stockholders took to the courts, suing not only Yale Express, but Peat, Marwick, the Certified Public Accountants who had put their seal on Yale Express’ reports. The air is now full of litigation, and it is not our purpose here to get into it. Suffice to say that with lawyers and the SEC in full cry, the accountants have begun to try to thread some consistencies, but there is genuine confusion among these accountants as to what earnings really are. Corporations, they say, are not all the same, and there has to be some flexibility just to reflect the differences in businesses.

The accountants have my sympathy. But not much of it. I have a lingering skepticism about reported numbers, because I have lost money accepting the reports of accountants, and there is nothing like losing money to burn in a lesson. A leading Wall Street publication says the letters CPA do not stand for Certified Public Accountant but Certified Public Assassin. I will tell you the origins of my own anti-accountant bias in a minute. It may serve you to listen well.

If the profit numbers on income statements are treated with such reverence, it was obviously only a question of time before some smart fellows would start building companies not around the logical progression of a business but around what would beef up the numbers.

Such a corporation is called a “conglomerate” or a “free-form” company, very popular when the market gets to tulip-time. A conglomerate is a company that grows by acquiring other companies, and the other companies can be in wildly different businesses. Conglomerate managers are supposed to be a new breed of brilliant wheeler-dealers, and the idea of the whole game is to take an ice-cream freezer company and merge it with a valve company and merge that with a flour mill. The valves and the flour and the ice cream never get together except on a balance sheet and an income statement, but Wall Street does look for growing earnings, and with the right accountant this whole process can make the earnings grow like crazy. Capitalism enters a new stage.

I happened to be in on the birth of a brand-new conglomerate, so you can see just how it is all done. The whole thing started with a lunch at the Colony.

I am well aware that Messrs. Batten and Durstine and Osborne did not invite outsiders that historic day at the oyster bar in Grand Central when they decided to go into advertising, and there is no record of kibitzers when Mr. Ash and Mr. Thornton were hatching the senior conglomerate of them all, Litton Industries, but this fellow called Sidney phoned up and wanted me to come uptown to the Colony for lunch.

Lunch at the Colony beats lunch at the places in the vicinity of Wall Street because of the girls in spring Pucci prints who swivel past your table, right up to the tables against the east wall. There, waiting for them, are grandfatherly gentlemen of obvious means who hold their hands. It gives one hope for the future. I spent this historic lunch listening to Sidney outline the new conglomerate, but I confess that while I was listening I was watching the prosperous grandfathers nibble the fingertips of the sweet young things. The sweet things weren’t nibbling, they were wolfing down lunch like it was never going to come again, and I even interrupted Sidney once or twice to ask what happened after lunch with the well-valeted seniors there, and Sidney said not much, but not for lack of trying. Anyway, out of this lunch I did get a new ambition for my autumnal years: I am going to sit against the east wall of the Colony with some porcelain-skinned thing who smells good and has a laugh like a brook, and let the young tigers in the middle tables spend their energies planning capers.

Before this lunch, I had only met Sidney once. Sidney is a broker, a customer’s man, at a firm that does a lot of retail business. He wears Bernard Weatherill suits and Countess Mara ties, and the corners of his handkerchief are always pointed properly in his breast pocket. He is considered a bright fellow by one and all, especially his Uncle Harry. He has done very well with Uncle Harry’s account, Uncle Harry having made the original stake in Wide-Stretch Flexi-Boost, or some such, a brassiere company.

Sidney has been around a lot of action and his interest in conglomerates stems from an inability to see any kind of opportunity pass by without reaching for it. The Colony was not Sidney’s choice but Uncle Harry’s, and I have to report that Wide-Stretch Flexi-Boost picked up the tab. Uncle Harry also brought two eager but considerably less prosperous associates.

I didn’t quite know what Sidney was up to, but as he began to talk it was obvious that he had his very own conglomerate in mind. He had seen it done a couple of times, and now why not try it himself? Sidney began warming up with the contemporary okay words like “input” and “synergy.” “Input” comes from talking to the computer people and is just what it sounds like—a friend has called you with a tip. The computer calls this a “bit.” “Synergy” is when the sum of the parts adds up to more than the whole, and is a word greatly favored by Harvard Business School graduates.

Uncle Harry likes Sidney, and is convinced of his abilities in the market, but it slowly dawned on him that what Sidney had in mind was using Wide-Stretch Flexi-Boost as the basis for his new free-form company. To Uncle Harry, of course, free form could be the name of a new bra.

“Sell the company? You’re crazy,” said Uncle Harry.

“Not sell it, not sell it,” said Sidney. “Go public. Create a vehicle.”

“Vehicle,” snorted Uncle Harry. “Wall Street doesn’t like the rag business.”

“I am talking,” said Sidney, “about a conglomerate, a growth company, with sophisticated management, using sophisticated financial techniques. I’m talking about a market value of one hundred million dollars.”

Uncle Harry started listening, because Wide-Stretch would never make it public by itself, and this was the nephew who got him into Delta Airlines before it went up ten times.

“It’s not important what our company makes,” Sidney said. “What is important is the image, the management, and the concepts. Wall Street loves all three.”

“The management in my company is me and I’m not sophisticated,” said Uncle Harry. “I’ve done very well without it.”

“Each division will run itself without interference, unless, of course, it needs help. The sophisticated management I’m talking about is on the overall corporate level, making the mergers, talking to Wall Street.”

“Finagling the piece of paper,” said Uncle Harry, listening well.

“I have a very bright manager already lined up, he’s graduating from Wharton this June,” Sidney said, “and I have a very, very sharp P.R. man ready to deliver concepts. As soon as we get the name changed and the stock public, we go after other companies. Maybe we could get somebody who used to work at Litton.”

“I know a business you could buy,” piped up Uncle Harry’s unprosperous Number One associate. We gave him our attention. “Maybe it’s not big enough,” he demurred. We coaxed him. “It belongs to my sister’s niece’s husband,” said unprosperous associate. “It’s a diaper service in Queens.”

Uncle Harry snorted and I thought Sidney would too, but he didn’t. I could see the wheels turning.

“That’s not a bad idea,” he said. “I can see a new division. Demographic Research—no, no—I’ve got it! Population Explosion, Inc.!”

“Does the diaper service make money?” Uncle Harry wanted to know.

“There are problems—”

“Management cures problems,” said Sidney. “We can juice up the accounting. He’s probably depreciating the diaper trucks too fast. Population Explosion, Inc.! It’s got a real ring to it. And the other part of the division will be devoted to research and products in the fantastic field of population—birth-control pills … who sells birth-control pills?”

“My cousin Carl sells birth-control pills,” said unprosperous Number Two associate. “He’s a druggist in the Bronx. Maybe he’ll sell you the drugstore.”

Sidney was now in a state of high excitement, but Uncle Harry wanted to know what Sidney was going to use for money. “We swap stock, we create a convertible debenture, we create preferreds,” said Sidney.

All of these, of course, are perfectly respectable instruments. But Mr. Meshulam Riklis, one of the champion conglomerateers, gave a seminar recently on how to build a conglomerate, and he called these instruments “Castro pesos” and “Russian rubles,” which does give one the feeling that they are not being used in quite the same old way.

“Computers,” Sidney was saying. “Computers are hot. Look at Control Data, SDS, SEL, the computer programing companies. We need a computer division.”

“I don’t know about computers,” said Uncle Harry’s Number Two unprosperous associate, “but my cousin Carl has a brother-in-law who reconditions adding machines. Sells adding machines, rents adding machines, also desk lamps, filing cabinets, anything you like. Very reasonable.”

“Where is the store?” asked Uncle Harry.

“Lower Lexington Avenue,” said the Number Two friend.

“Lexington!” shouted Sidney, rising from his chair. “That’s great! Lexington Computer Sciences! That one can go public by itself!”

By now you have realized that in my usual manner I have changed the names and numbers of the players, and I may have even exaggerated a bit. But not much, not much. There is really no reason why Uncle Harry’s bra company cannot be known as Space Age Materials. We are in the space age and it does use materials. Teledyne has a Materials Technology Group that used to be Vasco Metals, and before that Vanadium-Alloys Steel, but those are low price—earnings names these days and the object of the game is to get the market to chase the stock. That is why the annual reports of conglomerates are so slick and so beautiful with art work and P.R. men’s fingerprints that Albert Skira is going to bring out a $25 coffee-table edition.

In Beverly Hills, in the colonial mansion on Little Santa Monica formerly inhabited by MCA, sits the senior conglomerate, Litton Industries, and Litton has been so successful that conglomeration is respectable and the scoffers have retired to lick their wounds. Litton has collected boats and adding machines and books and made it all seem like the most contemporary of economic philosophies. They have even invented their own form of securities so that everybody is pleased when Litton buys something. Litton also has crew-cut squads from business schools that race off to shape up the kitchen-sink company when the kitchen-sink business goes down the drain.

So I suppose there is a right way to do everything, but I was once bitten by an accounting firm. As you know, the price of the stock depends to some degree on numbers, such as the numbers describing the profits. If you are only in the sealing-wax business, there is only so much leeway about what is a profit and what isn’t, short of actually fudging, which is frowned upon. But if you are busy buying and selling companies, every time they pass through your accounting firm you get the chance to try to describe artistically some of the assets as earnings, to capitalize costs that have previously been expensed, and in general to create what Wall Street is looking for, which is a neat pattern of constantly growing earnings.

If you really want to know all the accounting tricks, ask your accountant, or if he is loyal to his brethren you can call up Bart Biggs, who runs a hedge fund in Connecticut and is good at spotting tricks. I don’t know Bart Biggs, but he sounded off recently in a way that makes me think he was also once bitten by an accountant. So I will not go into the pooling-of-interests technique of buying a company when a price is over the book value, and a purchase-of-assets method when the price is below book value, but let us just say that accounting is supposed to be uniform and consistent and it isn’t, but the accounting associations are working on this.

Just so that you don’t believe everything I say, I will tell you why I am biased. A number of years ago I was running a tiny tadpole of a fund, all tail and motion and no body, and one day a salesman walked into my office, an institutional stock salesman. This is a man sent by brokers to call on institutions—mutual funds, pension funds, insurance companies, and so on—and since we had “Fund” on our door, salesmen came calling, even though the total assets of the Tadpole Fund were about what the Prudential spends on stamps.

Now I know full well that this salesman was dressed in a nice Brooks Brothers suit with a vest, but such is the power of memory and experience that when I think of him now I see him as Professor Harold Hill, the Music Man, dressed in a striped blazer and a straw hat and white spats. If you are sitting behind the desk, you do not ask the salesman, “Well, what are you hawking today?” You say, “What is the Concept?” and you make a little teepee with your fingers to show you are not easily impressed. If you really want to make the salesman uneasy you keep making your big toe go in a square while he talks. But Harold Hill was undaunted.

“You say you want ideas?” he said. “You say you want a Concept? Tell you what I’m gonna do. I’m gonna give you a Concept/That’ll put roses in your cheeks/And spring in your step/It’ll put such life in your portfolio/Your chairman will think you’re a genius/And your wife will think she’s on another honeymoon, yessirree Bob.”

I sent my big toe into the square, but it was faltering.

“Now I can tell by your intelligent face that I have a welcome reception here,” said Harold Hill, “a reception for one of the most unique ideas of this bull market, a stock that’s going to double and maybe double again, yessirree Bob, and I have the report right here in this briefcase, and if you’ll give me the order I’ll tell you the name. A tiny order, say five thousand shares, and your success in life is assured, I guarantee it, yessirree Bob.”

So I bought too much Certain-Teed Products. There was a caper going on in shell homes, sort of “We’ll give you four walls and you finish the house on Sunday with your cousin the plumber.” And Certain-Teed, which had been an unglamorous producer of shingles and asphalt roofing, created a division to build shell homes which gave it a glamour multiple in the market. The new division was called the Institute for Essential Housing. It had a nice ring to it, like the Institute for Advanced Study at Princeton.

“It’s not just another division,” said Harold Hill. “It’s not just a new product. It’s a social revolution! You’re buying in on a social revolution!”

If memory serves me, you paid something like $4.95 down on one of these houses and you got E-Z terms to pay off the rest of the $50,000, say, $25 a month. Certain-Teed reported as income the sale price of the whole house, even though the buyer had actually paid in cash only $4.95, and Certain-Teed’s reported earnings therefore went rocketing up.

Then Certain-Teed, which was selling about 60, tipped on one wing and started spiraling down, belching black smoke and developing the whine that indicates our boys have knocked off another Messerschmitt. A friend of mine called and said that the buyers of these houses were getting restive, they weren’t having their cousin the plumber finish up the house at all, they were just abandoning their $4.95 down payment. I called a vice-president of Certain-Teed, who had made a nice large, round earnings estimate, to ask him if he was sticking to it. Certainly, he said. In fact, I called the Certain-Teed management so much, as the stock collapsed, that the vice-president would have saved time if he would just have let me live at his house.

I continued to fret about the difference between $4.95, abandoned, and the whole price of the house, and finally I had a bright idea. I would go to see the accounting firm which certified Certain-Teed’s statements, one of the great world-wide accounting firms. The paneling was rich, the carpeting was thick, the portraits of the senior partners glowered from the walls. And, feeling like Oliver Twist, I was ushered in to one of the great senior partners, who naturally had mutton-chop whiskers and a scowl, just as Harold Hill wore a striped blazer. Timidly I asked whether everything was absolutely okay with reporting as income a whole house when all you had received so far was $4.95. And the great senior partner drew himself up to his full nine foot three and indicated in stentorian tones that the great world-wide accounting firm of——would never sign anything that wasn’t true.

Two years later they had a little footnote to the financial statements. They said there were “certain readjustments,” recognizing in effect that a lot of the houses were still standing there. This whacked the earnings back retroactively to the price the market seemed to have recognized much earlier. “Sorry about that,” said the footnote.

But of course the stock had gone from 62 to 11, so the little footnote was two years too late. I managed to bail out about halfway down, but it made a parenthesis on the portfolio sheet, indicating a loss, and parentheses are Very Bad. The president of the fund was very nice to me. He took me over to the window, his arm around me in a fatherly way, and we looked at the beautiful view from our thirty-third floor.

“Everyone makes mistakes, my boy,” he said. “It’s nothing to worry about. It’s all a part of learning, part of the great panoramic parade of life.”

Then he tried to push me out of the window.

So perhaps I am just not a qualified observer, and perhaps the conglomerates are indeed a new way of life. If the Federal Reserve is printing money like a banana republic, why shouldn’t some private citizens try it? Where there is a market there are those who fill the need, and right now Wall Street firms are busy poking through the quiet, slumbering portfolios of great banks and insurance companies, demonstrating there has been no “performance” or price action, and the Wall Street firms need earnings records and Concepts to help dynamite loose the long-slumbering ancient blue chips. When the dynamite goes off, the Wall Streeters gather buy-and-sell commissions to their bosoms. The Antitrust people have helped to justify conglomerates because obviously if you’re buying an unrelated business there can’t be anything antitrust about it. The conglomerate managers are bright and much more fun than the sealing-wax people, and any kind of action is better than inaction, as Our Lord Keynes once said.