So often with mega disasters such as One-Tel and Enron, there have been a number of warnings signs. Here I don't mean abstruse accounting jiggery pokery that only professional accountants could pick up.

Rather I am talking about little snippets that appear here and there that make you think that there is something wrong. Or, at least, indicators of management behaviour showing that this is not the type of company you want to be associated with.

It is very easy to criticize the auditing firms for sliding over rubbery or misleading figures. They did it for financial gain for themselves and for their own companies. In a word, greed. But we have to watch our own motivations. Do we find ourselves skating past warning signs onto thin ice because we have become fixated on big profits?  I know that I have.

Some of examples of warning signs are:

• Increasingly large remuneration levels when the profitability of the company as measured by sales growth, earnings growth and return on equity is going down.

• Excessive behaviour by the chairman or CEO.

• Problems with labour relations within the company.

• Publicity that contains large dollops of hype.

• Annual reports that attempt to cover the problems.

And I am sure you can add more of your own.

I am not suggesting that any of the examples of companies mentioned in this article have committed fraud or are about to commit fraud. They are warnings signs that may point to declining profits, not to illegal practices.

Hide and Seek in the Annual Report

Regarding attempts to downplay declining profits and profitability, consider Macquarie Bank. In the annual report for the year ending 31 March,2002, we read in the Highlights section that after-tax profits increased by 3.3%. Not great, but at least it is something.

But it is earnings per share that is important to shareholders, not total earnings. To find this out,you have to dig into the body of the report. There you read in the Statements of Financial Performance that EPS has dropped from $1.40 to $1.32, a drop of 5.6%.Definitely not great.

Let us continue. In the Highlights we read that it has an excellent return on equity ROE.

But when look at the ROE chart in Conscious Investor we see that ROE is the lowest it has been for the past six years. For example, last year it was 25.7% and the average for the past five years excluding the current year was 23.1%. Now it is well below 20%.

One more thing. The total remuneration for the top executives was $A49.9 million in 2002 compared to $A29 million in 2001. (In 2002 there were 13 in this category and 12 in 2001.) This is an increase of 71%. Putting it another way. This amount represented 19.9% of total profit in 2002 compared to 12.0% in 2001.

On 25 June, 2002 the Southern Cross Airports Corporation Consortium purchased the Sydney Airport for $A5.4 billion. Macquarie Bank-managed funds hold a 53 per cent shareholding in the asset. Also the bank put together the deal as a financial advisor and underwriter.

There are many concerns that too much was paid for the airport. Whether or not this is the case is a very tough question. Some idea of just how difficult it is can be gained from a recent statement by Allen Moss, the managing director of Macquarie Bank. "In the case of Sydney airport, a huge amount of work went in over two years with more than 20 people in Macquarie bank and at the peak up to 40 people and with an extensive expense in terms of external support."

What I am talking about above is not nearly so complex. They are very simple warning signals that do not take any great expertise to uncover. But looking over what we have just uncovered, I can't help thinking that if any corporation was going to pay too much for something, it is very likely to be Macquarie Bank.

Executives Who Talk Too Much

It is a good exercise to go to the annual meetings of companies whenever you can. You often pick up things that you may not otherwise hear. At the 2000 meeting of AMP, its chairman Stan Wallis told the audience that its shares were worth closer to $30 than to $20. Back then they were around $15 in price, much the same as they are now. If the chairman is wrong by a factor of two, we can only assume that he is trying to bolster the share price.

When the CEO and chairman start to make statements about how much they think stock in the company is worth I start to feel uneasy. The business of the executives is to run the company in the best way that they can, not to try to inflate its share price. 

As might be expected, Warren Buffet has had a few words to say on this. In his Letter to Shareholders in the 2000 annual report of Berkshire Hathaway we read:

One further thought while I am on the soapbox: Charlie [Munger] and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble.

The problem arising from lofty predictions is not just the spread of unwarranted optimism. Even more troublesome is that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud.

Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic--but others will turn out to be congenital optimists, or even charlatans.

Buffett ends by saying that it is not easy to know in advance which species we are dealing with. So, along with Buffett, I think that it is much better to stay away from companies with such CEOs to begin with.

Accounting Shenanigans

What are the shenanigans that Buffett is referring to? In many cases you don't have to be a $300 per hour accountant to find out about them. Often reading the newspapers or attending annual meetings is enough. The main thing is to be willing to see what is in front of you or willing to listen to what is being said.

Long before One-Tel crashed, many newspapers articles described its accounting shenanigans. I recall one article describing how One-Tel changed their accounting methods twice in one six-month period, each time capitalizing various expenses so that their losses were reduced. In other words, reducing their current losses by pushing them into the future. 

Executive Hubris

Sure, it takes a certain self-confidence to get to the level of the being the CEO or chairman of a major company. The danger comes when this self-confidence slips over to arrogance and hubris.

I remember reading an interview with Rodney Adler when he said that he didn't worry about the financials of an investment. He went with his instinct about the management.

He used Jodie Rich, the co-founder of One-Tel, as an example. This was just before the collapse of One-Tel and its investigation by the ASIC.

Next in line was Mr. Adler himself. Just last month the Supreme Court of New South Wales handed down penalties for Rodney Adler, Mr Ray Williams and Mr Dominic Fodera all former executives of the insurance company HIH. They related to charges that these three had breeched their duties under the Corporations Act.

Have a look at the statements made by the senior executives of a company. You will often see signs that that are pushing things just a bit too far. I don't mean anything illegal. Just signs that maybe their eye is not on the ball as much as it should be. Or that they are making statements more for their own bottom line, rather than that of the companies they are responsible for.

For example, Dick Warburton is chairman of three large companies-David Jones, Caltex and AurionGold-in very different areas. He is also a member of the boards of the Reserve Bank and several other companies as well as chairman of the Government's board of taxation. Too much? He doesn't think so, recently asserting that most board decisions are generic in nature so that the boards he is on, the more efficient and experienced he becomes.

The Australian Shareholders Association is one of those who disagree. "There's got to be an upper limit to that argument and he's well and truly passed it," explains its executive officer Stuart Wilson. "Director's shouldn't overload themselves, particularly in this environment, when they need to be critically examining the accounts and management's explanations. The more overloaded they are, the greater chance you have of missing something.

The moral is if you feel uncomfortable about something that a company is doing, don't push it aside or dismiss it. It is quite likely that there is thin ice ahead. Even if there is not, it is not much fun having investments that make you toss and turn at night.

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