Near zero interest rates for more than a decade, passive indexing, the rise of machine learning and the absence of an accounting accident since Enron are the key reasons for declining investor interest in financial reporting. The way forward might be to make quant models more intelligent by incorporating micro insights that a good analyst can eke out of financial statements.
“Who reads a 10-K anymore?”
I get asked this question quite often when I teach my class on deep fundamental analysis of financial statements. I gave a talk to chief investment officers of state pension funds the other day and asked who among them routinely reads a 10-K. Around 10% of the gathering of around 60 officers raised their hand. This is troubling. Here are a few hypotheses related to why the tepid investor interest.
“Free” money post 2008 due to quantitative easing
When interest rates are close to zero, realizing earnings next year relative to say 10 years from now is almost the same. Lower rates also encourage investment in speculative investments such as crypto currency or meme stocks such as AMC. My senior colleague, Trevor Harris, points out “with no discount rate, fundamentals are potentially less relevant.” One could argue that growth stocks tend to do well when interest rates are low relative to value stocks. However, even for growth stocks, the analyst needs to assess barriers to entry, competitive advantage and pricing power of the firm from financial statements.
No interest among the passives
Footnote 38 of the proposed SEC climate rules lists the multi-trillion dollar investor groups that are pushing for such rules. The list includes Blackrock, with assets under management (AUM) of $9 trillion on June 11, 2021, when the rule was proposed, and CERES, representing an investor network on climate risk and sustainability representing AUM of $37 trillion, CII or the Council of Institutional Investors with AUM of $4 trillion, Investment Adviser Association associated with AUM of $25 trillion (IAA does not manage assets), Investment Company Institute with $30.8 trillion, PIMCO with AUM of $2 trillion, SIFMA (Securities Industry and Financial Markets) with AUM of $45 trillion, State Street Global Advisors with AUM of $3.9 trillion and Vanguard Group with AUM of $7 trillion. To be clear, these numbers come from the SEC’s footnote 38 of the SEC’s climate risk disclosure rule.
This is an impressive amount of firepower. When was the last time this much firepower collectively advocated for specific disclosure and reporting related issues in a 10-K?
Changed priorities of the FASB and the SEC?
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Jack Ciesielski, owner of R.G. Associates, a research and portfolio management firm, has argued that the FASB has concerned itself with simplification of accounting standards, rather than prioritizing the improvement of financial reporting for the benefit of investors, especially as companies have grown more complex and larger, and place more investments in intangible assets.
The number of AAERs (Accounting and Auditing Enforcement Releases) focused on financial reporting and disclosure issues issued by the SEC has also steadily declined since the days of Enron. A detailed dataset maintained by Patty Dechow at the University of Southern California suggests that reporting and disclosure AAERs peaked at 237 in 2004. In 2012, the number of AAERs fell to 65. In 2018, the last year for which data was reported, the SEC issued 73 AAERs. It has been suggested that the SEC’s enforcement priorities after Enron and the passage of the Dodd-Frank Act had transitioned to policing of terror financing and then to the mortgage meltdown after 2008. Commissioner Clayton, during his term spanning 2016-2020, was known to focus on “retail fraud.” The emphasis now seems to be on ESG and crypto related issues.
Of course, there are other concurrent developments that analysts have blamed for such a small number of reporting related AAERs. Has the advent of the PCAOB reduced the number of accounting and reporting irregularities? That is hard to investigate partly because the PCAOB does not publicly disclose the names of firms with unsatisfactory audits.
Does the decline in the number of public companies have something to do with this? Michael Mauboussin, Dan Callahan and Darius Majd of Credit Suisse First Boston (CSFB) find that the number of publicly listed firms almost halved from 7,322 in 1996 to 3,671 in 2016. I am not sure that this declining trend can explain the lower number of AAERs. In one of my studies, Chief Financial Officers (CFOs) suggested that in any given period, about 20% of firms manage earnings to misrepresent economic performance. Even if half of these are frauds, regulators have potentially a lot more work to do.
No major accounting accident since Enron
Jack Ciesielski points out, “there have been fewer accounting tragedies. Self-interest associated with detecting and preventing tragedies is low now. Also - I often found that there was a higher degree of interest in financial accounting among investors when the FASB was active/proactive. Investors and particularly sell-side analysts were interested in how accounting changes would affect their earnings models. The FASB not only has gone deep into "simplification," they also have not taken on projects that are not so dramatic as say, income taxes in SFAS 109, or OPEBs with 106, or fair value in SFAS 157. The FASB soft-pedals their projects now.”
The rise of quant investing
“Investors have become monochromatic (e.g., value/growth based on M/B or market to book ratios and P/E or price-earnings ratios) and worry about accounting only when its too late,” says Jack Ciesielski. For instance, a relatively large literature has pointed out the distortion of M/B and P/E on account of mis-measurement of intangible assets. Large sums of money are run via quant models that can be quite simplistic.
Ciesielski adds “many that I know rely on Beneish’s M score, or Sloan’s accruals to convince themselves there is no chicanery and there is no need to go further.” Both Dan Baneish and Richard Sloan, the academics who came with the M score and the accrual anomaly respectively, are dear colleagues who I respect and admire greatly. They themselves will probably admit that summary measures such as Beneish score and accruals miss nuances associated with a firm’s business. For instance, income increasing accruals can either represent misrepresentation of a firm’s earnings or natural growth, as reflected in higher working capital accruals. The quant can try and condition such accruals on noisy proxies such as those reliant on corporate governance but such attempts to identify managerial opportunism are usually not very satisfactory.
Pranav Ghai, CEO of Calcbench says, “we see increased demand for our machine extracted financials but it is automated demand. Twenty five years ago, the users were people like Mary Meeker (or her team) and/or Dan Reingold at Credit Suisse. Today’s users are Aladdin, the portfolio management software of Blackrock.”
It perhaps follows that Aladdin is less likely to care about the SEC or the FASB’s pronouncements or lack thereof related to financial reporting. Even if Larry Fink, the CEO, cares about the nuances of financial statements, would that interest translate down into the channels that exist within Blackrock? And what the other quant shops such as Citadel, Worldquant or AQR?
The rise of machine learning
We live in a world where complexity is mostly dealt with through machine learning applications. Machines do not have a sense of the limitations of the underlying accounting measures. Nor can such machine learning application ask strategic questions that an analyst potentially can about the financial sustainability of a business. A research group of one of the largest passive index managers routinely runs NLPs (natural language processing) on 10Ks and proxy statements (and press releases, conference call transcripts and more). However, micro work associated with understanding the mosaic of information reflected in financial statements does not scale well and is hence very expensive to implement for 5000 plus stocks.
Dearth of patient capital
Unless an analyst can show that a strategy based on fundamentals can yield alpha quickly, hedge funds are usually not that interested. Trading has become relatively costless because technology underlying trading systems and exchanges marches on. Trevor Harris says, “ I think the patient capital problem is not new it is just that ETFs and mutual funds have proliferated. Almost zero transaction costs has made investing “costless” so trading and short-term activity has proliferated.”
Diversification
“Investors constantly hear that they should be diversified. The more diversified they are, the lower the importance of any one company-specific issue, such as accounting. This is just one of many risks they diversify away,” says Vahan Janjigian, Chief Investment Officer of Greenwich Wealth Management, LLC.
What, if anything, can be done about such tepid interest?
“I think the only thing that can be done is to keep the faith. At some point, there will be an "accounting tragedy" that reinforces the importance of looking behind the numbers” says Jack Ciesielski.
We also perhaps need a way to make machine-based models more intelligent about the micro analysis that a lot of us love to work on when we look at 10Ks and proxy statements. ESG is a whole new opportunity to bring the micro skills that analysts develop with financial statements to an area that badly needs discipline in measurement and reporting.
