Of coarse the stock market is rigged, it always has been
rigged, and I would speculate that it will always be rigged call it human
nature. So get use to it. The following paper is another indication of
the level of rigging.
“Earning Quality:
Evidence from the Field” Dichev, Grahm, Harvey, and Rajgopal www.isb.edu/faculty/upload/Doc952012946.PDF
From the above-cited paper you have reports that CFO of public
companies who responded (169 in all, although not typically by themselves) felt
that corporate earning reports were being managed within the economy in any
given period, by 18.43 percent of the firms.
Additionally 99.4 percent of the CFOs felt that “at least some earnings
management of the opportunistic kind happens”.
There however was a large dispersion in the answers provided by the CFO
as to magnitude of the earnings management.
The size of the dispersion precluded the authors of providing any statistically
accurate measurement of the magnitude of the earnings management.
These same CFO when asked a hypothetical for any reported
earnings what percent of the number is managed.
They estimated that about 10 percent of the reported value was the result
of some type of management. Most outsider
models estimate that the percentage of the reported earning that is managed is
much higher.
When asked under what conditions would they believe that
earnings management is being performed, the one of the following three
conditions were cited by the CFO’s (1)
fast growing firms; (2) firms whose earnings are more volatile than their
peers; (3) and firms with higher exposure to lawsuits.
When asked if earning were managed to upside versus to the
downside, only 58.8 percent indicated that they thought the management was to
the upside.
Why influence earnings, the number one answer is that
earnings influence stock prices. Given
that for many members of a company Senior Executive team not just the CFO have
their bonus contractually tied to the performance of the stock price relative
to some stock market bench mark (typically the SP 500) or to various named
competitors, it is no wonder that earning are managed, baby needs a new pair of
shoes.
My own personal opinion for what ever it is worth, would
suspect that companies that are currently trading with high P/E ratios would be
deep into the process of managing reported earnings, given that a short fall in
reported earnings could result in a significant drop in stock price given the
leveraging effect of their high P/E ratio.
In these high P/E stocks a small miss in earnings can have a profound
effect on the price of the stock, which in turn could significantly reduce the
expected bonus of the management team.
So how do you get around the rigging? Can you get around the rigging? At best I think that you can only minimize
the effects of the rigging, I do not think that you can get around it, it is
just too endemic to game. Therefore we
are left with minimizing the effects of the phenomenon. To that end my advice would be to invest in
broad base stock indexes, there is safety in numbers, as far as the index is
concern the broader the better, this will go a long way in minimizing the
effects of those companies that manage their earnings to the extreme, up or
down, call it regression to mean.
As an investor one needs to look at long term tends in the
indexes, minimize purchases on rises, and maximize purchases on retreats. A very long event horizon is also required, remember
that in the long term the stock market is a very accurate measuring device,
eventually some one somewhere will see the butcher thumb on the scale.
An investor should carefully listen to manage words, but
scrutinize managements actions, and act accordingly on any and all inconsistencies,
after all the devil is in the details. If management words are correlated with their
actions, the caution is advised.
If things appear to good to be true, well we all should know
by now that the pile of manure under the Christmas tree does not mean we are
getting a pony.
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