Potemkin Companies

Whether or not we feel like we have power in the public markets, we possess the one thing that public companies have to have: money. Even though one investor can do little, it is still our responsibility to tell companies that offer poor disclosure and play accounting tricks that we will not invest until they clean up their acts. It requires us to pull away the rose-colored glasses and try to view companies as they are, not as we want them to be.

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By Bill Mann (TMF Otter)
March 5, 2002

The reaction was reminiscent of that pregnant pause by a family competing on "Family Feud" when some less-than-clever relative has announced that, in fact, he thinks that Atlantic City is one of the most important fashion centers in the world.

I announced to my editorial comrades that I would be writing an article about "Potemkin Companies." Crickets chirped. In the distance, a dog barked. Finally, one of them piped up. Tom Jacobs, if I recall correctly, said "Gesundheit."


There are a great number of people looking askance at companies and their financial statements and wondering if they can trust any of them at all. Given recent events, this reaction is not without logic. I think the historical example of Prince Grigoriy Potemkin offers us a great historic lesson. Potemkin was the most powerful man in 18th century Russia for more than two decades during the rule of Catherine the Great.  Potemkin was the master of showing Catherine things not as they were, but as she wanted to see them. He was able to hide some uncomfortable truths -- that he had embarked upon development schemes that were so expensive and ambitious that they had to be abandoned due to their drain on the country's treasury.

So when Catherine wanted to tour one of her conquered territories, the story is that Potemkin built fake villages along the route, complete with actors to play the roles of devoted and prosperous subjects. Historical evidence suggests that these stories, while perhaps not entirely untrue, were exaggerated by foes of the Prince. This did not stop the term "potemkin village" from entering into the lexicon as something that has a showy fa�ade to hide a decrepit or shabby condition.

Were Potemkin a corporate executive today, his apparent talents for deception would be in high demand. Companies containing "Potemkin village" qualities abound, and though some of them can float along undetected or without significant penalty to shareholders for years, the potential cost to shareholders of the fantasy of corporate health can be massive.

Who should shoulder the blame? The media and the government paint analysts and rogue corporate executives as the bad guys in such recent sensational events as the collapse of Enron and the bankruptcy of Global Crossing. In both cases the insiders have ended up with more than a billion dollars in their own pockets, the employees, outside shareholders, and even the tax man have nothing. This is the easy way out, and it is one of the media's, and Washington's favorite games: find the villain. Hang him, shoot him, and then maybe later put him on trial. Maybe.

You will never, ever find me suggesting that these executives and the rogue companies they run should not be prosecuted to the full extent of the law, and stripped of the protection that directors and executives insurance provides. Fraud is fraud, period. But in any case of fraud, there must be a mark, a victim. Any fraudster is looking for someone who will buy the story. Without that, the fraudster will fail.

But as outside shareholders, we are nearly perfect patsies. We cannot see the inner workings of these companies -- really, we have no right to see them. We have to rely on the word of the company as to how it is operating. Oh, sure, we have the nominal protection of the Board of Directors and the auditors both of which are supposed to be checks on the activities of management. But guess who nominates the directors and the auditors? Yup, the management does.

I saw an interesting take in Forbes the other day that compared the executives at Enron to a frog in hot water. Frogs, being cold blooded, won't really notice if you put them in a pot of cold water and then slowly turn the heat up. Pretty soon, voila, they are no longer frogs, but some sort of disgusting stew that I would want nothing to do with. It's a nice picture, but it's inaccurate. The frog, in the case of Enron, was raising the temperature himself. Ken Lay was not a passive rider on the bullet train to hell. He was driving. He helped build the Potemkin company that was Enron, and whether or not he knew all of the little things that were going on, he knew full well that the company was not providing investors with a picture of the company as it was, but rather of how they would like it to appear.

For years outside investors had grown fat and happy with steady gains in the stock market, so frankly we quit sweating the details. We wanted to believe that the B2B e-commerce markets were going to be in the trillions of dollars by 2003, we wanted to believe that confiscatory stock option programs "aligned management interest with shareholders," we wanted to believe that General Electric (NYSE: GE) really could beat estimates by a penny every quarter of every year.

None of these things are true. None of these things were EVER true. They were Potemkin villages set up by insiders to help outside shareholders deceive themselves. Since everyone was getting wealthy, no one cared.

Well, we damn well care now, don't we? People are running in fear from companies that have even a hint of stink about their financials. We even hear of institutional managers refusing to buy the stock of any company audited by Arthur Andersen. We're swinging the other way. Where earlier we wanted to believe that everything was great, we now want to believe that every company with the hint of gaming the system is a total sham. OK, maybe we don't want to believe this, but we're afraid to believe otherwise.

While it remains difficult for outside investors to get a good idea of management conduct, there are some hints that can be pieced together that, in totality, suggest that you're going to want to put your money someplace else. Look for these hints:

  • Consistent "one-time charges."

  • Outsized stock options grants to management, either in a sheer size or as a percentage of the company's stock float.

  • Consistent insistence by management upon 15% growth rate predictions only to guide downward in the quarter.

  • When no one on Wall Street has anything bad to say about a company, which could be a sign of massive banking deals or pressure and threats by the company itself.

  • Any sort of aggressive accounting.

  • Use of "pro-forma earnings" to hide true performance rather than enhance information for the investor.

  • Management that takes credit for all of the positive events but blames negative events on forces beyond its control.

  • Increasing research and development spending in good times, lowering it once earnings suffer in a downturn.

  • Use of debt to buy back shares of stock.

  • Use of share buybacks to hide the effect of options dilution.

  • Poor or unclear disclosure of related party transactions.

  • Annual and quarterly reports that are a confusing to read or are poorly written.

  • A management that reprices options simply because the share price is down, or even worse, cancels old options and issues new ones.

  • Consistent reporting significantly higher earnings than they do operating cash flow.

  • Poor accounting of acquisitions and divestitures.

  • And perhaps most importantly, managements that complain about the price of their stock.

Any one of these things is inconclusive. But for each one that I see for a company, I make a mental note. Too many of them, and I don't care what this company does, I'm moving on. A few weeks ago I wrote a profile of some problems I had with American International Group's (NYSE: AIG) disclosure of such things as executive compensation. An article in this week's Economist that highlighted the many ways in which AIG is inscrutable by outside investors reinforced my concern. Is AIG a sham? Certainly not. But the company possesses many of the signs of heavy management of its public perception.

As investors, we've got to realize that the power to cause companies to give us better information doesn't lie with regulators, it lies with us. If we demand the information and follow through on punishing companies by taking our investment dollars elsewhere, they're going to get the message. You think that the 30% year-to-date drop in AIG share price wasn't central in motivating the company to promise more and better information about its insurance operations?

We're never going to be able to perfectly protect ourselves from those who wish to game the system, but where the game is so clearly out in the open, if we do not call companies on their shareholder-abusive policies, we've got no one to blame but ourselves.

Fool on! Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann would like it to be known that he has the highest respect for the fashion trends that have come out of Atlantic City over the last few years. That mullet thing was sheer genius. Bill owns none of the companies mentioned in this article. The Fool has a disclosure policy.