Welcome to the Machine

It just seems like every other stakeholder in the U.S. public markets is dishonest. Really. But in an age of billion-dollar blow-ups, dirty double-dealing and despicable pay packages, it just needs to be noted that none of these things would work unless there is a sucker. Although there is no sure thing, there are tell-tale signs of companies that may not have your best interest at heart.

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By Bill Mann (TMF Otter)
June 7, 2002

Welcome my son, welcome to the machine.
What did you dream? It's alright we told you what to dream.
  -- Pink Floyd

It feels like that, doesn't it? Tyco's (NYSE: TYC) CEO quit this week and the next day was indicted on tax evasion, but not before he negotiated himself a sweet severance package. Adelphia (Nasdaq: ADLAE) had to disclose that its majority owners, the Rigas family, were using the company coffers like a piggy bank, while its auditors, Deloitte & Touche fiddled. Deposed WorldCom (Nasdaq: WCOM) CEO Bernie Ebbers is receiving a $1.5 million stipend from the company for the rest of his life (or at least until WorldCom collapses, which may happen within the next 2-3 hours).

We also heard from The Wall Street Journal yesterday that Representative Edward Markey (D-Mass.) disclosed that the SEC is investigating 10 cases of equity analyst conflicts of interest, and that the New York Stock Exchange and Nasdaq are investigating another 37 incidents with equity analysts. Granted, a quick look at the actual complaints (.pdf file) show that these are not exactly Wall Street's most prestigious shops. Several are located in South Florida. I'm stunned.

It seems like no one is looking out for us. The markets have tanked, and now it feels like every organization, every stakeholder to whom we looked to keep the system stable, was grabbing ill-gotten money and power hand over fist. Individual investors are bound to feel like we have been pulled in by the world's most dastardly carnies into some circus game that we absolutely positively cannot win. Welcome to the machine. Just leave your pants, because by the time we're done with you, you'll have lost your shirt as well.

Oh, yeah, and stock options are free to outside shareholders. Barbara Boxer, you just keep telling yourself that. Insiders create billions in compensation that cost shareholders nothing. Riiiiiiiight. You're a part of the big fleecing machine, and you don't even know it.

It's just despicable. There's no other word for it.

This past month The Motley Fool released a document called the The Motley Fool Manifesto that detailed many of the biggest issues facing the U.S. stock markets, and impacting participation by individual investors. This culminated with my participation on an SEC roundtable for individual investors. At the meeting it was abundantly clear that the SEC is helpless to stop manipulative behavior by participants in the markets. I say this not as a knock on the SEC, but they are at the core, a regulatory authority. They can control how messages are presented, they can enforce when people break the rules. But they cannot legislate morality, nor can they force individual investors to be responsible for themselves. Do they have more to do? YES. Are they going to break the machine? NO. They'll change the machine, but they won't break it. They can't.

But YOU can. You're never going to make yourself immune from losses. They happen to everyone, and everyone at some point will be taken into a situation where those in charge do not have their best interests at heart. It happened to me, and not that long ago. No one willingly puts his money in the hands of a criminal, but it happens. The key is to try not to go where the criminals are. In other words: If it looks like a grenade, don't sit around and say "the chances of this being a grenade are small." Go to a place that is free of grenades and things that look like grenades.

For example:

Companies that focus on EBITDA. No, not every company that uses EBITDA (earnings before interest, taxes, depreciation, and amortization) is bad. But I can nearly guarantee that every company that is trying to obscure its true economic performance is using EBITDA. Why do they do this? The simple answer is that EBITDA earnings ignores the depreciation, interest, and amortization costs of older capital purchases, which can make an asset-heavy business look much prettier. WorldCom did this for years, then suddenly, "Whoops! We've got $30 billion in debt!"

Companies with dancing focuses. Perhaps even worse than EBITDA. It requires you to go back some years and read press releases. If a company trumpets "30% rise in revenues!" on a quarter and then "18% gross profit increases!" next, look out. They may not be telling you something. Also, make absolutely sure that when a company mentions something in its PR that it's telling you the whole story. Fifteen percent revenue growth (oh, but by the way, mostly due to acquisitions) isn't very impressive. One of my least favorite companies, Research Frontiers (Nasdaq: REFR), keeps bringing up ownership in the company by institutions. Never mind that most of the ownership seems to come from indexers, not fund managers that get all teary eyed over a company that has no revenues.

We've got tons of related party transactions. Beware of companies that self-deal. In my searches for a company for our "Stocks For Dad" special that will run next week, I thought I'd take a look at companies that ran golf courses. One such company, National Golf Properties (NYSE: TEE), owns courses throughout the U.S. It leases most of these properties to another company, American Golf Corporation. Turns out that the controlling owner of AGC, David Price, is also the Chairman of National Golf Properties. Run, don't walk, away from companies like this. This disclosure is in the footnotes to the financials in the companies' 10-Ks. Almost every company will have some related party transactions, but with ones that seem substantial in nature, look out.

Don't call us, we'll call you. I remain baffled that this remains an issue. Get a phone call for a hot stock tip? Hang up. Get emails about speculative strong buys on penny stocks, or companies not listed on the major exchanges? Delete, delete, delete. Ask yourself this one question, every time: "If this is such guaranteed money, why are they contacting me?" Unless you're a big venture capitalist, there is a 99.999% chance that you are the mark, the intended sucker, the one whose money is supposed to end up in someone else's pocket. Period. End of story.

We're making money, you aren't. Every company in the footnotes to its filings provides a listing of its stock-based compensation. Let me be frank, except for the most speculative, entry level companies (which most people shouldn't be buying anyway), you are being ripped off blind if the company is granting more than 2% of its total share count as stock options in a given year. And the companies that are fighting so hard to keep stock options from being expensed are not looking out for you. Sell 'em. And never, EVER, bother to hold a company's stock if it shows any willingness at all to reprice options, or cancel and reissue.

Same goes for big executive golden parachutes (which are disclosed in company filings in advance). What the hell are they going to do for you after they've retired? What incentive do they have if the company pays 'em gobs of money no matter what? That's a heads-I-win-tails-you-lose proposition of the worst kind. There are too many companies that are trying to increase long-term shareholder value for you to bother with companies too eager to bend the rules to their favor.

This is just the beginnings of a list. It need not scare you. All of the items I've spelled out are easily found in company filings and press releases. There are too many ignorant speculators out there to expect that every company will get the message, but rest assured, by not agreeing to be a victim of the machine you will be taking away ever so slightly the financial incentive of companies to play games. After all, what good is a predator's ball if the prey refuses to show up?

Join other Fools who won't fall for these kinds games on the Eyes on the Wise discussion board. Only on

Have a good weekend!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann can't take much more of this. At time of publishing, he held a short position in Research Frontiers. Please review his profile for his full list of holdings. The Motley Fool is investors writing for investors.