FOOL ON THE HILL
More Stocks to Avoid

Whitney Tilson adds another category of stock that the prudent investor should run far, far away from: financial companies in which there is even the tiniest bit of doubt about whether management is ultra-conservative in its reserving practices. He warns investors away from Farmer Mac and Allied Capital.

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By Whitney Tilson
June 26, 2002

A year and a half ago, I wrote a column called Stocks to Avoid. In it, I described the types of stocks I will almost never buy:

  • Weak, money-losing companies, generally with stocks below $5, in which bankruptcy is a real possibility.
  • Speculative, money-losing companies that have extreme valuations, often due to excitement over some type of emerging technology. In particular, beware of third- or fourth-tier "me-too" companies.
  • Blue-chip companies that are showing clear signs of weakness (especially on the balance sheet and cash flow statement) but retain high valuations due to their image as stalwarts -- and, in many cases, accounting tricks that maintain the illusion of strength.

If one were to add "extremely overvalued technology stocks" to this list, nearly all of the 69 stocks I've recommended avoiding in my columns have fallen into one of these categories. Of my 69 pans, 64 are down -- 37 by more than 50% -- and the average decline of all 69 is 49%. I shoulda been a short seller! (Click here to see the performance of all 69 stocks.)

Today, I'd like to add another category of stock that the prudent investor should run far, far away from: financial companies in which there is even the tiniest bit of doubt about whether management is ultra-conservative in its reserving practices.

More than any other type of company, financial companies -- by that, I mean most insurers, banks, credit card businesses, and others that lend or invest money (I'd include companies like Enron in this list) -- have immense discretion regarding what earnings to report. Why? Because loss rates, which are typically the primary driver of profits, occur in the future and thus can only be estimated. Of course, auditors and actuaries provide some degree of oversight, but the reality is that managers of most financial institutions such as those mentioned above can pretty much report whatever earnings they want, within reason.

Warren Buffett warned about this problem in the insurance industry in his 1987 annual letter to Berkshire Hathaway (NYSE: BRK.A) shareholders:

You should be very suspicious of any earnings figures reported by insurers (including our own, as we have unfortunately proved to you in the past). The record of the last decade shows that a great many of our best-known insurers have reported earnings to shareholders that later proved to be wildly erroneous. In most cases, these errors were totally innocent: The unpredictability of our legal system makes it impossible for even the most conscientious insurer to come close to judging the eventual cost of long-tail claims.

Nevertheless, auditors annually certify the numbers given them by management and in their opinions unqualifiedly state that these figures 'present fairly' the financial position of their clients. The auditors use this reassuring language even though they know from long and painful experience that the numbers so certified are likely to differ dramatically from the true earnings of the period. Despite this history of error, investors understandably rely upon auditors' opinions. After all, a declaration saying that 'the statements present fairly' hardly sounds equivocal to the non-accountant.

If it is to depict the true state of affairs, we believe the standard opinion letter to shareholders of a property-casualty company should read something like: 'We have relied upon representations of management in respect to the liabilities shown for losses and loss adjustment expenses, the estimate of which, in turn, very materially affects the earnings and financial condition herein reported. We can express no opinion about the accuracy of these figures. Subject to that important reservation, in our opinion, etc.'

We want to emphasize that we are not faulting auditors for their inability to accurately assess loss reserves (and therefore earnings). We fault them only for failing to publicly acknowledge that they can't do this job.

From all appearances, the innocent mistakes that are constantly made in reserving are accompanied by others that are deliberate. Various charlatans have enriched themselves at the expense of the investing public by exploiting, first, the inability of auditors to evaluate reserve figures and, second, the auditors' willingness to confidently certify those figures as if they had the expertise to do so. We will continue to see such chicanery in the future. Where 'earnings' can be created by the stroke of a pen, the dishonest will gather. For them, long-tail insurance is heaven. The audit wording we suggest would at least serve to put investors on guard against these predators.

The two companies I'd warn investors away from today are Farmer Mac (NYSE: AGM), a government-sponsored entity that was chartered by Congress to do for the farm mortgage market what its larger cousins, Fannie Mae and Freddie Mac, do for the housing mortgage market, and Allied Capital (NYSE: ALD), the nation's largest business development company, which primarily invests mezzanine debt and equity into middle-market private companies. Both companies have been targeted by short sellers (another warning flag I've written about) and, in fact, the short thesis with Farmer Mac is so compelling that not only did I make it my first short ever, but it is also my largest position.

What is rare in both of these cases is that the lead short sellers have published their analyses (most short sellers try to keep a low profile). Click here to read Gotham Partners' report on Farmer Mac, and here to read Greenlight Capital's report on Allied Capital. Both companies held conference calls to rebut the charges in the reports.  The replay is no longer available on Farmer Mac's site; click here to access Allied's response to the Greenlight report.

Keep in mind that the authors of these reports have a strong financial interest in seeing these stocks decline. Nevertheless, I strongly recommend that you read them, even if you have no interest in the two companies, because I think you'll learn a lot, as I did. It's so refreshing to read a meticulously researched bearish case for a stock -- something that you will almost never see from the perma-bull so-called "analysts" on Wall Street.

Farmer Mac
My research confirms every major charge in Gotham's report on Farmer Mac, namely that the company is:

  • Highly leveraged;
  • Hugely under-reserved (I estimate by more than a factor of 10);
  • Dependent on short-term discount notes (the company would likely be bankrupt within days were it to lose access to the commercial paper market);
  • Vastly mismatched in terms of the duration of its assets and liabilities;
  • Massively overcompensating its management and directors by granting stock options at a pace that would make Cisco blush;
  • Making many transactions with affiliates and related parties; and
  • Inadequately monitored by its federal regulators, though this may be changing -- click here and here to read two New York Times articles on this topic (free registration required).

The most troubling aspect about all of this is that as a government-sponsored enterprise, the U.S. taxpayer is on the hook for up to $1.5 billion of losses if Farmer Mac is unable to meet its obligations. Yikes!

Allied Capital
The primary charge in Greenlight's report is that Allied Capital is not marking down its investments to reflect their true market value, possibly in violation of Securities and Exchange Commission requirements. Like Farmer Mac, there also appear to be questionable transactions with affiliated companies.

I don't claim to be an expert on Allied Capital -- I don't have a position in the stock -- but the Greenlight report, as well as this fund's phenomenal track record, make me certain that this is a stock to be avoided at all costs.

Conclusion
Financial companies can make wonderful investments, but the only ones I'll touch are those such as Berkshire Hathaway, Wesco, and White Mountains, whose managements I trust completely.

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway and White Mountains and was short Farmer Mac at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.