Profit margins differ among industries and to a lesser extent among companies in the same industry. If margins are too low, the company is reliant on debt to expand. If margins are too high, it attracts competition. Importantly, if the profits are real, the company can pay cash dividends.
While some shareholders may prefer that a company reinvest its earnings to create future wealth for shareholders, the sad reality, as noted by Benjamin Graham in The Intelligent Investor, is that few companies are able to reinvest such profits to earn the same rate of return as the existing business.
Besides assuring shareholders of a minimum return on their investment, a cash dividend also serves as useful, albeit partial, proof that the company’s reported earnings are real.
If the profits are real, the margins will also be similar to that of competitors – after all, with the same capital inputs, the same workforce, the same customers, and the same selling price, the profits must also be the same. Few companies are so unique that they have no competitors and can set any price they wish.
So what happens if the profits are fake?
Generally, if the profits are fake, it is because the reported profit margin is too high. This can be detected in a peer comparison with the company’s direct competitors, or similar businesses operating elsewhere in the world. Given today’s globalized economy, very few companies will leave a region alone if it is seen that a peer is making good profits there. Thus, excess profits are unlikely to persist, and over time profit margins go back to normal i.e. there is reversion to the mean.
Because profits and losses from the income statement are reflected in the balance sheet, fake profits will also show up on the balance sheet, often in the form of imaginary cash balances.
The problem here is that cash is a transparent and easily auditable item, which makes it a prime focus of auditors. Blatant fraudsters may of course collude with bank officials to produce fake statements to fool the auditors.
However, even if the auditors are fooled, as cash apparently builds up on the balance sheet, it becomes increasingly more difficult to fend off minority shareholder demands for cash dividends, or at least a repayment of outstanding debt.
One way to avoid having to show the cash to the auditors is to not collect it in the first place. This then causes the trade receivables account to swell. This topic was discussed 3 years ago in the June 2009 newsletter, so it will not be discussed further here.
If one does pretend to collect the cash, then the logical progression is to use up the fake cash on items which are harder to evaluate than cash. Popular choices include inventory, machinery, supplier prepayments, intangible assets and even other companies.
Inventory, specifically finished goods, can be a useful place to dump fake earnings, as finished goods comprise a mix of different costs such as raw materials, capital and labour. This creates more work for auditors, who are not interested in dissecting the business to figure out the true cost of finished goods.
In a retail business, the stock is also scattered across hundreds if not thousands of stores. So a retail company can dump fake earnings here and be fairly confident that the auditors are not going to do a thorough stock-take.
For example, Ports Design, a luxury apparel brand, has reported very high profit margins for the past 10 years. One would expect that Ports would then be sitting on a huge cash hoard. Instead, Ports has opted to plow much of its earnings back into inventory, to the extent that since the end of 2009, its inventory holdings have represented more than 18 months of sales.
But apparel, by its nature, goes in and out of fashion. Therefore, stock…