If you just want to read about the current market or you know a lot about the market history, you can skip over the first 70 pages. If you are new to the market, you may find the first 70 pages to be the most interesting. Stock promotion and trading have always been corrupt. Over time, that corruption finds new ways to manifest itself. What's new now is that the potential financial stakes are so large that they would blow the mind of an ancient Egyptian pharaoh. At the same time, the social cost of corruption is equally large.
I found the book to be quite thorough when it came to the recent market bubble (and partial bursting in 2000-2002). The main area that did not receive enough attention was pointing out why boards go wild with options and CEO pay (even for lousy performance).
The book has two technical weaknesses in its observations that deserve note. First, like almost all financial writers, Mr. Berenson assumes that the current way companies employ stock options is unfixable except through accounting changes. Actually, the current use of stock options (although excessive in many cases for senior management) could easily be made into a major source of profits for companies. If companies bought back shares equivalent to the options they grant at lower prices than the option exercise price, any options that were later exercised would generate real cash and real earnings for the company. That's because Uncle Sam provides tax deductions for these options (as the author thoughtfully points out). Companies could achieve this positive result simply by granting options at exercise prices well above the current market while simultaneously purchasing the equivalent shares. The premium on the exercise price would have to account for the cost of capital on the money tied up in the meantime. If a company couldn't afford to do this, then it has a real cost of issuing options that should be recognized. Actually, that cost is recognized now through an increase in shares outstanding. Option grants are disclosed. If investors ignore these points, they deserve to bear the consequences. There's no real need to change accounting in this situation . . . just to improve financial management and board behavior.
The other problem is that Mr. Berenson doesn't quite understand accounting, and says things that are "almost" right . . . but not quite right in several places. Take his accounting comments with a grain of salt as exposing an issue . . . but don't quote him literally.
The book would have been much improved if Mr. Berenson had also examined those who managed their companies well. How did they avoid the evils portrayed in the book? What clues do those companies provide for the future?
I hope that in the future Mr. Berenson will write a book about the government numbers that mislead companies, investors and consumers about what's going on in the economy. The political propaganda that is disguised as economic information also plays a large role in stock market problems . . . and has an even larger social cost.
This book makes an eloquent piece of evidence for only investing in stocks through index funds. When you do that, you reduce your risk of being tricked by any particular corrupt company or person. You will also outperform 90 percent of all professionally managed portfolios (and a higher percentage of individually managed portfolios) when you do. Keep that in mind as you invest.
As I finished the book, I realized that the lack of practical economic education in high schools and colleges leaves each new generation exposed to the con men and women in the securities industry and those they use to weave their schemes and scams. Be sure that your children and grandchildren don't have to learn Enron-type lessons the hard way. Teach them what you know!
However, earnings depend a great deal on the methods of accounting used by the firm. In the 90s we saw a rise in very aggressive accounting. Any system of rules that is intended to be applied generally over a wide range differing conditions is going to have gaps and unintended effects that distort the intention of the rules. General rules rely upon the good will and integrity of the participants to keep the intention or spirit of the rules in tact in order for the rules to have any real meaning in application. In sports we also have referees to keep the game fair, but both teams still have to intend to follow the rules completely. No game could be played if the participants tried to push every rule to an extreme interpretation. Aggressive accounting uses extreme interpretations of the Generally Accepted Accounting Principles (GAAP) to present as favorable earnings number as possible. This results in a higher (and therefore more pleasing) EPS number.
Analysts started giving forecasts of coming EPS reports for firms and those that met or slightly exceeded that forecast were rewarded with higher share prices because investors competed for their shares. Those that missed the forecast by even a penny per share were punished as investors abandoned their stock. Mr. Berenson demonstrates that many companies had reserves and other accounting tricks to make sure their EPS forecasts were always met. However, as companies grow this becomes harder to do. And for companies such as Tyco, Enron, Adelphia, and even the mighty General Electric, it finally became impossible. The most aggressive companies had presented such a distorted picture of reality that they collapsed. Those that were still within shouting distance of reality remained solvent, but still suffered a significant depression in their stock price.
Since the EPS is inherently inexact it seems strange that the markets would react so strongly to that single measure. Mr. Berenson calls the number a lie. I think he does that for rhetorical effect and one time he does admit it is a white lie. I think he has a very strong point for those companies using aggressive interpretations of GAAP. The author also provides a history of the SEC and calls for stronger enforcement powers and the staff to provide that enforcement. While there is certainly a good case to have an effective SEC with sufficient resources (there will be a debate on what this level is), Mr. Berenson has more faith in regulation than I do.
Even if I fully concede his point and support an SEC of enormous size, it still could not provide the necessary enforcement to keep companies in line if the market keeps rewarding companies for fudging the numbers. The market will provide what people want to buy even if they want to buy lies. I agree with Mr. Berenson that INVESTORS need to become better educated and make more demands of the management of the companies in which they invest. Investors, by NOT investing in companies who use very aggressive accounting, could affect the way finances are reported than any regulatory body.
Not every company can be a growth company. Heck, even Microsoft isn't a Microsoft anymore. Investors have to demand that financial statements actually present a real picture of the financial state of the firm rather then providing a manufactured dream of ever expanding growth. One of the strengths of this book is the compelling evidence Mr. Berenson provides of management spinning these euphoric visions just long enough to cash out and then let the bad news (read reality) come to light on someone else's watch.
This is a fine book. I think that anyone who has investments in public companies ought to read it and better educated themselves on the realities of the equities marketplace. I think Mr. Berenson's recommendations for public policy are measured and good for debate even if I don't personally agree with all of them. There are a few minor quibbles I have with some of his explanations, but they don't affect my recommendation.
The book has a couple of short appendices to help the reader understand the accounting issues involved. There are helpful notes for sources and an index.