Conning Value Investors: A Cautionary Note

This post is irrelevant to the outcome of the Conrad Black trial; its content wouldn't change at all depending on the verdict for any of the four defendants. It's a sketchy look at how a crooked hypothetical CEO, of a supposedly stodgy company such as one in a mature industry, would con value investors.

Such a topic is hardly brought up nowadays, because it's actually quite antiquated. The last time in American stock-market history that value-investing measures such as shareholders' equity (book value) have been tampered with, to make a company's stock look better than it is, was during the 1920s. There hasn't been any widespread corporate scamming in the value-investing arena since then.

This lack of crookery is in large part due to the skepticism (not to mention cynicism) of Benjamin Graham, who actually saw the collapse of the 1920s stock market bubble. He and his kindred spirits, as a result, grounded value investing in the valuation of a stream of dividend cheques that don't bounce. Even this simple criterion requires a thorough analysis of a company's financial statements, to make sure that the dividend stream won't dry up in the future.

Growth investing requires a different mentality; growth analysts have to be boosters at heart. The saturnine perspective required for successful value investing has little place in growth investing - and the two attitudes are very difficult to combine without getting into the neither-fish-nor-fowl trap. Warren Buffett of Berkshire Hathaway is one of the few who have mastered that balancing act, seemingly by reserving the booster mentality for revenue growth (tending to focus on the growth of a product's popularity) and reserving the skeptical mentality for valuation of the companies who enjoy such growth. With the notable exception of investors in Mr. Buffett's class, though, it's either "fish or fowl," or "decay or collapse."

The skeptical life is sometimes a lonely life, and con men always play with others' emotions. In Alexander Tadich's phrase, they're "malignant narcissists," who aim to keep the marks placid, if not enthusiastic, so as to staunch their criticality. Growth and speculative stocks are an easy field for this kind of manipulation, because the skeptic often isn't wanted around at all. Thus, it's easy for a crook at the head of a growth or speculative company to turn the "mob" against the nay-sayer.

In the value field, though, nay-saying is the norm, and boosterism is looked down upon. The only psychological "opener" for a con man consists of latching on to any hidden loneliness in value investors - a sort of "who's your only friend?" approach. As long as the traditions of value investing are held to strongly, though, there will be little chance of widespread chicanery amongst value-stock companies, because any kind of palling around is, normally, easy to see though.

If these traditions be breached, however, then depredations may very well become blended in with the consequent new way. The relevant tradition that may be bent out of shape in the near future is accounting's "principle of conservatism." If it becomes stylish to mark assets (up) to market value at the expense of maintaining fidelity to accounting conventions, then a fertile entry point for opportunists, including crooks, will be created. Market values, after all, are oftentimes fickle, and there's no better camoflauge for a crook than a field where a measured opportunism is re-defined as a kind of probity.

This post was in part inspired by Roger Martin's warning about potential corporate-governance scam artists, and it builds on an earlier, prefatory post about chicanerous asset inflating.