In the 1990s, Albert Meyer was an accounting professor at Spring Arbor University, a small Christian college in Michigan. He had a background in forensic accounting, and through due diligence on one of the University's donors, exposed one of the biggest Ponzi-style frauds of the decade.
'The Foundation for New Era Philanthropy' had systematically preyed on colleges and foundations for years, promising cuts of donations solicited to the "Foundation" in a classic pyramid structure. Prior to Meyer's work, the "Foundation" had raised in excess of $500M, over $100M of which had been embezzled by its founders. The fraud's exposure shocked the nonprofit community. Meyer's work was globally recognized - featuring on the front pages of papers including the Wall Street Journal. The experience served as a springboard for his later success in multiple high profile causes and established his credibility as an expert in forensic accounting. In the years to follow, Meyer exposed numerous accounting irregularities at Tyco, Coca Cola, Enron, and Lucent. His work has been featured in Barron's, Grant's Interest Rate Observer, and the New York Times.
In 2006, Meyer relocated to Texas where he founded an asset management firm called Bastiat Capital. Bastiat runs a concentrated large cap strategy, and heavily relies on Meyer's background in forensic accounting. Meyer recently submitted a long on Goldman Sachs to SumZero, in which he both extolled the virtues of the firm while criticizing its compensation culture. SumZero sat down with Meyer to discuss Goldman Sachs and hear his thoughts on share based compensation.
Luke Schiefelbein, SumZero: What about Goldman Sachs caught your eye as a value investor? What sparked your interest in the name?
Albert Meyer, Founder of Bastiat Capital: We bought Goldman stock for our clients in the summer of 2013. We invested in Bank of America a year earlier. The financial sector was still trading at attractive multiples after the 2009 fiasco. It made sense to look for opportunities in this sector. Goldman was trading at 90% of book value at the time. We do not invest in companies unless we have completed an extensive due diligence exercise. We summarize our findings in an internal research report that includes a five-year earnings model which we use as a roadmap to monitor our expectations against reality. We were hoping for +9% p.a. revenue growth and +11% p.a. earnings growth.
Goldman has not met these expectations, which meant we held off on adding to our holding. Earnings growth has been just shy of +8% p.a. The stock has given us a return of +9% p.a. Not what we had hoped for, but still acceptable. Though earnings growth has been disappointing, dividends have fared better. The current dividend of $3.20 is close enough to our $3.40 forecast for 2018, made back in 2013.
The company’s practice of repurchasing stock, only to nullify the positive impact by re-issuing about half of that to employees, has played a big part in suppressing earnings growth. Management might disagree with our argument. The notion that stock awards incentivize employees has been ingrained in the psyche of those who populate the boardrooms of corporate America.
Schiefelbein: What catalysts should investors pay attention to as this thesis plays out?
Meyer: It is not so much a thesis as an observation. My analysis makes the point that shareholders and employees are better off if companies follow Berkshire Hathaway’s example by paying all forms of compensation in cash only. Cash bonuses could be linked to stock performance, but keep the share count stable, or in decline through stock repurchases. That is a win-win for all concerned. We made this point in a letter to the Board of Goldman Sachs back in 2013. They responded and promised that their accountants would consider our assertions.
Schiefelbein: What is your take on share-based compensation? Why should shareholders prefer cash-based comp to share-based com?
Meyer: I wrote an editorial for Barron’s in February 2004, “The Stock Option Nightmare.” In closing, I observed that “Boasting of the pervasive employee-option giveaways at Siebel Systems, Tom Siebel called the company a ‘Marxist dream’… Instead of citing Marx, it would be more appropriate to borrow from Winston Churchill: Never in the history of the financial markets has so much been taken from so many by so few.”
I have characterized the granting of stock options as front-running, insider trading and stock-watering all wrapped up in one and judged to be legal by the regulators.
In December 2002, I published a report on eBay’s stock option grants to illustrate how the lack of proper accounting for share-based compensation distorts economic reality. Harvard Business School got hold of the report and turned it into a case study for their MBA students.
Consider, during the past five years, Goldman Sachs repurchased 158.8 million shares, but management also issued 72.4 million shares to employees. At the end of 2012, the company had 465.1 million shares issued and outstanding. If the company had paid employee wages in cash only, then the share count would have come down to 306.3 million shares – a decline of 34.1% over the five years. The actual number of shares outstanding at the end of 2017 amounted to 374.8 million, whereas the weighted average basic and diluted share count came to 401.6 million and 409.1 million, respectively. The difference is stunning, even over a relatively short period of five years.
The proxy statements of corporations invariably contain 40-plus pages to explain why the Board agrees to these outrageous executive compensation packages, comprised mostly of stock awards. In contrast, Warren Buffett’s Berkshire Hathaway only pays wages in cash, right from top to bottom. It takes less than three pages in Berkshire’s proxy statement to deal with executive compensation.
Deloitte’s 2017 publication, “A Roadmap to Accounting for Share-Based Payment Awards,” comprises 648 pages. In this regard, consider the cost of compliance.
The irony is that companies readily admit that they repurchase stock to lessen the dilutive effect of issuing shares to employees. This circuitous route means that corporations embark on extensive share-based compensation programs that make a mockery of accounting for earnings. They then turn around and buy back the stock issued to employees. I liken it to giving an employee a coupon and then redeeming the voucher at a later date, the purpose of which is to bamboozle investors with accounting legerdemain.
If companies were forced to show the cash outflows on account of stock repurchases that combat dilution caused by share-based compensation in the Operating Section of the cash flow statement, companies would probably dispense with this form of compensation. Also, companies would probably switch to cash-based compensation if they were required to true-up their stock-based compensation accruals by comparing them against the actual gains realized by employees on exercise or vesting, i.e., the expense they claim in their tax returns. The IRS should lift any limitations that the tax code places on the tax deductibility of cash compensation. This fact is the only reason why there is some merit in share-based compensation. Companies are limited to a cash compensation deduction of one million dollars per employee if I recall correctly. See also the article I wrote for Accounting Today.
Schiefelbein: Doesn’t share-based compensation make more sense for both firms and their employees? Firms benefit from SBC deductions, and employees can receive a favorable tax treatment in short- or long-term capital gains.
Meyer: As noted above, favorable tax treatment is the only argument that one could make to support share-based compensation, mainly from a company’s point of view. Employees, for the most part, cash in their stock, because they need to buy homes, motor vehicles, go on vacation, etc. Stock options are not legal tender.
Schiefelbein: What makes Goldman’s use of Share-Based compensation a “folly”? What would Goldman gain from an entirely cash-based compensation plan?
Meyer: My analysis is based on certain assumptions, legitimate and realistic assumptions. Someone else may replicate my analysis, use slightly different assumptions, but the conclusion would be the same: life gets a whole lot better for shareholders if Goldman’s share count had shrunk to 306 million shares over the past five years, which would have been the case if they had not issued 72 million shares to employees. My analysis assumes that employees would have received cash bonuses equal to what they gained in option awards.
Schiefelbein: Most of your Goldman writeup focused on their compensation plan. Independent of compensation talk, why are you long Goldman? Walk us through your thesis.
Meyer: As noted above, Goldman has not met our revenue and earnings expectations over the past five years. The company has come close to meeting our dividend expectations. Clients are now earning a 2% yield on their cost basis. We are buy-and-hold investors, and we see no near-term merit in triggering a tax on our clients’ unrealized gains of more than 50% - not an inconsequential tax consideration. However, if we need to raise cash for these clients to reinvest in new and compellingly better stocks, Goldman would be on the list of potential sells.
Back in 2013, we wrote in our internal report that Goldman Sachs is viewed by the media, especially among independents, as the evil empire. We made no such judgment. We saw the company as having significant competitive advantages, with decedent prospects while trading at attractive valuation multiples. The company is a market leader in the global financial markets with a best-in-class reputation among investment bankers. The company stood to benefit from a recovery in capital markets and rising investor confidence. There is a positive correlation between improving equity markets and IPO/M&A activity. The company has deleveraged its balance sheet and increased liquidity. With healthy revenue and earnings growth, a strong balance sheet, well-diversified business segments and improving fundamentals, the current price provided investors with an opportunity to invest in a quality company at a reasonable price that promises attractive returns.
Even though Goldman had not quite lived up to our expectations, much of what we wrote above, still holds true, and more so should the company change to a cash-based compensation model. We are willing to give management the benefit of the doubt.
Schiefelbein: Could you walk us through your New Era Philanthropy story? How did you uncover the fraud? How did doing so impact your investment philosophy?
Meyer: The college where I taught Accounting courses got caught in the web of a Ponzi scheme. The New Era Philanthropy Foundation scammed over 500 institutions.
After much effort (pre-internet age) to obtain the financial statements of the Foundation from the IRS, I engaged in a very basic forensic audit. If the foundation were legitimate, it would have substantial liabilities on the balance sheet (between $10 million and $20 million) and approximately $600,000 in interest income, conservatively estimated. There were no liabilities of any substance, and interest income was a mere $33, 000 in the year that I examined. My conclusion was obvious: this foundation had all the hallmarks of a Ponzi scheme. It took some persuasion, but after about 200-plus phone calls, more than 20 letters and faxes to various institutions, agencies, and journalists, Steve Stecklow at the Wall Street Journal responded and exposed the scam in May 1995, for which he deservedly received the prestigious Polk Award. Daylight is an excellent disinfectant. Where were the auditors of the foundation and the 500-plus institutions that were caught up in the swindle? Good question but leave that for another day.
Schiefelbein: What are the biggest red flags that you look for as a forensic accountant? How does forensic accounting differentiate your research process?
Meyer: Forensic accounting in plain English is just a detailed and lengthy analysis of the financial statements, plus some analytical adaptations to make the numbers tell a story that might not be evident to the untrained eye. I was fortunate enough to teach Accounting for 15 years, which helps enormously not only in processing the information disclosed in the financial statements but also reading between the lines to see what is not disclosed or disclosed in an obfuscated manner.
Schiefelbein: In your Q4’17 letter, you “repeat[ed] your sentiment” from 2017, looking forward to 2018 with “unusual optimism”. What feeds into that outlook? Do you still hold it?
Meyer: My optimistic outlook was mostly predicated on the potential benefits related to the tax cuts, especially those pertaining to corporations. Taxing corporations makes no sense. The destruction of capital from a tax on corporations can be quantified by multiplying the amount of cash a company sends to Washington by the company’s price-to-earnings multiple. Hence, the lower the cash transfer, the more advantageous for investors. (The investor class includes employees at federal and state level, the firefighters and teachers, all of whom have an indirect interest in the stocks owned by their pension funds. To raise tax revenues, tax dividends and capital gains at 10% for all shareholders, including trusts, endowment funds etc. – no exceptions. Disallow short-term capital losses. Treat them like we treat gambling losses.)
Corporate profits were strong in the first quarter, thanks in part to the lower tax rate. This trend seems to remain intact, as economic indicators continue to suggest an expanding economy. We are not market timers. We invest for the long-term in the best companies we can find. Market corrections provide opportunities to allocate capital to equities. Market declines hold no fear for us. Recoveries occur hundred percent of the time, with only the period of recovery being an issue. I can think of ten good reasons to “run for the hills,” but that’s not unusual. Those who heed the ruminations of the fearmongers have nothing to show for their angst over the long-term.
Schiefelbein: Where else do you see value in the market today? What else do you focus on in your research?
Meyer: It pains me to say it, as I favor diplomacy above all else, but with a $700-plus billion per annum allocation to defense spending, the military-industrial complex is the clear winner. The sector is not without risk, as the warfare vs. welfare debate is ongoing. The Republican majorities in the House and Senate are tenuous and fluid, although when it comes to budgeting, both parties are willing to fund their boondoggles with equal enthusiasm. The cybersecurity sector is very much within our sights. We are also selectively and with the utmost caution looking at foreign stocks, where we hope to find compelling ideas that surmount the significant risks associated with venturing abroad. After all, our large-cap US stocks already provide us with considerable foreign exposure. That said, we have experienced excellent returns from the handful of foreign stocks that we own.