Friday, December 5, 2008

Beware The Big Bath

It is usually in economic times like these, where earnings are generally poor, that managements will incur asset write-downs and/or restructuring charges. This phenomenon is known as the "big bath". When earnings are negative, a further reduction in current earnings changes little in the way of currently non-existent management bonuses, but sets the company up for artificial earnings gains later, when bigger and better bonuses are to be had as a result.

A simple example presents itself in the form of the acceleration of an asset's depreciation. By writing said asset down now, earnings become more negative, but in the future this asset no longer needs to be depreciated to the same extent, resulting in an artificial earnings boost in the future.

When analyzing a company that is undertaking such charges/write-downs, investors should distinguish between asset impairments (like that of the depreciation example above) and restructurings, where changes to operations are expected to incur additional costs (severance pay, etc.). In the former case, the impairment is only of an accounting nature and is therefore a write-down of of past cash flows, while in the latter, future cash flows are affected.

In this paper by Francis, Hanna and Vincent (1996), asset write-downs were found to result in poor stock market returns, suggesting the write-downs were caused by poor business conditions (no shock there!). Restructurings, however, resulted in positive stock returns, as the market's perception implied an expectation of an improved profit outlook as a result of the upcoming operational changes.

While Wall Street may fall victim to this type of manipulation due to its focus on current earnings (as discussed on this site many times, as well as in this chapter of Security Analysis by Ben Graham and David Dodd), investors can protect themselves to some extent by focusing on average earnings over a business cycle, thereby smoothing out the effect of any earnings manipulations that might be taking place.

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