Fundamentally flawed trust

As children, when we started a new activity or sport, we were encouraged to “learn the fundamentals.” Our advisers, coaches and family members assured us that if we learned the fundamentals very well, it would lead to mastery of the activity and good (and hopefully great) performance.

Many will recall spending hours before a piano or on a tennis court or a baseball field drilling fundamentals. In addition to “learning” the fundamentals, the idea was that they would become so ingrained in us that we would not even think about them but execute them well when needed, and that such execution would prevent us from getting into trouble.

The recent problems in the stock market and in financial reporting reflect a failure to both understand and execute fundamentals in two different, but intimately related areas. Any attempts to repair and prevent such action in the future are doomed unless both sets of fundamentals are addressed.

One of the fundamental rules of investing in the stock market is that decisions regarding stock purchase should be based on sound present earnings (profits) and continued potential earnings. A key indicator that is often used is the price to earnings ratio. If one follows closely the earnings of an organization, sound investment decisions can be made (but are certainly not guaranteed). In the rapid run up of the stock market in the ’90s, this fundamental use of earnings was at best not followed, and more often than not ignored. One of the first challenges to the earnings rule was with the explosion of dot.coms. There we substituted earnings for revenue (sales) growth with the expectation that earnings would follow at a later time. Investors in these firms were assured that earnings were just around the corner, and oh, by the way, look at those jumps in revenue. As is now clear, the earnings were never achieved, and the dot.com bursting bubble preceded the market bubble burst.

Investment in stocks is also a risk-based investment. Those putting up their money to buy stock must realize that no return is guaranteed. However, in a risk based situation, others in the market can start to drive the price of a stock (or an entire market) upward by competitive bidding on the stocks themselves. This is what happened in the ’90s.

The question that needs to be asked repeatedly, and investigated in some depth is where were the stock market analysts here? Individual investors rarely have the time, knowledge, and skill to investigate the hundreds of companies and their stock and earnings performance overtime, and rely, or trust those analysts to provide objective and reasoned advice. It is this trust that was violated so clearly, and it is this trust that needs to be restored. No amount of rhetoric is going to improve the stock market without a fundamental investment in trust building.

Trust is clearly the link, and was further eroded by the string of seemingly endless restatement of earnings that has occurred in the last six months. Remember the first funda-mental – follow the earnings. However this fundamental approach to investing does not hold if the reporting of earnings is not accurate and unbiased. The accounting profession has allowed this trust and “fundamental” to be violated at three distinct levels.

The first violation of trust is with the owners of the organization who rely on the accuracy of reporting to assess performance. They were misled. This can be said in a variety of nicer ways, but the result is that the owners were misled. The second violation of trust was with general investors in the market as a whole. In a similar fashion, they rely on the accuracy of financial reporting in their assessment of investment options. Finally, analysts were misled as well, although they are not totally innocent here. Analysts with their years of experience and with the ability to obtain greater information should have known better, but choose either not to know, or not to ask more detailed and probing questions.

The stock market is not going to recover unless and until trust is restored, and the fundamentals of investing are reconsidered. Trust that analysts are independent of the corporations, and that they execute their analysis and commentary in a clear, detailed, and unbiased manner. Trust that the reporting of organizational performance is also accurate and unbiased must be restored.

Trust is a fragile thing, and once violated, is difficult to restore. Actions to punish corporate executives, analysts, and accounting professionals who did not perform their duties in a manner consistent with ethical and professional standards are not enough. Those who purport to lead and want to restore the public’s confidence have to focus on restoring the trust that was lost. It is a loss of innocence that is difficult to recover from here, but that must be addressed if the public’s faith in the stock market and corporate reports are to be restored.

John F. Mahon is the John M. Murphy Chair of International Business Policy and Strategy and professor of management at the Maine Business School at the University of Maine.