Booms, Busts, and Recoveries Message Board

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Strategies & Market Trends : Booms, Busts, and Recoveries

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To: smolejv@gmx.net who wrote (13399)	1/13/2002 12:54:25 PM
From: GraceZ	Read Replies (3) of 74559

Essentially you are saying that these earnings did not exist, correct? This was the suspected missing step I was trying to get DAK to clarify. If I run a company and I want to grow that company usually it takes capital to do that. Capital to spend on new plants, acquisitions, equipment and people. You project into the future and decide what expenditures will produce the highest return for the risk. The money or capital can come from any number of different places in a public company. The simplest way to fund growth is from operations, you use the profit from on going operations to fund expansion. The next is debt, you borrow from the bank or debt markets. If you don't have access to these sources sometimes you borrow from vendors. The third way to raise capital is in the equity markets. If I'm running this company I choose the cheapest way to obtain capital. By choosing the cheapest way I'm increasing my return on investment. There's nothing particularly sinister in the above scenario, this is how business grows. This is how all businesses grow. In DAK's scenario he's implying that there is some sort of fraud involved. With the way in which he's presented it, I can't see the fraud. That doesn't mean it doesn't exist. He's implying that companies bought earnings with fraudulently obtained capital. Now if he had presented the idea that the equity markets provided unreasonably cheap capital (remember I have the debt markets and operation to fund my expansion but I need to choose the cheapest) I'd whole heartily agree. If he is saying that investors disregarded earnings and focused on top line revenue growth in valuing companies, I'd also agree. If he's saying that companies tried every accounting trick in the book to make that bottom line figure positive and investors went along with this suspension of normal accounting for profit, I would also agree. But projecting higher earnings and using capital raised with those higher projections to buy capital equipment that then results in higher earnings is perfectly legitimate use of the capital markets and its also a good demonstration of the market feed back loop that Soros refers to. Notice now that equity capital is no longer cheap, companies are now using the debt markets to raise capital. When that becomes too expensive (and it will even though the Fed is trying to artificially hold down the cost of money, again) they will be left with the other option, funding growth from operations. Its a self correcting mechanism that would have corrected itself far sooner and with far less pain if the Fed had stopped interfering in the pricing of money.

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