Profit and share prices do not equate to value

A new book from McKinsey has pointed out the four cornerstones of value:

1. Companies create value by investing capital from investors to generate future cash flows at rates of return that are greater than the cost of that capital.
2. Value is created for shareholders when companies generate higher cash flows, not by rearranging investors' claims on cash flows.
3. Companies' stock market performance is driven by changes in stock market expectations, not necessarily by anything the company actually does. (the "expectations treadmill")
4. Value of the business depends on who manages it and what strategy they pursue - the "best owner" principle.

Financial Statements Fraud - "Cooking Methods"

The types of financial statements fraud include:

1. Revenue-related fraud (recognizing revenue before it is earned)
2. Expense-related fraud (improper capitalization; the red flag would be managements' obsession with selection of accounting policies)
3. Liability related fraud (concealing of liabilities by not recording them)
4. Asset-related fraud (skimming of cash receipts, forging of company cheques, pilferage of inventory and misuse of PPE)

Quantitative Easing: QE2

Inflation is too low and high unemployment may depress it further. The risk of deflation is what drives the Fed to employ quantitative easing as a monetary tool. Nobody knows whether this tool actually works, but the Fed thinks that by purchasing a large number of long-term Treasury bonds, they can force the public to pay more for similar bonds or invest in somethings else.

Obviously, there are risks to such a policy. The Fed could ignite too much inflation as QE is in effect "printing money". However, the Fed think they can retrieve the money lent at any time, either by selling back the bonds they buy or raising interest rates to induce banks to deposit funds with the Fed. Another risk is the creation of new asset bubbles, for example, in equities.

If QE2 fails, there are other options available to the Fed:

1. The Fed could employ a change in communication where the Fed would try to push up expectations of future inflation. This can be done by promising to keep interest rates close to zero for a long time or adopting a "price-level target".
2. A more aggressive form of QE could be employed, where an interest rate is targeted and large amounts of money are spent to achieve that. This means buying unlimited bonds and losing control of the Fed's balance sheet.
3. Buying as many Treasury bonds as Congress needs to cut all taxes on payrolls to zero for a time. (The least palatable)

Looking at the options available, the Fed is not running out of tools anytime soon.

Stalled post-crisis reforms must be restarted

Author: Mohamed El-Erian

The author of the article highlights 3 main key points to reform the world economy:

(1) Industrial country governments are to act decisively on the structural front. Fiscal stimulus and quantitative easing are not enough. (e.g. more support for education and research, pro-growth tax, housing finance reform, job retraining)

(2) Emerging economies need to be more resolute in shifting the emphasis of policies from just the producer to the consumer. There is a need to strengthen pension systems and other social sectors, harnessing the purchasing power of their growing middle class.

(3) The legitimacy of the G20 is at risk currently. Europe needs to show leadership and allow a much-delayed redistribution of IMF Board seats and voting power to show the legitimacy of the G20. Without legitimacy, the IMF can do little to inform and influence countries. Its analysis will fall on deaf ears.