Lying the golden egg

PUBLISHED : Monday, 21 November, 2011, 12:00am
UPDATED : Monday, 21 November, 2011, 12:00am


It has been said that new issue stories on the stock market are like fairy tales: what they lack in truth they make up for with magic and you mustn't ask the storyteller for proof. If you do, you won't be told any more fairy tales and may find the penalty on the market even greater.

So let us set this story in a land seemingly far, far away - just across the mainland border, in fact - and say nothing about the storyteller. All we will say is that it is about a chicken farm and that there are many similar agricultural enterprises, like plastic rubbish manufacturers, and even forestry companies.

Once upon a time there was a chicken farmer who wanted more money and didn't really want to earn it by working. He wanted it the easy way, the golden-egg-at-the-end-of-the-rainbow way. So he followed the rainbow and found that it ended in the big city in a bank office inhabited by twenty-somethings who wanted money even more than he did and were even less willing to work for it. Together they hatched their golden egg.

The first thing they had to do was establish how much he was worth, which wasn't very much. His neighbour had sold a similar chicken farm for only FM (funny money) 1 million the previous month. Our man thought it would be difficult to claim more for his own farm. Little did he know.

His new friends were not interested in buying chicken farms, only in convincing others to buy them through investments in the stock market. So they busied themselves devising a discounted net present value model for him.

They started by assuming that all hens laid one egg a day each at all times and that each egg was worth FM1 to our chicken farmer. Both estimates were a little on the high side but, well, why not be optimistic? A chicken valuer was quickly appointed to tell the world that this was the right figure. The valuer was, of course, also given the right figure.

The bankers then calculated that our chicken farmer had 1,000 chickens, which would mean an income of FM365,000 a year. They entered this figure into their calculators as a guaranteed stream of annual income over 50 years, applied an annual discount factor of 7 per cent, pushed the net present value function key and discovered that our chicken farmer's chicken farm was worth not FM1 million, but more than FM5 million.

This immediately raised the question of how our chicken farmer's neighbour could have been so stupid as to sell out for only a fifth of what he could have been paid. The bankers nodded their heads convincingly at this question and said that, yes indeed, he must have been a very stupid man.

They were particularly pleased that the question was phrased this way. One could as well say that if the bankers' calculations did not match prices actually paid on the market for chicken farms then it was the bankers who must have been very stupid and perhaps they ought to change their calculation methods.

There were certainly many ways in which they could have been very wrong, stretching all the way from the assumptions about the frequency of egg laying and the farmer's real income after costs to the discount factor they applied to their income stream.

But to all of these queries the bankers had two responses. First they cited their own financial training and pointed to their calculators. Did someone say that there was a fault in the microchip, that it gave false results?

And if this was not a sufficiently convincing performance, they pointed to the accountant's signature on the financial statements they had prepared for the chicken farmer. The accountant represented a reputable firm. Did someone say he was lying?

Certainly no stock exchange would say anything of the sort, not about a signature from this reputable firm. It was an expensive signature but well worth what it cost.

The one thing these bankers would not do, of course, is pay FM5 million for a chicken farm that the market valued at only FM1 million. That would have been the test of whether they really believed their calculations - but it was a test they would never take. It was one to which they would only subject others.

They were now ready to take their chicken farm to the stock market. In actual fact it was done as an agglomeration of chicken farms (plastic rubbish makers, forest holdings) but we shall treat it as one chicken farm for the purpose of this fairy tale.

Their immediate problem was that the chicken farm had no profit record. The chicken farmer had previously lost money on his egg production, a fact that was conveniently left undisturbed in its hiding place. The target stock exchange on which they expected to list this chicken farm, however, had a rule that all applicants must have a record of at least three consistent years of profitability.

But again, it was no serious problem. They already had a piece of paper saying that their FM1 million chicken farm was worth FM5 million. All they needed to do was take the FM4 million difference and pretend that this consisted of profits left in the business over the previous three years. Thus they assigned FM1 million to Year 1, FM1.3 million to Year 2 and FM1.7 million to Year 3. There was a three-year record of rising profits, they told the exchange.

Did someone call this preposterous? Why, not at all. What a calumny on a fine company! The bankers had a piece of paper from their reputable accountant saying that this method of corporate accounting was entirely above board. It was an even more expensive piece of paper than the previous one. But to make an omelette, you have to buy some eggs.

The omelette was still not quite ready for cooking, however. Having settled the past profit record, the bankers next had to work out what the future profits would be. They did this by buying several more chicken farms for the company at FM1 million each. Then they simply applied their magic calculators to make each worth FM5 million, from which they generated future profits at an ever-ascending rate.

Whether any money ever changed hands in these transactions is open to question among those who do not automatically believe the signatures of reputable accountants. In fact, whether these chicken farms even existed as described in the company's prospectus is open to question. The surveyors sent to value them for the purpose of the prospectus found they could not even gain access. They were next to a People's Liberation Army base and potential spies who could be working for foreign powers were not welcome in the vicinity.

Finally there was the question of how the bankers and their chicken farmer were to be paid for their efforts. They would, of course, have their shares when the company was listed and they could take fees at every stage of the listing process. But they all wanted to get fuller rewards, and to get them fast.

So they formed two more companies, 100 per cent owned between them. The first, Chicken Farm Feed Seller, sold our chicken farmer his chicken feed. As the fairy tale has it, 'Oh what big feed prices you have, grandmother', to which grandmother replies, 'All the better to trample you with, my dear'.

The founding shareholders of our feed company did not hold with telling the investing public this part of the fairy tale.

The other company was Chicken Egg Buying Company, again 100 per cent owned by our usual crew. It bought all the chicken eggs from the chicken farm, at prices that certainly discouraged food price inflation. Consumers would have welcomed such prices. Consumers were never given the opportunity.

The relationship with these two companies naturally had to be divulged in the prospectus - on page 632 - although the ownership of them was less than fully disclosed and the pricing arrangements not at all. Even so, there were one or two members of the listing committee who thought it a little odd.

They were easily dealt with. A proper plummy-voiced lawyer/banker was retained to thunder at them that it was not the job of a listing committee to decide on the investment merits of a stock. The market would make that decision itself. The listing committee had only to determine whether the offering met its criteria and it did: 'Here, gentlemen, is the signature of a reputable accountant.'

The final step was the hiring of a public relations consultant to brighten things up for road shows in America and Europe. For America, this included inviting one or two indigent Nobel laureates to dinner and asking if they wouldn't mind being advisers to the company. Naturally, they wouldn't. The chequebook took care of that. They might have reason to regret later how their names were used, but what of it? And as to Europe, well, if it sells in America, who needs Europe?

All was ready at last. The button was pushed, the public rushed to put their money into this wonderful investment in a booming economy and the deed was done within a matter of hours. The rich suddenly got richer and the poor got poorer.

And that's the story of the chicken farmer and his one big chance. I believe the chicken farmer is in jail now. He didn't cut his local provincial officials in on the deal sufficiently and they were very annoyed with him. He would have to pay them a larger share of his winnings.

The bankers themselves were untroubled. They operated from a different province where they happened to have a more two-way relationship with their provincial officials. They had also carefully made sure that they maintained a proper distance from the liars who contributed signatures. Who knows? Some of them may even be based in Hong Kong.

And so, even if they didn't all live happily ever after, enough of them did to ensure that this fairy tale would be told again.

As long as there are people willing to listen to fairy tales, that is.