By Tom Bradley

It’s a sad statement. Glencore Xstrata, the Swiss mining giant, announced that it’s taking a US$7.7 billion writedown on its investment in Xstrata. Writedowns in the resource sector are a daily event right now, but … but … Glencore just bought Xstrata for US$29 billion three months ago. Yes, three months ago when commodity markets were already extremely weak.

The writedown is an example of the accounting wizardry that public companies pursue to enhance their valuation. Glencore went through with the deal presumably because it thought it was getting value for its US$29 billion. Management absolutely expects to make a bucketful of money on Xstrata and it’s unlikely the projections for long-term returns on the acquisition have changed from when the deal closed. But by taking the writedown at a time when everyone else is doing it, their profits in the future (when investors care more) will look better (specifically, the return on equity).

I’m not an investor who uses book value to value stocks and this type of gimmickry is one of the reasons why. I do, however, look at the history of a company’s book value to see if writedowns are a regular occurrence. I much prefer to own a company that earns a 12% return on equity and grows its common equity (book value) year after year over a company that makes 16% ROE, but takes a writeoff every 5 years that wipes out years’ worth of profit.

Too many of the industry databases adjust for one-time gains/losses so investors can see the companies’ on-going earning power. Unfortunately, for write-off prone companies, normalized earnings are not representative of on-going earnings power. They’re just borrowing from the future.

Beware of accounting hocus pocus. Here today, gone tomorrow.