The Weighing Machine

We can thank the late Ken Lay and Bernie Ebbers for some of the mess our financial system is in now. I'm talking about mark-to-market accounting, a reform attempt brought in by the Sarbanes-Oxley law in an effort to prevent accounting frauds like the ones perpetrated by Enron and Worldcom. Before Sarbox, companies based valuations of many assets on expected cash flows, and this sometimes meant marking to a financial model. In the wake of those frauds, marking financial assets to market prices seemed to be the fair thing to do on a balance sheet. Market prices seem less susceptible to manipulation than prices coming out of a financial model. It seemed fair, that is, until last summer, when credit markets seized up, and no one was willing to buy derivatives, mortgage-backed securities or even commercial paper. Asset values plummeted, companies collapsed and so did confidence in our financial markets.

To illustrate what's going on, here is what mark-to-market would mean to your home mortgage. Let's say a few years ago you bought a house and put down a healthy down payment. You like your house and have no intention of selling, and you are paying your mortgage every month. But let's say houses in your neighborhood have been selling for much lower than they did when you purchased your home. Suddenly your home's value is less than the amount you owe on your mortgage. Now, as long as you keep paying the mortgage, the bank should be fine, right? Not so, under mark-to-market rules. In this scenario the bank would have to assess what that underwater mortgage might fetch in a distressed sale and ask you to make up the difference.Mark-to-market accounting was intended to promote transparency, but its unintended consequence is unnecessary forced trading. Value investor and Sears Holdings (nasdaq: SHLD - news - people ) Chief Executive Edward Lampert rails against it in Sears' current annual report. He quotes Benjamin Graham: "In the short run the market is a voting machine. In the long run it's a weighing machine." Our financial system now rests on the shoulders of a voting machine, says Lampert.

That's one reason I like to remind readers of the name of this column. Patience is a virtue in value investing and, like Graham, I tend to pay attention to the scale more than the ballot box.

There are lots of "toxic" assets on balance sheets today. In all likelihood they will be worth plenty in the future, but right now they aren't. Mark-to-market accounting means a company's value rests upon last-trade prices rather than the value that it stands to create over the coming years. I believe, like Steve Forbes and Warren Buffett, that this system needs fixing.

In the meantime, however, there are ways to capitalize on the resulting volatility. The way to beat the market is to ignore the voters and look further into the future to the weighing machines.

I recently added computer maker Dell (nasdaq: DELL - news - people ) (10, DELL) to my portfolio. Michael Dell resumed his role as chief executive in January 2007, but the market takes a skeptical view of his ability to reestablish industry leadership. Quarterly earnings reports have been disappointing, but I'm taking a longer-term view. The market values the company at $19 billion, but it holds $8.4 billion in cash and generated $1.9 billion in operating cash in the past 12 months.

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