Portfolio Rule Five

News: I’m planning to submit my paperwork to Maryland on Monday for registering my investment advisory.  Aside from that, I am giving a talk on the Efficient Markets Hypothesis in New York City on Wednesday to the Society of Actuaries.  Onto tonight’s topic:

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Maybe I should rephrase that to be “avoid companies that abuse their accounting, overstating earnings,” because it is perfectly possible to overreport earnings, while staying within the boundaries of GAAP accounting.  Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

  1. For nonfinancials, review the difference between cash flow from operations and earnings.  Companies where cash flow from operations does not grow and  earnings grows are red flags.  Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.  The latter portion of that rule can be applied to financials.
  2. For nonfinancials, review net operating accruals.  Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.    The values of assets on the balance sheet are squishier than most believe.  The accruals there are not entirely trustworthy in general.
  3. Review taxable income versus GAAP income.  Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.  b) management is clever in manipulating GAAP earnings.  It is the job of the analyst to figure out which it is.
  4. Review my article “Cram and Jam.”  Does management show greater earnings than the increase in book value plus dividends?  Bad sign, usually.  Also, does management buy back stock aggressively — again, that’s a bad sign.

The idea is to see how honest and focused on the long term the management team is.  Management teams that cut corners in financial reporting will cut corners elsewhere, and deliver negative surprises to you.  That’s what I aim to avoid.