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:
- 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.
- 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.
- 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.
- 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.
[...] David Merkel, “Management teams that cut corners in financial reporting will cut corners elsewhere, and deliver negative surprises to you.” (Aleph Blog) [...]
I think that this is one of the best rules (vis-a-vis risk management). This would have kept people away from Enron, for example.
Also, I think of earnings quality like borrowing. Any accelerations of earnings/revenue will result in a reversal in the future (how long it can be prolonged is hard to determine). No one wants to be left holding the bag when that negative event occurs.
David, I think you are too categorical in the second part of rule 4. The problem is not with the concept of share repurchase, the problem is that managements buy high and sell low just like most mutual fund managers.
As a portfolio manager, it is your job to assess if a price is cheap or expensive. If cheap, you should want management to be purchasing shares within levels of balance sheet prudence. It is very possible that the IRR on repurchase is quite high.
In general, managements do a horrifically bad job of timing share repurchases–no argument there. But I have made too much money over the years when companies have bought in cheap stock to dismiss it as a valuable tool.
microcap, I agree with you, and I will flesh it out further when I write on Rule 6.