Quality of Earnings
A book by Thornton O'Glove
Motivation and the Institutional Imperative
The author explains that early in his carreer at a broker in the 60s, he read 120p prospectus whereas other brokers were focusing on the sale. He noticed that some companies went to IPO with nothing but a name and lofty pronouncements, and he was unsure the investors learned anything from their failures, since they surfed the market and never cared to read financial statements.
Quickly, O'Glove found that he would mostly find red flags and bad practices by analysing the financial statements, and that most clients were unwilling to hear bad news about the stocks they owned.
Worse than that, brokers were often hired by firms to issue stocks and having an analyst who consistently issues sell opinions is a red flag. The more egregious the overstatement of earning, the harder the protest. The usual outcome would be termination of the analyst who spells it out truthfully.
For this reason, O'Glove's never worked for the largest broker, nor would he rest in the same company for more than 5 years. "The new management appreciated our work, but told us it would be impossible for us to stay." For this reason, he advises not to trust Analysts reports if their pay comes from fees at the discretion of the management of the companies whose statement they analyse.
Finally, in the 80s, the author decided to stop and write down his accumulated knowledge of 25 years into a book that would be accessible to retail. This book is recommended by many as being "the real thing".
Summary
- don't trust analysts: analysts follow the institutional imperative of placating longs confirmation bias and firms that bring business
- don't trust auditors: auditors first job is to cover themselves from legal liability, then to do their job while placating the board that hired them. qualified opinions are indicative of creative management communication techniques.
- company annual report: scan them from one year to next to see how well they predict. Challenges are usually burried under optimistic statements and cloaked by arbitrary framing.
- differential disclosure: by comparing different statements published by the company, you have access to different framing of the company situation made by different teams and PR persons.
- Ordinary/Extraordinary income classification can be important, as CEO may chose to divest all their winners, one-off tax gains etc to manipulate income.
- increase or decrease of earnings need to be reviewed in detail and can portend bad or good news depending on findings. The author gives the negative examples of change of accounting, favorable tax rate, currency exchange rates, as well as positive change due to additional marketing or one off charge due to closing unprofitable business.
- Tax statements vs Gaap statements: f1120 and its schedule M-1 reconciliation is only available to 1% shareholders. Typical situation is that a faster amortization leads to lower tax, higher earnings, and accumulated deferred tax. Oil Co was capitalising instead of expensing unsuccesful explortation (dry holes), Tech Co had aggressive revenue recognition (recognising discounted future services to be provided).
- Account Receiivables and Inventory: divergence of either w.r. to revenue can indicate revenue manipulation. Inventory divergence where finished goods increase and raw materials decrease is bearish, whereas the opposite is bullish
- Debt: Monitor LT Debt/Asset ratio, Total Debt/Asset Ratio, Interest Expense. Increasing Interest Expense can be a threat to survival. 35% was considered prudent by Graham but the right leverage level depends on company situation.
- Dividends: some CEO cling to their dividend policy as if it were a suicide pact, rising debt with constant dividend with increasing payout ratio is a red flag. The author stresses the equivalence of buybacks and dividends as ways to return money, the former being taxed at a lower rate as capital gain.
- Accounting Changes: there is a Gresham Law for accounting that liberal practices tend to replace conservative ones. While cashflow is unchanged, earnings can reach a higher plateau for a few year and even help reach higher P/E despite EMH saying that accounting changes ought to be transparent. Lengthen depreciation period, increase pension investment return assumption.
- Big Bath Charge: books scrubbing is a sign that a management change is going to happen and often a positive sign. Stocks tend to react well to such big bath. Restructuring charge is usually expensed on the year it is decided instead of being dragged on the years it is carried out.
Conclusion
Over 3 decades, the author has acquired a jaundiced view of accounting and investor relations in the US. He reviews accounts for about 500 companies per year and therefore would not advise to spend days on any of them. He says that 15 minutes is often what it takes to make one's opinion.