Introduction: What This Book Does for You

 

Simple: Show me where I’m going to die, so I don’t go there.

Many investors have owned a stock that skipped merrily on its way higher and higher, the CEO a deity, everything skittles and beer—until one day they wake up to see that stock has detonated a bomb in their brokerage account. They had whistled past the graveyard, and now they are in it. With this book, you won’t be one of them. We help you find where the investing bodies are buried, so you don’t join them.

Shareholders Beware

The world has never known since the earliest slingshot hawkers at the corner of Boulder and Dinosaur a time without financial chicanery. From Dutch tulipomania to the first joint stock companies, managers often devoted more energy to keeping up appearances than to keeping the books. Think of the South Sea Company bubble of the early 1700s and the railroad and canal companies of the 1800s.1

“Shareholders be damned” was the smug rule of managers until the Crash of 1929 and Great Depression led to their first obstacle, the 1934 founding of the U.S. Securities and Exchange Commission. Sure, the Great and Glorious Company Management Oz still tried smoke, fire, sound, and nonsense to prevent Dorothy and the shareholder gang from paying attention to what was really behind the curtain, but when the persistent Totos could finally poke their noses behind the management curtain, they did so with the watchdog SEC on their side.

The game may have become tougher in the ensuing decades, but managements have remained inventive. Some know they can placate the majority of shareholders with high-calorie, low-nourishment earnings press releases. It’s then just a touch more work to distract the handful who actually listen to earnings conference calls or read the transcripts, but after that it’s a breeze. Few investors even glance at company SEC filings, and only a fraction of those burrow into their seemingly objective financial statement lines and obscure notes.

This book shows you the only fine print that matters—where management most frequently hides the information that shows their chicanery. You need not turn over every stone—only those that are the best predictors of trouble. Because you are a practical investor and most likely are not planning a career as an accounting Ph.D., you don’t have to memorize the minutiae in a forensic-accounting textbook. You want to avoid losing money, period. That’s why we’ve picked out the tools most likely to find the aggressive accounting that leads to large losses. You can avoid buying those stocks, sell them, or even short them for profit. Every blowup avoided improves the performance of your portfolio: Lose less, profit more.

The Pressure to Push

With 17,000 stocks traded in the United States and at least 45,000 worldwide, you have to beware. There is no shortage of land mines. Only half of all businesses can be above average; still fewer can be great. Management faces crushing pressure to make things appear better than they are. Few execs can resist the pressure from boards, Wall Street analysts, and shareholders to meet each quarter’s earnings expectations. It’s a jungle out there, and the corporate beast will do anything to survive. Management tortures the numbers to “beat by a penny” and to keep the Wall Street analyst predators and their dreaded downgrades at bay. Rules and regulations allow creative companies to twist, push, knead, and tweak their way to the very edge, where the gray area of aggressive accounting can become black indeed.

Aggressive accounting may not be illegal, but it’s chicanery. It’s usually tough to catch until it’s too late—when, though it’s worked before, now it doesn’t. The company can beat by a penny this quarter and by another penny the next—perhaps even for several quarters, by ever-thinner pennies. Sooner or later, however hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.

Stunned shareholders shake their heads and say “wha’ happen’?” But the alert investor can avoid that surprise when prepared with this book’s techniques. Our goal is for you to avoid or to sell the stock before it blows a hole in your financial life—and even profit from the ensuing downfall by shorting in appropriate cases.

Earnings Quality Is Job One

The job is to analyze earnings quality . For any line on a financial statement, a company can choose a best, good, OK, or questionable practice. The better the treatment, the better the earnings quality—and vice versa. To evaluate earnings quality is to avoid losing money when that quality is poor.

The financial media focus on earnings per share (EPS), hence “earnings quality,” but there is no single indicator. This book may place revenue recognition at the top and inventory management next, but every part of the financials connects with another. “Earnings” is the financial picture taken as a whole. As every macroeconomist and Buddhist knows, everything is interconnected; no line item or footnote is an island. Revenues, inventories, operating cash flows, charges, acquisitions, margins, cost of goods sold—each must be understood in relation to the others. Many investors wish for one magic metric to rule investing. Those wishes ride hearses.

Fortunately, investors do not need advanced degrees in earnings quality, though at first glance it may appear difficult to grasp the many moving parts. Management may change the company’s revenue recognition policy to raise revenue this quarter and massage inventory treatment the next, manage working capital to boost operating cash flow, obscure real earnings power with serial acquisitions, and on and on, with countless ways to use aggressive accounting to mask the real situation.

But this book’s method is practical. You don’t have to check off an endless list. Some forms of aggressive accounting are more aggressive than others—you will learn here which. The more management uses the aggressive accounting measures most likely to predict trouble, the lower the earnings quality. Most investors don’t know any of the ways, let alone the most important ones, through which management can stretch the truth. Those investors ignore the risks, and inevitably own stocks that are digging deep graves in their portfolios.

This book builds on the few resources available on earnings quality—books and authors to which we owe enormous debts, including the path-breaking Thornton (Ted) O’glove’s Quality of Earnings 2 and exhaustive (in a good way) works by Professors Charles Mulford and Eugene Comiskey.3 Our book is different, because we augment their learning with a practical goal. With arithmetic and effort, you can use this Monday morning. You don’t need to spend years and tuition at the Del Vecchio-Jacobs College of Earnings Quality (wire transfers and Krugerrands welcome). We focus on the best accounting indicators and prioritize them for you. We take you from what to look for to how to use what you find. This book is a total and practical solution that you can use to make money and avoid huge losses now .

From Here to Monday Morning

It’s a two-part process. Part 1 begins exploding the myths of stock performance, expected returns, earnings quality, and short sellers. Then you’re prepared to analyze financial statements—not to be the best accountant there is, but to be the wealthiest investor you can be. You don’t need every indicator of poor earnings quality and potential losses—you just need the most accurate predictors.

For 13 years, John distilled from the universe of earnings quality issues the best predictors. These are the most serious danger signals that, when identified, will help you avoid huge losses. On the investing highway, you want to read, not all the signs, but only those that lead to your destination. John’s tested these to produce a remarkable investment record.

After Part 1 arms the investor with the best financial statement predictors of poor results, Part 2 provides a tactical manual for applying them in the day-to-day real world of portfolio management. Stopping after Part 1 might earn readers an “A” in earnings-quality studies, but Part 2 shows how to go forth to make (and not lose) money.

There you will see how earnings quality analysis works with Tom’s experience of long-side investing in order to make a truly effective long-short portfolio. Backed by research data and experience, our preferred strategy for the long side (“long book”) is Tom’s small-cap, low-valuation, asset-backed, catalyst-driven world of opportunistic value and special situations. We close with performance data showing that, if you start with earnings-quality analysis and pair Tom’s long strategy with John on the short side, then, as a risk manager, you will form a long-short portfolio with less overall volatility and greater returns.

Next comes John’s specific, technical analysis and market timing (neither the voodoo varieties). These added portfolio risk-management tools supplement fundamental earnings quality analysis in order to manage the short side (“short book”) of the long-short portfolio. These can help you avoid a bear market in part or completely. If you do that, it really doesn’t matter what you do the rest of the time.

We don’t ask you to take this on faith. This book does not titillate with “if only you had done this, you would have avoided the explosions.” Our examples are all real-time, including actual reports provided to clients (which you can find in full and for free, at www.deljacobs.com). Both John’s Chapter 9 and Tom’s Chapter 6 present hard data showing that this book’s investing strategy, versus market averages, works.

Your Strong and Confident Future

While you read, you are certain to both enlarge your view of what can happen and worry more about the land mines. Be philosophical. No matter your investing style, strategy, or experience, and no matter how much you learn, you will encounter in your investing life companies that bring revenue forward to make today look better at the expense of the future, which only delays paying the piper. You will consider buying companies which say that their business is growing so much that of course it’s taking longer to collect from customers—a nonsensical explanation for rising days sales outstanding or days sales in inventory, which may be the two great single indicators of trouble in the next quarter or several. And you will at least once, and usually many times, unwittingly own companies that reveal these and other ways they are doing anything they can to meet Wall Street expectations, putting off the day of reckoning when they have exhausted all the ways and all the time that aggressive accounting can manipulate numbers.

No investor can avoid every problem. It’s impossible to have all the information, not least about the unknowable future. But you will be prepared. This book can help you avoid serious losses, so you won’t wake up living a nightmare after aggressive accounting at your company stops working and the stock craters. When, for the first time, everyone sees the company without clothes as they and the stock fall into the Florida sinkhole, you’ll have your eyes wide open and your feet on solid ground.

Enjoy and prosper!

John Del Vecchio, CFA          Tom Jacobs, J.D.

Dallas, Texas                           Marfa, Texas

 

August 2012

Website: www.deljacobs.com

E-mail: JD@deljacobs.com, TJ@deljacobs.com

Twitter: @deljacobs