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An Introduction to Peek Behind the Numbers
Earnings Quality Analysis, and What You Can Expect to Gain from Reading Our Work
“Investors should start with a view of skepticism. They should become intellectual investors rather than emotional investors. They should be careful, and they should be skeptical.”
- Arthur Levitt Jr.
“Skepticism is the first step towards truth.”
A Little Bit About Us
Behind the Numbers was founded in 1988 to provide sell recommendations based on earnings quality analysis to institutional investors and hedge funds. Our focus has always been on evaluating the quality and sustainability of a company’s reported results by painstaking review of financial statements, footnotes, supplemental presentations, and management commentaries to identify situations where the numbers are telling a different story than the Wall Street narrative. We were among the first and remain one of the few research firms focusing on this important and often overlooked area. While our institutional clients can use our work to identify both potential long and short ideas, we believe one of our most important contributions is helping clients uncover and avoid hidden accounting risks in their portfolios.
We are starting Peek Behind the Numbers to help investors hone their skills in detecting earnings management and to develop a healthy level of skepticism in their approach to analyzing and valuing companies. We will draw on over 30 years of our company’s history of uncovering instances of companies manipulating reported results to meet market expectations. We hope our stories will both inform and entertain you. But most of all, we hope that by reading our work you will become a better investor and boost your returns in the process.
So, What Is Earnings Quality?
Reported results are vitally important to investors. They utilize accounting performance measurements such as sales, operating profits, net income, and cash flows to assess current returns, management performance, compute valuations, and ultimately calculate the present value of future benefits to equity holders. As the legendary Ben Graham surmised, anyone putting their money to work who is not crunching the numbers is speculating, not investing.
On the flip side, reported results are very important to company executives. Wall Street analysts forecast revenue and earnings per share figures for future quarters. Companies that disappoint these forecasts can see their stock prices pummeled by the market. What’s more, many corporate executives receive sizeable bonuses based on hitting predetermined levels of revenues, earnings, and returns. In short- management has a lot riding on hitting its targets.
What many investors do not realize (or perhaps appreciate) is the degree to which companies can manage the results they report. We categorize earnings manipulations we see into three basic types: accrual-based earnings management, real earnings management, and non-GAAP disclosures. We’ll take a quick look at each below.
Accrual-Based Earnings Management
All the accounting-based figures investors utilize to measure company performance such as sales, operating profits and net income are based on policies that require management assumptions and estimates. If these assumptions are changed or are significantly out of line with a company’s peer group, it can result in the company reporting significantly higher sales or profits than it would have otherwise reported. Managements also have a large variety of tools at their disposal to manipulate earnings without violating the letter of law as laid down by Generally Accepted Accounting Principles (GAAP). With both the incentive and ability to manage earnings, a cynic might conclude that there is a decent chance that some managers experiencing weaker than expected results might succumb to the temptation to “play a few games” with the numbers to report results that satisfy the market. Such a belief would be backed up by logic, experience, and a sizeable body of academic research.
A key point to realize here is that we are not talking about the next Enron- just a management wanting to make the next quarter in the hopes that the weakness they are covering up for is temporary and it will be able to get back on track the next quarter. Unfortunately, the hoped-for recovery often doesn’t materialize, and the company is in the position of continually borrowing from future quarters to make the current one. This seldom ends well and typically results in an earnings miss or a company reducing its outlook. Investors who can identify such a situation early enough can keep the resulting stock price declines from hitting their portfolios.
Real Earnings Management
In addition to tweaking assumptions behind accounting measures, managements can make budgeting decisions to hit their goals for a particular quarter such as reducing spending on advertising, cutting research and development, or delaying investment in new systems. Actions such as these can improve short-term performance but eat away at future growth prospects.
As the name suggests, these are earnings that have been prepared outside the guidelines of Generally Accepted Accounting Principles (GAAP) and include company adjustments under the guise of making them more “useful” to investors. We believe abuse of this practice has become a huge problem area in recent years as virtually all companies now offer some form of non-GAAP earnings figures every quarter. If GAAP earnings can be manipulated, just think of the reality-stretching that goes on with non-GAAP results. What’s more, these non-GAAP results have become the accepted “real” earnings by Wall Street. Earnings forecasts and valuation ratios are all conducted on non-GAAP terms with GAAP earnings virtually ignored by most onlookers. This makes a critical assessment of what’s in these adjustments vital.
The Value of Quality of Earnings Analysis
So, if earnings quality analysis is so valuable, why aren’t more people doing it? We believe this can be traced primarily to one factor- it’s hard work. Good earnings quality analysis is time-consuming. It requires constant monitoring of footnotes and supplemental disclosures looking for changes that appear out of line with underlying trends. Much of this data is not maintained by financial databases which means investors relying totally on quantitative approaches are likely not incorporating all of it into their models.
Perhaps most importantly, earnings quality analysis requires subjective assessment. It involves a thorough understanding of the business model to determine if accounting policies are accurately reflecting the economic reality of the business. For example, suppose a company incurs a sizeable amount of one-time expenses such as a big lawsuit payment or a loss on selling a business. That should be added back when calculating adjusted profits, right? But what if it’s an expense that has been going on for 15 years such as stock compensation, amortization of intangible assets, or “one-time” restructuring charges that never end? At what point does one question it? This makes earnings quality analysis as much art as it is science.
It doesn’t help matters that Wall Street is inherently biased. People love the comfort of the crowd and most are inherently drawn to positive stories. It’s also no secret that many analysts operate in an environment with strong conflicts of interest. Reporting the cold, hard facts may not be what is best for their firm’s associated brokerage, investment banking, or portfolio management operations. This also works in the other direction as well. We regularly see sell recommendations published by analysts working for hedge funds who have large short positions in the name in question which makes us question how unbiased the work is.
In addition to being inherently biased, Wall Street and investors both tend to love the comfort of crowds. The resulting herd mentality discourages people who may be thinking that the Emperor’s new clothes are at the very least out of style from saying so. And remember, the crowd-following goes both ways. Research has proven time and again that value stocks tend to outperform growth stocks over time. We believe this is at least in part due to the herd failing to recognize a growing value proposition resulting from a firm that is out of favor. Such conditions lead to the buy recommendations we publish for our institutional clients which are based on especially conservative accounting making for easier hurdles in upcoming quarters or uncovering hidden assets.
All of these factors result in few truly independent people incentivized to do the critical thinking, ask the tough questions, and put in the hard work necessary to find instances where management’s narrative is not lining up with the real story the numbers are telling.
What You Can Gain from Reading Peek Behind the Numbers
We will teach you the nuts and bolts of how reported results can be manipulated and bring it all to life with real-world examples from our 30+ years of research history.
We will examine academic research that explores the extent of earnings manipulation and the opportunities identifying it can provide to investors.
We will keep you current on new material developments in accounting changes.
Finally, and perhaps most importantly, you will learn how to think skeptically, critically, and independently.
Being a good analyst requires you to always be learning. It’s not enough to familiarize yourself with a handful of ways accounting can be manipulated. Detecting earnings quality is a way of thinking and looking at the world which comes from constantly seeing examples of it in action. Ultimately, that is the purpose of this column- to make you a better analyst and investor by teaching you how to approach the numbers from the perspective of a skeptic who has seen all the tricks from many different angles.
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