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Monday, August 14, 2006

Earnings Quality and the 10Q Detective

From Value Discipline

Careful readers will note that I have added a new link, "10Q Detective" which is published by David Phillips. As David describes it, "investors often overlook SEC filings and it is the job of the 10Q detective to dig through business' 8-K and 10-Q filings, looking for financial statement 'soft spots' such as depreciation policies, warranty reserves, and restructuring charges."

David does a fabulous job in tearing apart financials, but also examining compensation excesses, pump and dump stock frauds, and the reasonableness or illogic of growth expectations. In short, David's mission is to protect investors from the BS promulgated by some managements, their IR firms, and the deferential verbal obeisance of investment bankers. It is a blog worthy of your time and I recommend it highly.

David pursues one of the aspects of investment management that is I believe critical to investment success. As a young analyst, I was chided by a fellow analyst and brilliant CFA who said, "Nobody has really made any money by looking for good accounting." My counter of course was "Plenty have lost money from bad accounting." A large part of investment success is simply avoiding investment failure...avoiding trouble.

The reason this is so important stems from the asymmetry between gains and losses. If you have a 20% loss in a portfolio, you need a 25% gain from that level just to break even. The numbers look like this:

Percentage loss......Gain required to Break-even

Regrettably, as you can see, the arithmetic of this asymmetry makes it tough to overcome a "torpedo" hit.

The frequency of these holes has been increasing with the increasing volatility of these markets. Relying on Reuters data for the last month, of 8892 US stocks in their database, there were 748 stocks which had dropped 20% or more in the last four weeks, almost 9% of all stocks. But surely, these companies will come back over time, right? Well, not exactly. This market takes no prisoners...using the same database but over a 26 week period, fully 2,294 companies of the 8892 or 25.8% were down over 20%. I daresay, 983 companies, or 11% are down over 40%...needing a 67% rally to breakeven. Scary!

The best way to avoid them or at least reduce them is to investigate before you invest. Never rely on a tip, a story, or the tout of some investment expert to get you into a stock. Study David's blog, check out Michelle Leder's Footnoted, another excellent source. In some small way, perhaps even Value Discipline can provide some guidance. Please read my note on accruals. Ultimately, do your own research and satisfy yourself as to the earnings quality of what it is you are buying.

What exactly is "earnings quality?" It is very difficult to define per se. Not unlike the explanation of pornography," I know it when I see it" earnings quality presents a struggle to define with exactness. Yet, there are some real hallmarks or footprints to earnings quality.

The accountants tend to look at earnings quality as "representativeness"...does the measure of income correspond to the change in net economic assets pther than from transactions with owners? In other words, how much better off is a firm at the end of the accounting period than it was at the beginning from its "outside" transactions. Earnings quality is considered over there persistence in the earnings, is there predictive ability that is derived from the earnings?

I believe that a much more simplistic definition of earnings quality can be understood from "closeness to cash" and looking at the relationship between cash flow from operations and net income over time. Earnings quality tends to go down when accruals become a larger part of earnings. Earnings quality tends to go down with the greater proportion of estimates and forecasting that is required of management in preparing the financial statements. Companies with percentage of completion revenue recognition for long term contracts (as GAAP requires) may have questionable earnings quality. As accounting becomes increasingly focused on "fair value" accounting, it seems to me that the number of management judgments will increase and the potential for poor earnings quality will increase correspondingly.

Frequent earnings restatements is another yellow flag for poor earnings quality. An excellent academic article on this topic is "Predicting Earnings Management: The case of earnings restatements" by Richardson and Tuna at Wharton and Min Wu of Hong Kong University. As they conclude, " Information in accruals, specifically, operating and investing accruals, are key indicators of the earnings manipulation that lead to the restatement."

The capital markets have had far too many examples of firms whose earnings and income recognition policies have pushed the limits. By using some of the resources that I describe today, and careful thoughtful examination of your investment, I believe you can avoid much of the grief.

Capital preservation is rule one in this business. Performance comes from buying stocks that are undervalued. But before one can begin to assess value, one needs to understand the business, and its earnings stream. If earnings quality is poor or suspect, there is no need to even bother with valuation thinking.

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