Friday, 30 September 2011

And Now for Some Good News - Low & Stable Inflation Expected

Amongst all the big market swings and dire news of countries at risk of defaulting on debt, there's one key economic variable whose outlook is relatively benign that is of crucial interest to investors - future inflation rates.

Big unexpected leaps in inflation that hurt both stocks and bonds do not seem to be in the cards at the moment, despite the latest CPI figures from Stats Can for August which showed a still-high rate of 3.1%.

The future according to:

Bank of Canada - The organization responsible for monitoring and controlling inflation in Canada states that its
The Market - By subtracting what investors are willing to pay (accept as a return) for inflation-indexed Real Return Bonds from ordinary non-inflation indexed Canadian government bonds of similar maturity, we can infer the market expectation of inflation. Reuters thankfully has been doing the tracking for us in the Canada Breakeven 20 Year chart, the update as of September 29, 2011 shown below. Note how expectations have varied quite a bit in the last five years, though never going above about 2.8%.

  • current expectation 2.08%
Best future inflation estimate: 2%

How likely is it the forecasts will be correct?
We all know how prone to error forecasts can be. CanadianFinancialDIY blogged about a Credit Suisse report that surprisingly found central bankers to be the most accurate though they too erred by more than 1% above and below the eventual real rate.

What does it mean for the investor? Low and, especially, stable inflation would remove a major troubling element for investors as inflation is a potentially very nasty risk (see our recent post on how how bad inflation and its effects have been in the past). Despite the good forecasts it may still be wise to be cautious and hedge bets by building inflation protection into a portfolio, as we discussed in Investments to Protect against Inflation and in Investing Risk: What is there to Lose?

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 21 September 2011

Twelve Tricks in Financial Statements and How to Detect Them

Last post we listed a dozen general warning signs that company management may be up to no good and be trying to conceal outright illegal fraud or painting a rosier-than-justified but still legal picture of the financial condition of the company. This week we look at some of tricks of the managers and a few ways to detect the manipulation.

Deceptions on the Balance Sheet

1) Liability provision for Product Warranties in excess of what's needed to cover actual costs. This reduces current earnings and creates a "cookie jar", as Al and Mark Rosen describe in their book Swindlers, that can be used later on to boost earnings by simply reversing the excess provision. The obvious sign: the provision rises significantly and out of line with sales.

2) Excessive restructuring charges upon a reorganization or cutbacks, often after poor results. Erring on the high side gives management the opportunity to look good by using this form of the cookie jar to boost earnings in subsequent quarters and try to deceive investors that a quick turn-around has taken place.

3) Resource companies can use, and often have used, asset writedowns to lower earnings initially and then raise them later by reversing the writedown. Similarly reserves for claims are a key variable in life insurance companies, or loan loss provisions in banks and it is very difficult for an investor to figure out what such values should be, even at times company management is trying its best to be forthright.

4) Expenses booked as an increase to Assets - capitalized expenses - instead of including the amounts in operating expenses. This results in higher immediate earnings. One way to uncover this subterfuge is to to compare the choice of methods used to capitalize expenses in other similar companies, as explained in notes to financial statements. It also helps to compare the depreciation and amortization expense amounts with the average asset balance. If either depreciation expense as a percentage of fixed assets or amortization expense as a percentage of intangible assets is much lower than in prior years, this might indicate the fraudulent classification of operating expenditures as capital expenditures. (from What's Your Fraud IQ? in the Journal of Accountancy)

5) Hidden asset impairments that should trigger a reduction in earnings through writedowns but don't because hidden. Such impairments might consist of obsolete equipment and facilities in industries like manufacturing, technology, media and communications. At an extreme of impact, we note the example of toxic mortgage and related derivatives assets on bank balance sheets which played a central role in the credit crisis. Often the problem is hidden in a manner that is quite within accounting accounting rules but which effectively masks economic reality by choosing a favourable valuation technique. The way to discover the ruse is to read the notes to financial statements regarding accounting assumptions and then to compare with other companies in the same sector.

6) Significant liabilities off the balance sheet. Items such as leases and contractual obligations and pension liabilities can hide a weak financial situation. Tracking them down involves going through various sections of quarterly and annual reports such as the notes and the management's discussion and analysis, the company's annual information form and the proxy circular.

7) Omitted or down-played contingent liabilities. The best example is the possible impact of lawsuits, which companies are wont to under-emphasize, if only to not publicly admit culpability before a case is settled. There may not be a hard and fast answer until actual resolution of a lawsuit but the investor may be able to develop a sense of where things are heading by reading up on what is said in the media, for which Internet search tools are a wonderful help.

Trickery in the Income Statement

8) Lower credit standards, allowing more people or firms to buy products, who otherwise would not be accepted. This raises sales in the near term but results in higher future write-offs for uncollectible bills.

9) Premature recognition of revenue in multi-year contracts, such as construction and projects, through overstating progress towards completion, again in order to enhance immediate earnings.

10) Fictitious sales are outright illegal fraud. In one variation, a company ships product to an outside warehouse, books the revenue to meet a year-end goal, and then returns the goods to its own inventory. A clue is that a large proportion of reported revenue is uncollected - the Swindlers book warns that when accounts receivable represent 80%+ of a quarter's sales, danger lurks. Another indicator is a reversal to accounts receivable in later periods. A third sign is a big sudden increase in the Quick Ratio, of which receivables is a key part.

11) Big discounts or extended payment terms to customers to bring forward sales into the current period to boost earnings. One sign is that the Gross Margin (Sales - Cost of Goods Sold) will decline.

Cash Flow Manipulation

12) Operating cash flow juiced up by a whole menu of possible tactics such as: sale of receivables, separate sales companies, stock option compensation instead of pay, prepaid maintenance, substituting property ownership for leasing, buying R&D instead of doing it in-house, paying consulting fees to related parties with shares and other techniques, as described by in Cash Truths that Aren't.

The Beneish M Score - A good way to start investigating a particular company would be to apply the system of financial ratio tests developed by Indiana University professor Messod Beneish to detect earnings manipulation. The test uses eight different financial ratios and produces a single number that in Beneish's testing successfully identified about three quarters of manipulators, though it also wrongly labelled 18% of non-manipulators (see David Bricknell's short and readable summary on iStockAnalyst of the various ratios and what they mean).

That kind of result reminds us too that detection of fraud or manipulation is not always possible. Therefore we might not be sure about what a company is doing and how much that should affect the value of its stock. However, investigation directed at typical trouble spots can be a real boon for the investor contemplating purchasing a particular company's stock.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 14 September 2011

Financial Statement Manipulation and Fraud: A Dirty Dozen Warning Signs

Controversy again erupted on the stock market recently with first Sino-Forest Corp (TSX: TRE) being accused of illegal deceptive financial reporting and then Silvercorp (TSX: SVM) too being accused of falsifying data. Though the verdict on the accusations is not in for these two companies, it reminds us that financial misrepresentation does happen, ranging from dubious but often legal earnings management through to outright falsification and fraud.

Whether dishonest perpetrators eventually get caught or not, in the meantime investors can lose a lot of money since the inevitable result of the malfeasance is big losses in stock value and often total loss. It's better to detect problems in the first place and either avoid the stock altogether, or for those brave enough, such as those first raising the stink about Sino-Forest and Silvercorp, short-sell the stock.

To that end, we offer a list of warning signs that something may be amiss in a company. Most of these signs are culled from two books: Financial Statement Analysis (4th edition) by Martin Fridson and Fernando Alvarez and; Swindlers by Al Rosen and Mark Rosen (reviewed by CanadianFinancialDIY, by Jonathan Chevreau in the Financial Post and by CorporateKnights)

  1. Unexpected turnover of senior management - e.g. the sudden resignation of the Chief Financial Officer or the CEO
  2. Late financial statements - companies must publish results within a certain time after quarter and year-end dates; e.g. the Ontario Securities Commission sets out deadlines here
  3. Incomplete quarterly statements - e.g. missing the Balance Sheet or Cash Flow Statement
  4. Professional financial analysts state they cannot understand the company's financial statements - Fridson and Alvarez note that such was often said about Enron before it went up in smoke. They cite Warren Buffett's trenchant comment - "... if you cannot understand the footnotes [in financial statements], it is because management does not want you to."
  5. Board members not sufficiently independent of management or not very experienced or with little ownership stake or simply a Board that is too small - this forms part of overall corporate governance, which we reviewed in our post Stocks and Corporate Governance: Do the Good Guys Finish First or Last?
  6. Infrequent meetings of the Board audit committee - on the other hand, it is a good sign when the independent (i.e. not family or business relations of senior managers) committee members meet more than twice a year (see study in next bullet)
  7. Members of the audit committee had short term stock options - see Corporate Governance and Earnings Management (download here from SSRN) by researchers Sonda Marrakchi Chtourou, Jean B├ędard and Lucie Courteau
  8. Management untrustworthy on other grounds - Fridson and Alvarez give the example of insider trading by Richard Scrushy at HealthSouth before it imploded
  9. Related party non-arm's length transactions and private companies set up by executives to do business with the public company - these situations present opportunities for the executives to enrich themselves at the expense of the public company and its shareholders
  10. Corporate restructurings - where there is the danger that excessive costs are written off, creating a cookie jar account reserve that management can use later to boost earnings as the high costs do not come to pass.
  11. Industries that are more susceptible include non-manufacturing, non-retail sectors like finance, credit unions, banks, insurance, real estate and not surprisingly, resources
  12. Weasel words in earnings conference calls - we can listen carefully to those post-earnings conference calls where management explains results to professional analysts (which the Internet now makes possible for individual investors to listen in on - get links from the company investor relations website area or a news website like CNW's webcast listing). According to David Larcker and Anastasia Zakolyukina's paper Detecting Deceptive Discussions in Conference Calls, the question and answer time at the end is where "... the answers of deceptive executives have more references to general knowledge, fewer non-extreme positive emotions, and fewer references to shareholder value. In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words."
None of these warning signs is necessarily sufficient to conclude that hanky-panky is going on. Combinations of factors along with actual digging through the accounting statements is required to arrive at a determination. Nor is it 100% sure that even with the utmost expert due diligence - that was the depressing take-away from the Enron situation where pretty well everyone was oblivious to the fraud - will it be possible to detect every fraud. Nevertheless, paying attention to warnings signs and checking out the situation can help avoid investing grief.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Wednesday, 7 September 2011

Getting Started in Value Investing

Our last post reviewed past blog post lists of stocks picked by industry or by certain characteristics. Now is an opportune time to bring up the grand-daddy method of stock selection that is the basis used by most active investors - Value Investing. As Wikipedia explains in more detail here, Value Investors attempt to find bargain-priced stocks through so-called fundamental analysis of accounting data. Often this starts with the ratio of current stock Price to company Earnings, the P/E ratio, with lower P/E being better, i.e. the lower the Price paid for the company's yearly profits the better off the investor is.

Analysis then usually proceeds through a series of other ratios considered to be indicative of a "good buy", like low Price to Book Value, low Price to Assets, high Dividend Yield (dividend over Price) and of safety margin, like low Debt / Equity and high Interest Coverage (by how much the company's earnings exceed required interest payments to avoid a disastrous default). Within the general concept there are many variations in the practical specifics. To get you started, here are a few Value investor examples and some useful tools.

First, let us acknowledge Benjamin Graham, the practical and philosophical inspiration of Value investing. His book The Intelligent Investor, as updated by Jason Zweig, is still an essential read for any Value investor.

Ben Graham Center for Value Investing - headed by Dr. George Athanassakos
The website contains papers, audio downloads, links to data sources, book references. Athanassakos writes a regular column for the Globe and Mail, the most recent of which, The Contrarian Case for Active Investing, tells of his success in picking stocks that have outperformed. In A Faster Way to Identify Value Stocks, found at the Canadian Investment Review he gives more detail on his method, which includes these factors to derive the best combined SCORE to pick the stocks:
  1. Low P/E stocks, excluding negative numbers (i.e. companies with negative earnings / losses)
  2. Price > $1
  3. Smallest Market Cap stocks (small companies)
  4. Least liquid stocks (small trading volumes)
  5. Highest Asset Turnover stocks (ratio of Sales over Balance Sheet Assets)
  6. Highest Revenue growth stocks
  7. Highest Earnings Per Share (EPS) growth stocks
  8. Highest Earnings Before Interest and Taxes (EBIT) stocks
Mutual Funds - Amongst the resources listed by the Ben Graham Center are several fund management companies offering services to Canadian investors, who are said to espouse value investing methods, such as Burgundy Asset Management, Chou Associates, I.A. Michael Investment Council / ABC Funds (its principles for stock selection shown here on the Globe and Mail site), SteadyHand and others.

ETFs - Unsurprisingly, there are many Value-based ETFs. Sporting the word "value" in the fund's name, they vary in which factors are used to select the stocks, some using only historical P/E and P/B data, others using analyst forecasts as well. has a list of Value Stock ETFs here. CanadianFinancialDIY commented on the "slippery" meaning of Value in ETFs and Yahoo Finance describes the different ETF definitions of Value.

Tweedy, Browne Company LLC - The 91 year-old portfolio management company subscribes to Value investing principles, which it explains in its free booklet What Has Worked in Investing. The factors Tweedy looks for:
  1. Low P/E
  2. Low P/B
  3. High Dividend Yield combined with a low Dividend Payout (ratio of dividends to earnings)
  4. Insider purchasing - executives and Board members buying shares themselves
  5. Small market cap
  6. Significant Price declines from highs
StingyInvestor - Investment advisor Norman Rothery lists his current and past stock picks using what he interprets to be Ben Graham's Value principles (e.g. in table 2 of 7 Graham Stocks for 2011). He provides informative comments on the practicalities and on the success of his picks.

Screening and Data Tools - To do your own searches and then assessments for Value stocks, here are some online resources.
  1. (free registration required) - This is by far the most complete and flexible source to screen stocks with numerous and varied criteria. One unique and very helpful feature is that for any metric chosen ADVFN shows the range of values and where the median and average values lie. This tells us what is a high or a low PE value at the moment; for instance, in the screenshot below we see that of all the TSX stocks with a positive P/E ratio (to do that we entered a constraint of PE greater than 0.1), the average P/E is 33 and the median is 12. We might thus set the constraint that a potential Value stock must have a P/E under 12. Adding other criteria results in a shorter and shorter list of candidate stocks. After winnowing the list down to a manageable number the real work of individually assessing each company begins and ADVFN includes a large number of financial ratios going back five years, along with graphs of many key numbers to enable quicker trend spotting and understanding what is driving each company.
  2. - This site contains perhaps the one thing missing from ADVFN that Value investors often monitor - Insider Trading e.g. Bank Of Montreal.
  3. GlobeInvestor's My Watchlist - Quickly construct a portfolio of candidate stocks, with a selection of the key fundamental data in a variety of standard views plus the capability to build your own view with only data of interest to you. It's handy because the Watchlist is part of the GlobeInvestor website of business and investing news.
Methods of Corporate Valuation - The late Prof Ian Giddy of New York University wrote this short readable introduction to the methods of valuing a stock. - The anonymous investor author gets to the gist of many stock valuation issues with a very practical perspective. He notes many of the potential trip-ups and mistakes that can subvert an investor's evaluations in the sections on Stock Picking and the Cash Flow Debate.

The essence of Value investing is smart detective work. That's what will distinguish the companies and stocks that deserve their low price, as most do, from those that are truly under-valued. As a corollary we also need to keep in mind that sometimes we will be wrong - the detective work, even when done with great care, may give the wrong answer. The idea is that there may well be more losers than winners but the winners' gains will more than compensate for the losses on the losers. It is necessary to keep at it, keep track of new information and not put everything on the line in one stock.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.