The following thirteen red flags come from the book The Focus Investor by Rich Rockwood.
1. Watch for companies conducting large amounts of merger activity
Companies practicing accounting deceptions or with slowing growth may try to mask that with a lot of merger activity.
The only way to find out about a lot of companies aggressive accounting is to follow merger activity, be cautious if a company's G+I/A (Goodwill + Other Intangibles/ Assets) ratio is higher than ten percent.
2. Watch for companies that consistently meet earnings target over an extended period of time or project high growth rates
If you're reading a 10Q/K and the company claims it will grow at 15% CAGR for the next five-ten years, be cautious, natural business activity is not that smooth and good management knows that.
“If it seems to good to be true; it's neither good nor true”
If you find a company that continually grows earnings or revenue at a generic number like 15% be extremely cautious, on the other hand if the company refuses to even release earnings target, this is perfect, it gives the value investor a chance to buy stock if and when the company doesn't meet Wall St.'s lofty target.
3. Watch Companies that take big bath charges
Some companies have seasonal quarters that are historically better than others. If a company is in a historically good quarter and won't make earnings estimates it may shift expenses from that quarter to a quarter that has historically low numbers.
For example a company can fire 1000 employees and reserve their severance packages in one quarter. This will boost income in future quarters.
For another example see this article.
The FASB (Financial Accounting Standards Board), in 2002, issued a new accounting statement, SFAS No. 146, which accounts for costs associated with exit or disposal activities. In other words, when a company terminates a lease or has to pay certain employee severance packages, this expense has to be realized when incurred.
For more on big bath charges see:
http://www.sec.gov/news/speech/speecharchive/1998/spch220.txt http://www.sec.gov/news/speech/speecharchive/1998/spch230.txt
4. Pay close attention to Accounts Receivables in the Balance Sheet
If the “top line” number is shrinking or growth is slowing while accounts receivables is rising faster, customers may decide to “flex their financial muscles” and wait to pay the company back, when that happens the company starts to lose money.
5. Determine if the company uses conservative depreciation practices
Try to determine what depreciation practices are used in the industry, if the company uses different methods find out why.
6. Watch for companies that rely heavily on options as financial incentives
Issuing some options to reward employees for good performance is not bad, but when it gets out of hand shareholders are the people who lose.
Watch out for companies that break in to your piece of the pie by diluting the number of shares, and don't be fooled by companies that buy back a lot of shares to try to make up for it.
7. Monitor Revenue/Expense Recognition Issues
Some companies recognize revenue before they actually receive money, or they realize expenses before the money is actually paid.
This is nearly impossible to determine before something bad happens so always invest with quality management, read in the footnotes to the financial statements how the company recognizes revenue if it doesn't seem conservative or you don't understand it pass on the company.
For more read this.
8. Monitor One-Time Gains
One-Time gains or losses are OK, if it only happens One-Time.
When calculating cash flow for a company always add one-time losses and subtract one-time gains.
Watch out for companies that always have one-time gains or use one-time losses to disguise a bad quarter.
9. Monitor Pension Plans
General Motors hasn't been performing very well lately, the main reason: after years of coddling the unions GM has $169 billion in Pension Fund debt, compared to a market cap $15 billion. This debt is cripplincar makerrmaker.
In the late 90's companies were reporting higher income because, under GAAP, theyallowedlowwed to report gains in the pension accounts because the stock market was going up and these gains made a big difference. Watch for companies that are predicting too high returns in their pension fund portfolios.
10. Monitor companies that report revenue as cross-company payments/barter transactions
Keep a close eye on companies that become involved in deals where they receive money now, but must perform a service in the future. Because something of value is being provided revenue should not be recorded.
11. Watch for turnover in the CEO/CFO Position
The CEO and CFO are intensely tied into the financial statements that a company issues, because these two people are so knowledgeable in this area when a CEO or CFO resigns it may be because of accounting issues.
Also if a type of incentive package is tied to earnings the people at these two positions may try to juice earnings to receive more money.
Most of the time the CEO and CFO are trustworthy, but because they are so powerful watch them closely.
12. Look for Inventory Write-downs
Sometimes companies will sell too much product to the distributor to juice up revenue, when this happens the distributor may not be able to sell the product and may not buy as much in the future, this is hard to see when it is happening.
When reading a press release or reading in the footnotes make sure you know why inventory is being writ down. If companies have inventory levels that have been rising higher than sales the inventory write down may not be their biggest problem.
13. Look out for companies that use EBITDA as a measure of performance
A quality management team knows deprecation is a real expense and not just an accounting entry. If management is trying to fool you into thinking depreciation isn't a real expense, what else are they trying to fool you on?
Read what Warren Buffet said in his 2000 annual report:
"When Charlie and I read annual reports, we have no interest in pictures of personnel,
plants or products. References to EBITDA make us shudder; does management this the tooth fairy pays for CapEx? We're very suspicious of accenting methodology that is vague or unclear, since too often that means management is trying to hide something."
4. Pay close attention to Accounts Receivables in the Balance Sheet
If the “top line” number is shrinking or growth is slowing while accounts receivables is rising faster, customers may decide to “flex their financial muscles” and wait to pay the company back, when that happens the company starts to lose money.
5. Determine if the company uses conservative depreciation practices
Try to determine what depreciation practices are used in the industry, if the company uses different methods find out why.
6. Watch for companies that rely heavily on options as financial incentives
Issuing some options to reward employees for good performance is not bad, but when it gets out of hand shareholders are the people who lose.
Watch out for companies that break in to your piece of the pie by diluting the number of shares, and don't be fooled by companies that buy back a lot of shares to try to make up for it.
7. Monitor Revenue/Expense Recognition Issues
Some companies recognize revenue before they actually receive money, or they realize expenses before the money is actually paid.
This is nearly impossible to determine before something bad happens so always invest with quality management, read in the footnotes to the financial statements how the company recognizes revenue if it doesn't seem conservative or you don't understand it pass on the company.
For more read this.
8. Monitor One-Time Gains
One-Time gains or losses are OK, if it only happens One-Time.
When calculating cash flow for a company always add one-time losses and subtract one-time gains.
Watch out for companies that always have one-time gains or use one-time losses to disguise a bad quarter.
9. Monitor Pension Plans
General Motors hasn't been performing very well lately, the main reason: after years of coddling the unions GM has $169 billion in Pension Fund debt, compared to a market cap $15 billion. This debt is cripplincar makerrmaker.
In the late 90's companies were reporting higher income because, under GAAP, theyallowedlowwed to report gains in the pension accounts because the stock market was going up and these gains made a big difference. Watch for companies that are predicting too high returns in their pension fund portfolios.
10. Monitor companies that report revenue as cross-company payments/barter transactions
Keep a close eye on companies that become involved in deals where they receive money now, but must perform a service in the future. Because something of value is being provided revenue should not be recorded.
11. Watch for turnover in the CEO/CFO Position
The CEO and CFO are intensely tied into the financial statements that a company issues, because these two people are so knowledgeable in this area when a CEO or CFO resigns it may be because of accounting issues.
Also if a type of incentive package is tied to earnings the people at these two positions may try to juice earnings to receive more money.
Most of the time the CEO and CFO are trustworthy, but because they are so powerful watch them closely.
12. Look for Inventory Write-downs
Sometimes companies will sell too much product to the distributor to juice up revenue, when this happens the distributor may not be able to sell the product and may not buy as much in the future, this is hard to see when it is happening.
When reading a press release or reading in the footnotes make sure you know why inventory is being writ down. If companies have inventory levels that have been rising higher than sales the inventory write down may not be their biggest problem.
13. Look out for companies that use EBITDA as a measure of performance
A quality management team knows deprecation is a real expense and not just an accounting entry. If management is trying to fool you into thinking depreciation isn't a real expense, what else are they trying to fool you on?
Read what Warren Buffet said in his 2000 annual report:
"When Charlie and I read annual reports, we have no interest in pictures of personnel,
plants or products. References to EBITDA make us shudder; does management this the tooth fairy pays for CapEx? We're very suspicious of accenting methodology that is vague or unclear, since too often that means management is trying to hide something."
Rockwood recommends the following books to learn more about forensic accounting.
Financial Shenanigans - By Howard Schilit
The Financial Numbers Game - By Charles Mulford
More Debts Than Credits - By Abraham Briloff
Unaccountable Accounting - By Abraham Briloff
K-Swiss
1. Growth By Acquisitions
K-Swiss not attempting to grow with acquisitions, this ratio is under 2 for K-Swiss. Royal Elastics is the only notable acquisition K-Swiss has made in a while.
2. Project Too High Earnings Growth
After listening to the conference call I was impressed with K-Swiss' policy to only predict numbers for the whole year and next quarter.
K-Swiss does not forecast high numbers, and usually beats their own estimates.
3. Big Bath Charges
I did not find any big bath charges.
4. Accounts Receivables
Financial Shenanigans - By Howard Schilit
The Financial Numbers Game - By Charles Mulford
More Debts Than Credits - By Abraham Briloff
Unaccountable Accounting - By Abraham Briloff
K-Swiss
1. Growth By Acquisitions
K-Swiss not attempting to grow with acquisitions, this ratio is under 2 for K-Swiss. Royal Elastics is the only notable acquisition K-Swiss has made in a while.
2. Project Too High Earnings Growth
After listening to the conference call I was impressed with K-Swiss' policy to only predict numbers for the whole year and next quarter.
K-Swiss does not forecast high numbers, and usually beats their own estimates.
3. Big Bath Charges
I did not find any big bath charges.
4. Accounts Receivables
Accounts Receivables have grown an average of 18% over the past nine years, compared to 24% revenue growth.
5. Depreciation Practices
K-Swiss uses "strait line and accelerated methods" I believe this is fine.
6. Options
Stock based compensation was less than 15%.
I discussed, in my K-Swiss Review, the use of options at advantageous times.
7. Revenue Recognition
If we look at this right from K-Swiss' footnotes:
"We record revenues when title passes and the risks and rewards of ownership have passed to the customer, based on the terms of sale. Title passes generally upon shipment."
It looks like K-Swiss does not have any Revenue Recognition issues.
8. One-Time Gains
K-Swiss had no one-time items in 2005.
9. Pension Plans
I didn't find any pension problems.
10. Cross-company payments
K-Swiss did not report any revenue from cross-company payments or barter transactions
11. CEO/CFO position
Steven Nichols has been with the company since he, and a group of investors, bought it in 1986.
12. Inventory
K-Swiss is OK with Inventory write-downs.
13. EBITDA
I did not find any references to EBITDA.
It looks like K-Swiss management is trustworthy.
7. Revenue Recognition
If we look at this right from K-Swiss' footnotes:
"We record revenues when title passes and the risks and rewards of ownership have passed to the customer, based on the terms of sale. Title passes generally upon shipment."
It looks like K-Swiss does not have any Revenue Recognition issues.
8. One-Time Gains
K-Swiss had no one-time items in 2005.
9. Pension Plans
I didn't find any pension problems.
10. Cross-company payments
K-Swiss did not report any revenue from cross-company payments or barter transactions
11. CEO/CFO position
Steven Nichols has been with the company since he, and a group of investors, bought it in 1986.
12. Inventory
K-Swiss is OK with Inventory write-downs.
13. EBITDA
I did not find any references to EBITDA.
It looks like K-Swiss management is trustworthy.
5 comments:
Speaking of the greed of the executives as mentioned in the previous post, corporate expenses for KSWS have been 11-17% of operating profit in the past three years. I don't have much experince with determining what an appropriate corporate expense is for a company like KSWS, but I know that Buffett in his annual letter in 1992 gave the example of 10% of operating profit as an excessive amount of corporate expense.
From the 1992 chairman's letter:
"our after-tax overhead costs are under 1% of our reported
operating earnings and less than 1/2 of 1% of our look-through
earnings. We have no legal, personnel, public relations, investor
relations, or strategic planning departments. In turn this means
we don't need support personnel such as guards, drivers,
messengers, etc. Finally, except for Verne, we employ no
consultants. Professor Parkinson would like our operation - though
Charlie, I must say, still finds it outrageously fat.
At some companies, corporate expense runs 10% or more of
operating earnings. The tithing that operations thus makes to
headquarters not only hurts earnings, but more importantly slashes
capital values. If the business that spends 10% on headquarters'
costs achieves earnings at its operating levels identical to those
achieved by the business that incurs costs of only 1%, shareholders
of the first enterprise suffer a 9% loss in the value of their
holdings simply because of corporate overhead. Charlie and I have
observed no correlation between high corporate costs and good
corporate performance. In fact, we see the simpler, low-cost
operation as more likely to operate effectively than its
bureaucratic brethren. We're admirers of the Wal-Mart, Nucor,
Dover, GEICO, Golden West Financial and Price Co. models."
This post was very helpful! I'm new to investing in the stock market and am always looking for insightful information to help me make decisions.
If you have any tips for a newbie, I would be very grateful if you would drop them on my blog. :)
To anon concerned with corporate costs in excess of 10% of operating profit:
BH is a holding company, not an operating company. Operating companies need legal staff, accountants, HR, etc. Without them, they run the risk of losing all of their capital in lawsuits.
Mike:
Nice analysis. But I will say that you are going up against some monsters who own this stock...Bill Miller, Jeremy Grantham, John Gunn, and Marty Whitman.
Would love to hear their opinions as to why they believe you are wrong.
invstmnt:
If they own the stock I doubt they believe I am wrong, K-Swiss is my biggest position and this article was to check for red flags as part of my analysis.
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