The discovery of skulduggery in a company's accounting department is just about the worst thing that can happen to a shareholder, because it's usually followed in short order by a collapsing share price.
Is it possible for the average investor to avoid such problems by spotting signs of financial chicanery early on? A pair of sleuthing U.S. money managers who specialize in detecting overly aggressive accounting have written a tell-all book on how they approach their work, which may make it easier for others to sidestep firms that have potential troubles.
They are John Del Vecchio, who runs Ranger Equity Bear, an actively managed $260-million (U.S.) exchange-traded fund, and Tom Jacobs, a value-oriented investor and contributor to the Motley Fool website. They contend that investors can improve returns, not through stock picking acumen, but from its opposite – avoiding companies likely to crater.
"It's more important to lose less, to avoid the losers, and let the winners take care of themselves, than it is to … think you're going to get the next [stock that will rise 20 fold]," said Mr. Jacobs in a recent interview about their book, What's Behind the Numbers?
The idea that stock rejection may be more important than stock selection is based on an important research study from Blackstar Funds that the two cite in their book.
The fund firm studied the performance of all the shares traded on major U.S. exchanges from 1983 to 2007, one of the strongest bull markets in history, during which the overall market rose 900 per cent. Yet, nearly 40 per cent of stocks produced a negative total return. One in five stocks were really bad investments, losing at least 75 per cent of their value. About two thirds lagged the index (in this case the Russell 3000).
The market's entire gain was produced by a minority of stocks – the best performing 25 per cent. The remaining 75 per cent had a collective return of zero per cent.
The study provides convincing evidence that the vast majority of companies are poor investments, but it leaves unanswered an important question: What is the best way to figure out which stocks to pass over?
According to Mr. Del Vecchio and Mr. Jacobs, a good way to detect whether companies have termites in their moral timber is to check for companies that are being aggressive in recognizing revenue. Revenue is the top line, from which profits ultimately flow, and is a favourite place for companies to try to mask a slowdown in earnings.
Looking at a company's revenue-recognition practices "puts you on alert for what management is out there doing and why they want to stretch revenue to please Wall Street, to keep their stock options up," Mr. Jacobs says.
One of the easiest ways to spot whether companies are playing fast and loose with revenue is a measure known as "days sales outstanding" – or how long on average it takes for a company to be paid by its customers. Calculated on a quarterly basis, the metric shows whether companies are having to extend more lenient payment terms to customers, or are trying to artificially boost revenue in one period, a practice known as "stuffing the channel."
Other warning signs are playing fast and loose with inventory management and raising debt to pay dividends.
If Mr. Del Vecchio is feeling particularly convinced about a company with aggressive accounting practices, he goes a step further and sells it short, a financial manoeuvre that profits from a decline in share prices.
Mr. Jacobs personally favours value stocks – typically those trading at low prices in comparison with their book values and earnings. Another good sign is strong buying by key corporate executives and other insiders. This would be unlikely if managers are cooking the books to produce artificially high earnings.
It's generally easier to find bargains among companies that are neglected than among those that are closely followed, so he looks for value in smaller capitalization issues and shies away from behemoths such as Apple, Google and Microsoft.
There is another reason Mr. Jacobs believes investors would be wise to be highly selective about what they buy. He worries that stocks are in what is known as a secular, or very long-running, bear market, punctuated by only temporary upturns.