Introduction:
Why Accounting Matters More Now Than Ever
Anthony Scilipoti, President and CEO
and
Darryl McCoubrey, Head of Research
In financial markets, unfortunately, some of the most valuable experience we can acquire is from losing money. Even though every investor prefers to gain their experience the easier way – without losing money – it often takes a sector or market correction to expose unforeseen risk.
But there is a shortcut. Reading the financial statements.
No really. As crazy as it may seem with rock bottom interest rates and the mania surrounding growth and price-to-sales ratios, history has shown that good old-fashioned financial analysis mitigates risk.
In fact, we think delving into the financial statements matters now more than ever.
Why? Because the checks and balances that have helped keep companies honest in the past are breaking down.
Consider the following trends:
• Passive-aggressive: Based on Morningstar data, passive funds and retail investors now make up ~46% and ~25% of U.S. equity fund holdings, respectively1. Passive funds follow the market by rebalancing to an index, a set of factor returns, or a market-weighted theme. Retail investors, while their acumen may vary, typically do not hold enough vote to sway financial reporting. In general, attention to the corporate governance or the quality of accounting and disclosure, therefore, rests on the shoulders of the minority.
• MiFID II in, Analysts down: With fewer active funds to advise and stiff regulatory pressures, the business of giving equity advice is shrinking. Headcounts are being reduced and those analysts that remain are less experienced and are left to cover a much larger roster of companies. Fewer analysts means fewer questions for management.
• Short-sellers exiting: Short-interest on major indices has fallen to all-time lows and many short-sellers no longer publish their findings. Love them or hate them, short sellers provide a critical function in challenging business models and improving price discovery for stocks.
• Fraud percolating: Fraud investigators are commenting that significant misconduct is being covered up by easy access to financing and credit. Three private organizations have recently been called out for malfeasance by regulators: Bondfield Construction Company Limited, Bridging Finance Inc. and Fortress Real Developments.
As imperfect as they are, the financial statements remain the most objective information available to assess the performance of a company. Compensation schemes and pressure to ‘make the numbers’ can lead management teams to take on excessive risk and focus on the short term, to shareholders’ detriment.
When times are good – as they seemingly are today - capital is flowing and investors are making gains. There is very little incentive to question a company’s performance, or the source of its share price gains.
We are often asked how we knew a company was going to be the next blow-up. The honest answer is that there was never a single data point or moment in time when we knew a stock was going to collapse.
It always came from paying attention to the details over time. Sometimes a long time. We would pull one thread, then another, and another. Sometimes it took years for the threads to unravel.
Our Vision 2021 series is about following the details and nuances. In other words, the threads. Each report will focus on the key financial reporting issues within each sector.
Most of the time, following the details and understanding the accounting nuances helps us cut through the noise and focus on sustainable cash flow so that we can value a business properly. That is the meat and potatoes of what we do every day.
In other cases, there may be threads to pull that lead us to pull more threads down the road. This is how we find the outliers – the big blow-ups that happen every business cycle.
Financial statements and company disclosures offer an early warning system so that you can avoid the painful extremes. We are here to help make sure that system is on and functioning.
Let's Play a Game
A lot of smart people have said over the years that history is doomed to repeat if you don’t learn from it.
We have collected five excerpts from five companies’ letters to shareholders over the past 20 years, changing a few details to keep each company anonymous. See how many you can get right.
Company A
“‘Company A’ manages efficient, flexible networks to reliably deliver physical products at predictable prices. [In the past year], ‘Company A’ used its networks to deliver a record amount of [various commodities] and other products. With our networks, we can significantly expand our existing businesses while extending our services to new markets with enormous potential for growth.[Our] performance [this year] was a success by any measure, as we continued to solidify our leadership in each of our major businesses. In our largest business, wholesale services, we experienced an enormous increase of 59 percent in [physical commodity] deliveries. Our retail [commodity] business achieved its highest level ever of total contract value. Our newest business, [communication] services, significantly accelerated transaction activity, and our oldest business, [commodity infrastructure], registered increased earnings. The company’s net income reached a record [this year].”
Answer: Enron - Within six months of reporting these comments to shareholders in its 2000 annual report, the company restated its financials for the years 1997 through 2000 and by the end of the year declared bankruptcy, done in by off-balance sheet arrangements and fictitious accounting.
Company B
“For ‘Company B’, [this] was a year of accomplishment and global growth – a year of benefiting from the investments we’ve made in designing and building [advanced technology infrastructure]. The [advanced technology infrastructure] is the backbone of the [omitted] global economy and the foundation of a new era in global communications that’s touching the lives of people in all regions of the world. By enabling [new technology], creativity, and collaboration, the [technology] is radically changing the face of business and transforming whole industries. The [technology] makes it cheaper to design products remotely; reduces the need for vast inventories; provides a better means to target, communicate with, and service customers; cuts the costs of delivering many services such as healthcare; and helps companies like our own streamline operations and internal organizations so they are more effective and efficient. Many companies are already achieving extraordinary gains in performance and productivity as the [omitted] economy is transformed by the [technology] revolution.”
Answer: Nortel Networks - Veritas first warned about Norlel’s lack of cash flow and its accounting practices in February 2000. On the second page of its 2000 annual report, from which our excerpt is drawn, Nortel reported ‘Earnings per Common Share from Operations’ with a key asterisk noting that it excluded: acquisition-related costs, including
Company C
“We continued to move 0ur business forward during [this year], achieving solid operating and financial performance. Our continuing progress has earned us leading status in the [industry], not just in Canada or North America, but around the world. This is our fifth year as a stand-alone entity and for each of those years, we have delivered the same level of leadership, consistently delivering a leading performance relative to our peers and surpassing our own results. We continue to demonstrate the stability and experience of a seasoned veteran and the energy, enthusiasm and potential of a youthful start-up. Such complementary strengths are a source of considerable strategic advantage because we can offer integrated [product] solutions. Given the breadth of our platforms, we are able to promote cross-selling and bundling propositions to our customers and thus grow our business. The same is true for our [media] business [Subco] Corporation. [Subco] offers a suite of leading print and online destinations covering four categories: [omitted]. [Subco] is the first and only nation-wide [media] business [of its kind] in Canada.[This year] was one of transition for [Subco] during which we focused on building a fully integrated national company while investing in news systems and in our people.
Answer: Yellow Pages Income Fund - The excerpt is from comments by board chair Marc L. Reisch in the company’s 2007 annual report. Subco is Trader Media, acquired by Yellow Pages in an effort to fill out an online sales model. As we outlined in our reports in late 2006, Yellow Pages’ growth-by-acquisition model was highly risky because its underlying businesses were eroding. The company was masking its declining profile by raising its prices and letting its page counts decline (we know – we counted each type of ad in each book). The company’s unit price would peak in late 2007, only to fall more than 60% by the end of 2009, eventually leading to a dilutive 2012 restructuring. Our favourite quote from that era was CEO Marc Tellier’s response to our criticisms during a conference call: “Well, 13 out of 14 analysts have a buy on our stock.”
COMPANY D
“[This fiscal year] was another year of exceptional growth for ‘Company D’. [Our] subscriber account base grew substantially, [Company D] launched more new [models] in [this fiscal year] than ever before and we achieved record financial results in terms of both revenue and earnings. As [Company D] continues to expand the presence of [our products] in both [professional] and consumer markets, we see tremendous momentum in our business and are confident in the Company’s ability to continue to grow and succeed in [the coming fiscal year]. We are proud of the Company’s accomplishments and grateful to approximately 8,400 employees around the world whose talents, hard work and determination enabled [our company] to once again execute effectively and deliver solid results. We would like to thank all of our employees for their commitment to excellence and congratulate them on another successful year. We also thank our customers, partners and shareholders wholeheartedly for their support throughout [this fiscal year].”
Answer: Research in Motion (now Blackberry) - These comments are drawn from the company’s 2008 annual report, whose slogan was: “Ask Someone Why They Love Their Blackberry”. The company’s annual report actually begins on page 10 following nine pages of glossy advertising and testimonials to the company’s multiple handheld models. (Do you remember the Curve? How about the Pearl?) The company’s sales and net income continued to grow over the next few years. Ultimately, however, the entry of Apple into the smartphone market and an inability to compete in the consumer space (which Veritas warned of in 2009) ultimately led the company’s shares to decline by more than 95%.
COMPANY E
Six years ago, ‘Company E’ embarked on a journey to establish a new business model in the [industry omitted] space. A model:
• That focused on high-growth [omitted] segments where customer relationships continued to be valued and [revenue] was more certain;
• Where lower risk innovation played an important role and significant unmet [customer] needs existed;
• Where we adopted a geographic lens that focused on emerging markets where population growth, improving incomes and low [industry] spend promised growth for decades to come;
• With a decentralized model that attracts entrepreneurial local management teams who embrace decision making and accountability;
• And one where we adopted rigorous financial hurdle rates for deploying capital to ensure we could deliver outsized returns for our shareholders.
Over these past six years, we have built a thriving, durable [industry] company that has multiple platforms for future growth. I have never been more optimistic about our future – our ability to provide superior products for [customers], our opportunities to enhance the provision of [services to intermediaries] and our ability to continue to provide industry-leading returns to our investors. In closing, I would like to thank our more than 17,000 employees worldwide for their professionalism, commitment and hard work; our Board of Directors for their active oversight and leadership; and each of you –our investors – who believe in our company, our strategy and our ability to execute. We look forward to delivering another terrific year [this year].
Answer: Valeant Pharmaceuticals (now Bausch Health Companies) - The excerpt is from their 2014 annual report, fresh off the first full year of owning Bausch + Lomb and a failed bid to buy Allergan. As we argued, Valeant’s business model of buying limited-life patents to hike prices, while doing little if any internal R&D to grow, was unsustainable without larger and larger asset purchases to fill in the growing gaps. Add in reckless marketing through a non-arms length pharmacy (Philidor Rx Services) – a story which we helped break – and Valeant’s excessive leverage and it led the shares to collapse by more than 95%.