It's (almost) all in the numbers

I was never that great at accounting, and yet as I made it (eventually) onto year 2 of my 20-month MBA program, I opted for a less than popular course named International Financial Statements Analysis, or INFSA for short. Over the course of 10 weeks, we pored over financial filings of public entities in search of both hidden value and more interestingly, signals of impending trouble.

Whilst this academic interest began to take shape in the fall of 2003, recent reading has brought the relevance of accounting solidity and earnings quality to the forefront of my thoughts. To borrow once again from the wise words of the legendary Warren Buffett:

“accounting is the language of business”

… and as such it pays to understand it.

Numerous authors from Thornton O’Glove in his 1987 classic “Quality of Earnings” to the more recent “Financial Shenanigans” authored by Howard Schilt point to the increasing relevance of performing consistent and thorough analysis of publicly available financial reports. Common practice these days however suggests that all too often investing decisions are made on recommendations of research analysts, CNBC pundits or worse, “well-intentioned” suggestions of friends and relatives.

We’ve talked here before about the less than stellar record of equity analysts in predicting earnings numbers, not to mention their sometimes-obvious conflicts of interest (especially for those working within large full-service investment banks. But at least these people tend to look at financial statements, thoroughly or not.

Financial journalists and other well-meaning members of our social circle however, pose a bigger concern. Frequently we may find ourselves being served an opinion that is just that, the result of a “gut feeling” exercise or equally hazardously, a conclusion drawn from the prevailing consensus at the time…

So, how much does accounting matter? Very much, according to Glen Greenberg of Chieftain Capital, for who even “quality financial information aggregators” (think expensive services such as Capital IQ or Reuters), simply do not cut it. Instead this remarkable investor opts to rely on the raw material filed with the SEC, namely the quarterly 10 Qs and the annual 10 Ks, which all quoted enterprise must present.

So why don’t more people follow suit? After all once you feel the pain of asset declines you’d think there would only be two choices left: steer clear of the markets or do it on the basis of good information. Well, there are actually a number of reasons, though not any “good” ones in my book.

1. It is boring. It sure can be. Reading and analysing years of financial statements for the vast majority of people is about as much fan as watching paint dry.
2. It takes time. Performing the kind of research required to truly understand the numbers is a painstaking effort and can be perceived as waste of one’s time.
3. It is sometimes difficult. Notice I say “sometimes”. At its core financial statement analysis is not a difficult endeavour but rather a fairly mechanical and repetitive exercise. It becomes “difficult” at times as a result of the arcane language used in such documents and the conscious, sometimes blatant effort of corporate accountants to obscure the facts and confuse the readers of reports by burying vital information in remote footnotes.

What to do then in light of this rather ominous scenario?

I believe that there are only two paths available for the serious investor.

1. DIY – Put the effort (and the hours) in and benefit from identifying potential short-sell opportunities (both Enron and Lehman Bros. where called out by professional investors months before their demise

2. Seek a professional money manager where the focus is on analysis and not on marketing. Check out the ratio of Investing professionals to Sales & Mktg staff to get a sense of where the focus may lie.

Just note that time not spent talking to self-serving sales types or following the advice of idea-a-minute journalists could be more wisely spent looking at the raw numbers!