Not All Information is Created Equal

Alex Shevelev

Promises. We’ve heard our fair share from company management teams over the years. iSelect told investors that earnings before interest and tax would be $26m to $29m for the year. A little over two months later expectations were slashed by over 60%. How much weighting should management guidance be given in investment decisions? And what happens when it clashes with other sources of information?

Management has access to information that outside investors don’t. Shouldn’t their guidance be better than anybody else’s?

Unfortunately, it is not that difficult to punch a few optimistic sentiments into Microsoft Word and lodge it with the ASX. We lodge the NTA for FOR on the ASX every day – all it requires is a few short clicks of the mouse.

And the information that management sees is usually processed in a cloud of optimism. Incentives encourage positive, not realistic, guidance. Have a good story to tell? Tell it early and often. Things going badly? Hold back until you know it’s not going to turn around.

It goes beyond just guidance for the current year. Plenty of companies will tell investors that they have “no competitors”. Really? A small company from Australia has this global market all to itself? Or, like Smart Parking (SPZ), they lay out a presentation slide that suggests 300% annual returns on capital. Extraordinary claims will require extraordinary proof, and management claims alone won’t do.

Especially in the smaller stocks, where promotional management teams run rampant, trusting what senior executives say can be difficult. Often it will be dependent on who is doing the talking, and how they have behaved in the past.

What about me?

Next along the quality of information spectrum is us. First, our hypothesis of what the world is going to look like in the future. Personal experience might suggest that newspapers are dead. NZME’s (NZM) profitable print business suggests otherwise. And there are plenty of steps between going into your busy local Lovisa (LOV) and buying the stock. Our views of the world’s future have their own biases. It doesn’t mean you don’t think about how the world might change. It just means you shouldn’t overweight your own subjective opinion.

A little more sustainable is our view on what a good or bad business looks like. Should a competitive mining services business be earning high returns on capital? It is possible, but that deserves a lot of scrutiny. And it might be very short lived. Those more likely to earn high returns on capital are businesses that have an identifiable competitive edge. Think CSL (CSL) or REA Group (REA).

Trusted information is hard to find

Then there is the information that comes from trusted sources. Conclusions from Australian Bureau of Statistics (ABS) data, for example. Or historical industry growth rates. And the big one: audited financial information. Of course there are issues. We are constantly on the lookout for earnings manipulation and other accounting red flags. But there is likely to be more truth here than in management proclamations about the future.

And time matters. A few years of audited financials is good. Five or ten is better. There has been more time to see structural changes in the business, more time for instabilities in the business model show themselves, and more time for management to prove themselves sound capital allocators.

When the latter points come into conflict with the former it is the latter that usually win. If management imply returns on equity that clash with a rational assessment of the business model, the business model view is likely to win out. If our view of the business model clashes with years of audited accounts, we are probably going to change our mind.

With so much information on stocks it can be hard to prioritise, but weighting new information equally is not the answer. Preferencing more accurate sources will flow through to more accurate decision making.

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Alex Shevelev

Alex is a Senior Analyst at Forager Funds Management, responsible for researching stocks for the Forager Australian Shares Fund.

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