The art of positioning the truth

Andrew Macken

Montaka Global Investments

Investing is never easy at the best of times. Making sense of complex financial accounts takes both time and the aptitude to anticipate the numerous ways in which CFOs can position their businesses in the most favourable light. Sometimes the business models themselves allow for great subjectivity in arriving at the reported earnings level. Sometimes management actively encourage investors to focus on favourable metrics, while discouraging the unfavourable ones. And sometimes, just sometimes, the numbers are simply wrong. Let’s step through a recent example of each.

QBE Insurance (ASX: QBE) is an $18 billion international property and casualty insurer. The business model of such an insurer can be summarised as follows: the insurer receives a premium today to bear a specific risk of loss over the insured period – even if that loss takes many years to determine. In the meantime, the insurer can invest that premium and generate an incremental investment return.

It is perhaps not surprising, therefore, that the majority of the balance sheet liabilities of a property and casualty insurer relates to incurred claims. These reflect the insurer’s best estimates of the future losses it is on the hook for. And therein lies the enormous level of subjectivity in the business. Because management needs to estimate the future amounts to be paid out – an impossible task that involves predicting the future – this liability can be revised upwards or downwards at any time. And this change runs through the insurer’s income statement as a source of income or expense.

Consider that in 2016, QBE reported US$366 million of “positive prior accident year claims development”. In layman’s terms, this means that QBE were previously overestimating the future outstanding claims they were on the hook for – being too conservative – and, as such, have revised down the estimated liability. The amount is significant. Without this change in estimate, pre-tax earnings would have been 34 percent lower. Furthermore, while QBE proudly touted an improved return on equity of 8.1 percent in 2016, this would have been a deterioration to around 5.5 percent without such a favourable revision to estimates.

Then there is Snap (NYSE: Snap), the $26 billion owner of ephemeral messaging app Snapchat. The company recently reported its first quarterly result since becoming a publicly-listed company. The result fell well short of expectations and the stock plummeted by 21 percent. Sequential revenue growth actually fell by 10 percent and the business continues to be loss-making. Daily-active-user growth also fell short of expectations.

But on the conference call, company founder, Evan Spiegel, argued that even daily-active-user growth was the wrong metric to focus on (let alone profitability). “How we think about daily active user growth is really through the lens of creativity and creation,” Spiegel told confused analysts. Spiegel referred to the number of snaps created per day and time spent in the app as metrics for investors to focus on (again, in place of profitability no doubt).

Finally, we have Dick’s Sporting Goods (NYSE: DKS), the $7 billion retailer in the US. In recent weeks, it made the following statement in a public filing with the Securities and Exchange Commission in the US: “This Form 8-K/A is being filed solely to correct a computation error in the calculation of Adjusted EBITDA within the ‘GAAP to non-GAAP Reconciliation – Adjusted EBITDA’ tables” contained in the company’s March release of fourth quarter financial performance. “This computation error resulted in a $23.4 million overstatement of Adjusted EBITDA amounts” which is about an eight percent overstatement of quarterly Adjusted EBITDA. The market was naturally unamused by this “computational error” sending the stock down by four percent on the day.

The message for investors is clear: take the time to understand the accounts of your businesses. And try not to be influenced by the “guidance” of management. As you can see, at best it’s self-serving; at worst it’s simply wrong.


Chief Investment Officer
Montaka Global Investments

Andrew is responsible for managing all investments at Montaka, including the ASX-quoted Montaka Global Long Only Equities Fund (ticker: MOGL) and Montaka Global Extension Fund (ticker: MKAX).

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