Unlike the US, which releases detailed accounts every quarter, Australian companies release their results every six months, though the full year accounts are materially more detailed. We sometimes get asked, if we are long-term investors, why do we place so much importance on analysis of a company’s annual report?
This is a good question and generally speaking I would agree that the market often places too much weight on short term earnings. However, I believe that thoroughly going through the accounts of companies in which you have a position, or could potentially have a position, is an essential part of the investment process. There are a few reasons for this:
1. Audited accounts prove or disprove our long-term thesis
As an investor, we are always working with incomplete information. Our investment decision relies on:
- Gaining an accurate snapshot of how the business is travelling today,
- Forecasting the company’s future earnings power,
- Using our judgement to work out how the market will value that company given our earnings forecasts.
While audited accounts are still imperfect, looking through the full audited accounts gives an enormous amount of colour to the quality of the result. What we are looking for is to make sure that the earnings generated are a true reflection of the sustainable cash generation of the business. More importantly we are trying to assess whether or not there are any quality issues within the result which may have a material change to our longer term thesis. More often than not, there is no change to our longer term thesis and hence any share price over-reaction to a result which misses market expectations often creates a buying opportunity.
2. Do the words match the numbers?
We always have an angle for owning a stock. While we conduct our own independent analysis, part of the input is information gleaned from the company’s presentations. What is essential for us is that the numbers match the company’s rhetoric. When they do not match, we need to have a firm understanding of the reconciliation between the words and the numbers. As outsiders looking into a business, when we consistently see differences between the way the company presents its results and the audited accounts, we view this as a red flag.
3. Early identification of a deteriorating market darling are great shorts
A happy hunting ground for our shorts has been finding market darlings where we have identified weaknesses in the business model ahead of the rest of the market. Market darlings are broadly companies well-liked by the market and would typically have a high price to earnings ratio (P/E ratio). What often happens with high P/E companies is that the management and board get addicted to the market’s love affair with their company that then makes it difficult for them to deliver bad news. For instance, often a company becomes a market darling because it grows their earnings consistently year in, year out and will almost always meet, or in fact beat, their own guidance. The market loves these sorts of companies because there is perceived safety in buying a company where the earnings seem to be highly predictable. Even better, if the company consistently beats the market’s forecasts, then investors will pay an even higher P/E ratio!
Before every reporting season I will often get brokers calling me saying “You must own a certain company leading into results because they always surprise on the upside!!!!”. While the advice is often accurate, I find the reasoning for making the investment extremely short term and not a great risk return as it is more often than not the consensus view.
Unfortunately, too often for these market darling companies, management start believing they are bullet proof and get addicted to the strong share price. This is understandable. When you consistently have fawning fund managers and brokers telling you how wonderful you are it is easy to get a big head. It makes me nauseous when I hear people start their question on conference calls with “Hey, great result guys”.
The first problem is how it impacts the relationship between the board and the CEO. As the share price soars, the power shifts away from boards towards the CEO. When the share price is flying, it is difficult for boards to question what the CEO is doing or to push back on potential acquisitions. It seems to me that there is an inverse relationship between boards’ involvement in company decisions and the share price of that company.
The second issue is how addictive the strong share price and the investor adoration can be for the CEO. This is just human nature. When the crowd is cheering you on, you don’t really want to tell them any bad news. It does not matter how good a CEO or a business is, there will always be short term factors (both positive and negative) which will impact the company’s earnings results from period to period. Some of these CEOs only ever want to release good news stories. Typically, they want to convey the perception that the business generates consistent and predictable growth. So when something unpredictable occurs and the company looks like it's missing its earnings forecast, it is very tempting for the management team to use small accounting tricks to make sure they meet their numbers. Some (but definitely not all) of the more popular tricks is when the company:
- Presents an adjusted or normalised earnings numbers which strips out “one-offs” every year
- Has operating cash generation well below profit and loss earnings
- Has capitalised costs which are consistently growing faster than operating costs and are materially greater than depreciation/amortisation, and
- Uses acquisition accounting or provision write backs to boost short term earnings.
Often these accounting tricks are done as a one-off. The next year the company returns to strong growth and the market is none the wiser. However, in the event that the earnings do not bounce back, these market darlings will then have to dig deeper into their bag of accounting tricks. It is at this point that an extension of an old Han Suyin quote is especially relevant:
“Truth is like a surgery. It hurts but cures. Lie is like a pain killer. It gives instant relief but has side effects forever.”
The problem is, when you start with a small lie, you need to make a bigger and bigger lie in order to give the perception to the investment world that everything is travelling well. This is the point in time that the management of market darlings can see the writing on the wall and when these companies start to exhibit some red flags. These include:
- Insider selling
- Management turnover (especially CFO), and
- Large acquisitions – Acquisitions are great tools to be able to hide from the market the true state of the underlying business.
However, this only works for so long. When the market eventually twigs the market darling is not going as well as expected (and in the situation described above it is a “when” not an “if”) the share price reaction can be brutal. It would have been better to have come out early as the market would still trust the company. Thorough and detailed analysis of the annual audited accounts can often shine a light on early warning signs that all is not right in a well-liked company. This has provided some great opportunities to identify and generate alpha on some short opportunities over the last year.
Written by Anthony Aboud
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