What’s Behind the Numbers by John Del Vecchio and Tom Jacobs is a practitioners guide to earnings quality, building on the academic framework built by Thornton O’Glove in Quality of Earnings. The book outlines a practical way for an investor to apply quality of earnings metrics to improve your investment results. Here are five things that I learnt from this excellent book:
1. Most Stocks Lose Money
Blackstar Funds, a US investment management company, studied all stocks that would have qualified for the Russell 3000 between 1983 and 2007. This was, so far, the longest secular bull market in history, and during this period the Russell 3000 rose nearly 900%. And yet:
- 39% of stocks had a negative total return
- 18.5% of stocks lost 75% of their value
- 64% of stocks underperformed the broader index
- The best performing 25% of stocks accounted for all of the indices gains and
- the worst performing 75% had a total return of 0%!
On this basis, it is extremely important to avoid the losers! Del Vecchio argues that minimising losses ultimately leads to maximising wealth, and on the basis of these figures, its hard to disagree.
2. Aggressive Revenue Recognition flows all the way down.
Because revenue is the top line of the income statement, all other items flow from revenues. The conventional wisdom is that revenue is difficult to manipulate, but there are many ways for a management team to manipulate revenues if it suits their purpose. It is also vital to scrutinise revenue, as any doubt about the sustainability of revenue growth for a company calls into all aspects of the financial model.
So how can revenue be manipulated? The answer is accrual accounting. Revenue is recognised when it is earned, but the timing of when revenue is earned is open to interpretation. While the Financial Accounting Standards Boards provides some guidance, there is significant discretion for management teams.
Revenue is “realised” when cash is paid into a company bank account. But as Del Vecchio notes, there is a large difference between a dollar in the bank and having a claim on a dollar at some point in the future. Revenue can also be recognised when it is “realisable” – essentially, when management believes it has a claim to some cash or a claim on cash. But what it this revenue is not able to collected in the future?
Lastly, “earned” revenues are those that are recognised when a company has “has substantially accomplished what is required to be entitled to benefits”. Those of you with lawyers for friends will realise the amount of wiggle room provided by that statement.
3. Days Sales Outstanding is your first point of reference
Days sales outstanding (DSO) is a ratio that shows on average how many days it takes for a company to be paid.
Days Sales Outstanding = Accounts Receivable / Revenue
The reason days sales is important is because a business wants to be paid as soon as possible, all things being equal. The longer DSO gets, the company is effectively giving its customers interest free finance, becoming a lender to customers.
Del Vecchio says we should track DSO semi-annually (or quarterly, in the US) in order to watch the moving trend of DSO. As investors, we should be wary of the DSO trend increasing, and here’s why:
“Higher DSO has absolutely nothing to do with collection but everything to do with revenue recognition. If the company did not offer extended terms, it wouldn’t have been able to book the revenue in that quarter, regardless of whether it collects on the receivables. The company uses looser terms to pull revenue forward into the current quarter. This is called stuffing the channel.“
So why would management intentional “stuff the channel”? The answer is in forward looking statements issued by companies throughout the year. Unfortunately, once guidance is issued, management is heavily incentivised to ensure that the company meets or exceeds that guidance. Management may therefore pull revenue forward un order to book revenue in the current period, temporarily boosting revenue and avoiding the associated stock sell-off that occurs when a company “misses guidance”.
Of course, stuffing the channel merely steals revenue from the future. In other words, stuffing the channel works until it doesn’t.
4. Cashflow is the truth.
Operating cashflow should, over time, track net income. Therefore, the trend of operating cash flow as a percentage of net income can tell an investor a lot about both the quality of earnings and the sustainability of earnings in the future. A declining percentage calls into question the companies earnings.
Another way to track the cashflow of a company is to calculate the companies operating cash flow margin. This ratio highlights how much of the companies revenue is translated into operating cash flow, and is important because it provides a very accurate gauge of business strength. Del Vecchio encourages the investor to watch a rolling 12 month average, and if the trend is down, lookout!
Lastly, track the spread between EBITDA margins and operating cash flow margins. This can highlight earnings manipulation on behalf of management, as the company can (legally) pull levers n the income statement to generate growth in EBITDA that will not translate to growth in cash flows. The absolute value is not important, but if the trend in this measure is widening then this is of concern.
5. Disciplined research pays off
All of the measures outlined above add to an already large amount of research that an investor should do before considering an investment in any company. It is not exciting, and its not difficult, but it is time consuming and does require some thought on behalf of the investor.
I have found that consistently applying this framework to my own investing has already paid off. Australian investors may be aware of the poor performance of Slater and Gordon (SGH), a company that made some exceptionally poor acquisitions and ultimately ran into trouble. By using the framework advocated by Del Vecchio, I was able to realise that the company’s cashflows were at total odds to the rosy picture painted by management, allowing me to avoid the company and the subsequent loss of capital. In fact, this one incident alone more than paid for the cost of the book – and I expect the book to pay for itself many times over in the future.
Conclusion:
Balance sheet analysis has never been “sexy”. In fact, I consider it pretty boring. But this book helps an investor to build a framework to allow a more disciplined and robust analysis of potential investments. Its already helped me avoid some huge losses and I have no doubt that this book could help almost everyone do the same. This book is one of my favourites in my investing library and I highly recommend it to everyone.
