November 1, 2024 • 1hr 6min
TIP672: Quality of Earnings: Uncovering Hidden Red Flags w/ Clay Finck
We Study Billionaires - The Investor’s Podcast Network
Key Takeaways
- Don't trust analysts blindly - Most have an inherent bullish bias and rarely issue sell recommendations
- Don't trust auditors completely - They have incentives to maintain good relationships with clients and may not catch everything
- Do your own analysis - The best expert you can trust is yourself with proper due diligence
- Watch for red flags in financial statements:
- Differential disclosures between documents
- Rising accounts receivable relative to sales
- Increasing inventory levels
- Changes in accounting methods
- Non-recurring income being used to boost earnings
- Quality of earnings matters more than absolute earnings numbers - Understanding what the numbers mean is more important than the numbers themselves
Introduction
This episode reviews the book "Quality of Earnings" by Thornton O'Glove, a Wall Street veteran known for pioneering red flag deviation analysis. The book provides guidance on determining how much money a company is really making and avoiding costly investment mistakes by looking beyond reported earnings numbers.
Topics Discussed
The Problem with Analysts (07:26)
Most analysts have an inherent bullish bias for several reasons:
- People want to be told what stocks to buy, not what to avoid
- 86% of brokerage recommendations are neutral or buy
- Analysts need to maintain good relationships with companies they cover
- They can fall victim to the "liking bias" after spending time with management
Issues with Auditors (15:13)
Investors shouldn't blindly trust auditor sign-offs because:
- Auditors are paid by the companies they audit
- They need to maintain good client relationships
- May cut corners if companies won't pay for thorough audits
- Often sell other services to audit clients creating conflicts
Reading Annual Reports (22:35)
Key things to watch for in company reports:
- Differential disclosures between narrative sections and financial statements
- Overly optimistic language that doesn't match financial reality
- Changes or removal of previously included metrics
- Discussion of "challenges" which often signals troubles
Earnings Manipulation (31:13)
Ways companies can legally manipulate earnings:
- Non-operating and non-recurring income inclusion
- Changes in accounting methods
- Timing of revenue recognition
- Classification of expenses
- Use of reserves and provisions
Quality of Earnings Analysis (34:06)
Tools for assessing earnings quality:
- Compare cash flow to net income
- Analyze recurring vs one-time revenue
- Evaluate working capital needs
- Assess fixed costs and operating leverage
- Look at debt levels and coverage ratios
Accounts Receivable and Inventory Analysis (35:55)
Key metrics to monitor:
- Accounts receivable growing faster than sales can signal:
- Trouble collecting payments
- More liberal credit terms
- Channel stuffing
- Rising inventory levels may indicate:
- Difficulty selling products
- Potential write-downs ahead
- Obsolescence risk
Impact of Dividends (49:36)
Considerations around dividend payments:
- Tax inefficiency of regular dividends
- Special dividends can be more optimal
- Risk of maintaining unsustainable dividends
- Trade-off with internal reinvestment
GAAP Accounting Limitations (53:11)
Issues with GAAP accounting:
- Subjective nature of many calculations
- Different methods can yield very different results
- May not reflect economic reality
- Treatment of intangible assets
Conclusion
The key message is that investors need to look beyond reported earnings numbers and do their own thorough analysis. Understanding the quality of earnings and what the numbers actually mean is more important than the absolute figures. By watching for red flags and doing proper due diligence, investors can better avoid costly mistakes and identify truly high-quality companies.
