TIP672: Quality of Earnings: Uncovering Hidden Red Flags w/ Clay Finck
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Many investors who analyze stocks take the numbers provided by the company at face value, but there are times when this can be a massive investing mistake to help should lie on what the earnings provided by the companies really means for us as investors. I picked up this book called quality of earnings by threaten og love. Thorn is a wall sty veteran known for pioneering of red flag deviation analysis.

This book is an in dispensable guide to determining how much money a company is really making to help us avoid making costly blenders during this episode. Will cover why you shouldn't trust your analyst or auditors. What's to keep an eye when reading in the annual report red flags to look out for when analyzing a company's filings, how managers and accounts can legally manipur earnings per share however they see fit, the impact of dividends on your returns as an investor and much more, increasing my standing of accounting is a skills that i've long wanted to find tune in. This book is certainly a step in the right direction. So with that will dive right into today's episode covering quality of earnings by thorn og love.

Celebrating ten years and more than one hundred and fifty million downloads, you are listening to the investors post network since twenty fourteen. We study the financial Marks and read the books that influence self made billionaire most. We keep you informed and prepared for the unexpected. Now for your host play, think.

Hey, everybody, welcome to the investors podcast. I'm your host. They think on today's episode, i'll be covering this book called quality earnings by the the investor's guide to how much money a company is really making.

This book was published back in one thousand nine hundred and ninety eight. And IT. I seem a bit outdated, but i've seen IT recommended a number of times. And I just recently had lunch with Chris mayer, and I had asked him for some book recommendations related to accounting. And this is one of the books that he mentioned to me there.

I'll also just provide a brief disclaimer here that some of the accounting references that are made during this episode maybe a bit outdated since the book was written over twenty five years ago. So please take that into consideration as i'm not a trained account and don't have A C P. A license.

So the purpose of this book is really to Better understand and make use of the reports and other documents that public companies are required to file. Thorn sort of has a bit of a different writing style because he has a background of looking for companies to short or he's betting on companies whose stocks that he thinks is gona go down rather than up. So rather than trying to find the positives in the company, he's looking for any clues that the company might be in deep trouble and is trying to cover up what's really happening underneath the surface.

He points out that most investors won't bother to read the reports published by companies and understandably so because it's really a lot of work. And he came to the conclusion that since most investors didn't do the necessary due diligence on stocks, then some crazy things can happen with stock Prices, and the Price can easily detach from the fundamental to the website or to the downside. Thorn rights here, because the documents were lengthy, very few brokers would take the time to read them.

Accordingly, I concluded that one could obtain some edge on the market by diligently reading a perspectives from cover to cover. By the way, this is still true today. Even though the institutions dominate the market to a far greater degree than in the past equal.

He also believed that there is no substitute for doing the work yourself and will get into why you really rely on other people to determine what stocks you should or shut by if you're really taking stock investing seriously. Thirteen points out that investors often look at the earnings presented by a company and simply take IT at face value. Perhaps the company has an earnings per share of two dollars.

Few are going to stop to consider what if the company had a reason to understand, even overstate, the earnings. Perhaps the management team knows that tough times are ahead, so they want to understand earnings this quarter, so next quarter doesn't look nearly as bad. Or perhaps management is trying to hit their short term guidance in sacrificing the long term earnings potential.

These things clearly matter and simply aren't being included in the E. P, S. Figure that being presented. So since thorn was a short seller, he looks at the reports as if management is trying to hide something from them.

If one assumes the worst, then they're more likely to see the bad things when they're actually there. However, most of the the time, the closet isn't going to have a skeleton inside for us to discover in the row. Sorting gets a little bit into his background and finance. He graduated with an MBA in the late nineteen sixty, and he got a job as an analyst at bank america.

Bank of amErica didn't really like thorn because he won't get really deep into the weeds of the financials of the business, and he wanted to really understand the company rather than just blindly handing out another by recommendation for the stocks that think of amErica was selling to customers. He assumed that being a critical analyst was simply a part of his job, but apparently not, because six months into the job, they let him go here, right here. This was the greatest break of my life, because otherwise I might still be at bank of amErica going through the motions.

But after being fired, I was even more intrigued with the concept of contrary opinions. I had been given a clear demonstration of the fact that most people prefer illusion to reality. If IT conforms to a view to which they are committed, this is still the case.

Changing people's minds about their investments remains a most difficult task. And quote, then sometime later here, he was able to get to another firm that really just much Better suited the type of work that he wanted to do. IT turns out that at that time, I really wasn't easy to find a job that told people what stocks not to buy.

So then he started putting out this institutional research refer to as the quality of earnings report. Over twenty five years into his career, he ended up writing this book that were discussing today. He rightly points out that as investors, we try to gather information from all sorts of sources, whether that be social media, newspapers, the news, are cnbc, research by analysts or publications.

All of this information largely comes from other people. And we often times assume that these other people, which many people would tell themselves as experts, people assume that these people have the answers, were looking for. He claims that too often this simply isn't the case.

He believes that was some effort. The best expert that can be trusted in counted on the most is, in fact, yourself. It's clichy.

But if you give a man a fish, you will feed him for a day. If you teach him how to fish, he'll feed himself for life. And that's essentially why thorn ended up writing this book. One of the things that he helps me realize is just a perverse and seniors.

I play with people in the finance industry, for example, if you turn on C, N, B, C, often times you're going to see someone interviewed who has very extreme views, perhaps are calling for a stock to empress by ten x within the next two years, or perhaps are calling for a collapse of the stock market, because this is what drives views for C N B C. So the incentives are religious, broken with a lot of these firms, and they are in the business of Sparking people's emotions rather than sharing sound analysis. So thain's first tip for improving your analysis is simply not trust your analyst.

Analysts, along with many other people in finance, tend to have a bullish bias. Nobody wants to pay somebody else to tell them what stocks not to buy. They want to be told what stocks they should buy.

Zx investment research at the chicago found that from thousand nine hundred eighty one, two thousand nine hundred eighty four, eighty six percent of broker house recommendations were either neutral or bias. Twelve percent were sales in two percent were strong cells. For many analysts, being neutral on the stock is about as barriers as they'll ever get.

This data doesn't align well with the research that hendrick best and bind are released. Who I spoke to on the show here just a few weeks ago in his research found that most stocks, in fact, under perform U. S.

treasuries. So while most analysts are issuing by recommendations on stocks, the reality is that most stocks actually end up doing pretty poorly. Thorn has a quote here in the book from an unknown source.

If you put out a negative on a stock, people who own the stock hate you, management hates you, and the people who don't own the stock don't care. Professor William sharp from stanford business school believes that this bullish bias can actually cause many stocks to become overvalued. He illustrated a very simple example here.

Let's say you have ten market participants, each of which have a different opinion on the stock. The first one thinks is worth one dollar. The second one inks is worth two dollars, that are three dollars in all the way up to the tenth person believing in its worth ten dollars.

So the consensus stock Price comes out to around five dollars per share. The first four people, of course, aren't going to buy IT because it's above what they believe it's worth. And this leaves us with the other six participants.

So the stock Price may actually turn out to be seven dollars because the most optimistic participants are willing to drive the Price up above what the consensus believes is worth the way he puts IT is that Price will not reflect all available information, but only that which was held by optimists. And this is one reason why short sellers can be such critical players in the markets as they can help bring some rationality to market Prices. Turning back to his points here about analysts.

Analysts go through a lot of work to get to know management gets no a company. But at the end of the day, the analyst is working for the company that they're with and not those that might be reading their buy recommendations. Often times the analyst is expected to beyond good terms with the managers he's in touch with, which means that they're less likely to make a cell recommendation even if they believe that, that the right decision.

And if you spend so much time getting into our company and interacting with the investor relations person and the management team as well, many have a tendency to fall for the liking bias or simply fall in love with the company they are analyzing. And to add the problem, the analysts might get most of their information from the company itself, which often times tends to be bullish. Jim chaos is highlighted in the book car.

He's a well known short seller, had a very successful career with short selling channels, would rarely speak with management, and he doesn't even visit a company that is even blish on. He believes that it's just too easy to get blind sided by management, and he prefers to stick with the information that the company is required to file with. The S C, C one thousand nine hundred and eighty two channels was just twenty four years old, and he made a cell recommendation on a company called bodye united channels, received a tuna push back from the finance industry in even from baldwin CEO.

One wall street veteran even warned chaos against ruining his reputation at such a Young age. Then much of the claims that channel had made at the time came to light as boldon was investigated by regulatory agencies in the stock ended up falling by ninety percent from fifty dollars a year to under five dollars a year. However, the working points out that we aren't looking for the blemishes in everything we look at what he shares in the book is intended to help us avoid disasters and catch some of the warning science before others realized what lies ahead.

Just as our analysis can uncover undervalued hint gyms, they can also be used to spot losers and overvalue situations or companies. We should proceed with more caution. So the rap of this point on not trusting your analyst warn buffer is happy if he can find just one or two great ideas per year, and he isn't finding these ideas by reading analyst reports.

He's pouring over documents that are provided directly by the company. There's also a chapter here on not trusting your auditor. Often times, you'll see auditors sign off on reports filed by the sec, which essentially says that everything that is supposed to be disclosed is disclosed and that the numbers are not actually incorrect. IT doesn't mean there hundred percent right, of course, but there hasn't been a major error.

But there are cautions us that we shouldn't just assume that all auditors do a good job in actually assessing the of the reports just because an auditor signed off on the accuracy of the reports isn't a guarantee that the company isn't trying to hide something with respect to where the company is heading in the future. Yet again, we can look at none other than the incentive that are in place. Often times, it's in the interest of the auditors to maintain good relations with the company they are auditing.

So first here, the client pays the bill to have the independent audit done and will likely be quite upset if the auditor discover some irregularities that might prevent him from offering a clean opinion. Professor Abraham brill off shared a story that thorn told in the book that I thought was quite funny. I call here.

The president figured he'd make the rounds asking, C, P, A firms, how much is two plus two? Invariably they all said, for finally, when he gets to the last firm on his list, he poses the question once again, how much is too plus to this time? The response is more to his liking.

What did you eventually mind when the auditor is interested in winning business? IT might not be in the best interest to find things that you, as an investor, might be interested in. In many firms, three, audits like a commodity, they just need a repeatable firm to sign off on IT.

So firms will go Price shopping, making IT difficult for some firms to differentiate themselves. Now think about IT. If a company doesn't want to pay up for their audit work, then that might mean that the auditors aren't going to do the property diligence because they need to cut corners just to turn a profit.

And then one last issue that i'll mention here with auditors is that the auditing services can serve as a gateway to pitch other services. The firm offers things like consulting, taxes, executive recruiting in actuarial services into the best of my knowledge, the big four accounting firms here in the U. S.

Have their toes in all sorts of industries, not just accounting and audit. So if the firms decide to uncover these irregularities in the accounting statements, then they risk losing those other services that they might offer to the firm. So thought made the case that we can trust the analysts, we can trust the auditors.

So he uses the rest of the book to give us the tools to do the analysis ourself. So i'll do my best here to highlight many of the high points in the rest of the book. The next chapter here is on the shareholder letter.

Public companies are required by the S, C, C to file a number of documents. This includes the K, Q and the proxy statement. All of these reports are open for anyone to view. Thanks to the internet making IT readily available, the early spring companies also sent out their end of reports to given overview of the previous year, which is also a requirement. Many companies put a big focus on the annual report because is the Price way for the company to be able to communicate with the public at large.

One thing i've noticed about any reports and the shareholder letters is that the management team likes to paint an optimistic picture of the company just about how great they are and how good they're doing with little focus on what they've done wrong and where things might go wrong in the future. So thorn puts its so eloquently here, the N O. Report with its glossy pictures, A, B pro tables and notes should be looked at as one might a possible mind field before you, is a version metal.

But you know, there might be explosives under all of that Greener. And quote, one of the things that recommends looking out for in the report is whether the company mentions their problems and if they do see if possible solutions are discussed. Let's take a quick .

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Members all right back to the show warn buffer gladly points out the mistakes he's made in what berkshire do to address big problems going for in this builds trust with shareholders because they know that he's going to clearly communicate how the company is actually performing and how they should interpret the financial statements. Part of a manager's job is to ensure that the documents they've received from the company clearly show how they're doing today and what the plans are for the future. You also want the shareholder letter from the management team to be jargon free and easy to understand for your investor.

A capable manager can not only recognize the problems, but they have the ability to solve them, and also recognize the new opportunities to deliver the superior results to relative to their competitors. But you can almost be a shred of is that with most companies, if things are going well, they're going to be happy to pass themselves on the back, sharing more about how great their performance has been. And if things are going, you know, not so hot, then surely they're going to tell you that Better years are going to lie ahead and the companies is making strides to improve.

All companies want to try and put their best foot forward, whether they're doing so honestly or not. One of the things that buffett would often do is that if his results looked Better than they actually were, then he would explain in simple terms how good the quarter actually was, what sort of adjustments we need to make from an investor can point when looking at these gap accounting earnings. Unfortunately, most managers aren't like buffet.

They aren't as transparent. So we'll need to dig deeper ourselves often times to understand what's really happening underneath the surface. Thorn also talks about how most of the shareholder letters are signed by the chairman or the president, but they're usually written by the P.

R. team. The managers typically don't want to give too much inside into the other workings of the business if they don't have to. One red flag we can look out for is to look at past reports.

And if anything stands out for them, perhaps the past report shows way overly optimistic expectations for the future that ended up not being met or the forecasts they provided in the past are no longer included in the reports because they aren't performing as well. Thorn shares the example of a company called international harvester, which was a component of the door Jones industrial average. He claims that their thousand nine hundred and eighty shareholder letter is one of the most flag erant examples of attempts to minimized difficulties that he's ever seen.

In thousand nine hundred and eighty, the company had a tough year and the stalk was down fifty percent. But if you read the letter to shareholders, you would have thought the company was doing quite well. IT discusses their improved cost structure, they're accelerating progress and how well position the company was for the future.

If an interested shareholder were to continue flipping through the report, they would find that the nineteen eighty results were quite troublesome, with earnings down significantly from the prior year. Just by simply reading the shareholder letter and then looking at the company's financial statements, should have put off many red flags as an investor. So two years later, the stock was down to under three dollars a year, over a ninety percent decrease from its high in nine hundred and seventy nine.

Another example, foreign res, is colaco, which is a video game company that saw its stocks rise from three dollars to sixty five dollars in less than a year from nineteen eighty to nineteen eighty three. These companies known for of releasing video games like donkey on and packman. Anyone who followed thorn's methods would have steer clear r of this stock.

He writes here an analysis of the baLances in one thousand nine hundred and eighty three would have indicated trouble ahead since college had an abb, Normally large inventory, one of the most certain signs of trouble ahead. And quote also, if we were to look back at past reports, you would have maybe recognized some other red flags. So in the eighteen seventy three letter, management touted their great year with significant progress both in terms of sales and earnings.

But the income statement show their earnings fell by fifty percent in thousand nine hundred and seventy four. Management predicted an increase in earnings for the follow year, and then in one hundred and seventy five, the company had one penny in E, P, S. For the year, but managers remain confident in the future.

After a history of poor predictions in terms of the business business performance, they had yet another miss in their predictions. But for this one, their revenue targets were far exceeded. The video game market was taking off at the time in college was along for the right in thousand nine hundred and eighty two.

They predicted sales of three hundred million dollars in actual revenues came in at over five hundred million. Koo was now a darling on mostly with soaring sales, soaring earnings and a soaring stock Price. Colaco was the only company producing home video games software for three systems, their own atti and mattel.

There was also this talk of the adam home computer, which the company would sell during the Christmas rush. Then the thousand and eighty to shareholder letter predicted revenues eight hundred million dollars for the following year in one might infer record earnings as well. Now let's think about if you are a regular everyday investor at this time, you might pull up their annual report and see their rosy forecast predicting record sales, record earnings.

You might see click o on the front page of the wall street journal talking about how hot the video game industry is and how all the analyses are following. IT are recommending investors to buy the stock. And you might even know somebody who got watching their portfolio values skyrocket within weeks holding this stock.

And you might also have your broker calling you, telling you to buy the stock. So when we look at the first nine months of thousand nine hundred eighty three, colaco earned one dollar and seventy one percent per share, down from one dollar and ninety three cents per share from the following year. So the stock had following around fifty percent from the high. But the ball still had hope because Christmas season was going to hopefully build them out. There were rumors that the adam computer was having production issues, to which management quickly denied after a poor Christmas performance from the adam computer, management said that sales would pick up during the first quarter after the production issues had been addressed.

When IT was all sudden done, colaco posted a forty eight cent loss for thousand nine hundred eighty three in one thousand nine hundred and eighty four, the company had a one hundred and forty million dollar right off on the adam computer in the four dollars and ninety five cent per share loss from the stock's ae of sixty five dollars in one nine hundred and eighty three. IT proceeded as trade down to below ten dollars per share. Had an investor been diligent in reviewing the filing sent out by the company and down proper analysis, they likely would have quickly ignored the by recommendations put out by analysts and hung up on the brokers that called them pitching IT for their accounts.

Jumping here to a chapter on differently disclosures that i'd like to touch on here. Differential disclosures is simply a fancy way of saying what the company says in one document is substantially different than what said in another document. It's a big red flag if you're able to catch this and investors should proceed with caution.

The reason this can exist is that some reports sent out by the company are meant to be read by stock callers or perspective stock callers with the intention of impressing them with charts that go up into the right big total addresses. Markets in the companies is amazing ability to execute. And then when you contrast that with things like the ten k and the ten q, these are official reports that are filed with the S, C, C.

And they must conform. S, C, C. Guy vines, another way to put IT is that the narrative portion of the ano reports is crafted by the P.

R. Team in the financial reports are compiled by accountants. That's not to say that the narrative portion isn't important because they can shed lie on the company strategy.

They have the opportunity to share what numbers are in the financial statements and what they mean for the business in its future prospects. So I wanted to share an example he used with convergent technologies. The company reported forty cents in earnings per share in one thousand and eighty.

That was slightly down from the thousand nine hundred and eighty two figure. The management team was quite optimistic about the future of the company. They painted a very rosy picture, but the ten k wouldn't have excited investors nearly as much.

The shareholder letter stated. One thousand nine hundred eighty three was a year of progress and chAllenge for the virgin ologies. And I immediately loved the reaction that thread has here, he writes. Now, this word chAllenge always puts me on guard.

Management often uses the word chAllenge to mean trouble, so while the shareholder letter left the subtle clues of the company going through a chAllenging situation, they didn't necessarily highlight what sort of chAllenges they were facing. Once you read the ten k, you would have noticed that the ambitious goals and the entrepreneurial spirit would be significantly limited based on the information that was provided in the tent. K, the point is that the S, C, C reports might require the company to release information that they would rather the shareholders not know, but they must release IT in order to comply with regulations.

Next year, let's talk about non Operating and non recurring income. It's pretty self explaining ory. But non Operating income is simply income that is earned outside of the businesses. Mal Operations, I think we can all agree that alphabet Normal Operations include add revenue from google search or add revenue from youtube, but if they were to sell off one of their data centres for hundreds of millions of dollars, this should probably be considered a non Operating activity.

Usually, it's fairly easy to tell what is Operating and what is not Operating for a lot of businesses, but the difficulty lies in when is really up to the judgment of the accounts. What if alpa t happens to sell off a portion of their data centers every few years? Perhaps IT should be a part of their Normal Operations.

The reason this is important, understand, is because as an investor in a company, I want to know how the core Operations of the business are doing. If there's a big non mercury charge that significantly moves the earnings per share, then I want to be able to make adjustments so I can see a clear picture of what's actually happening with the core Operations. This can also be tRicky if you have a management team who's trying to intentionally hit their earning star S A, hit a certain number.

So for example, before the accounting rules were changed around how capital gains flow through the income statement, for a company like bircher, halfway companies would be able to sell off a portion of their investment portfolio if they wanted to incur capital gains and then boost earnings. This, of course, can be done forever, but is another example of how management can sort of manufactured in E. P.

S. figure. Another great point by thorn as a relates to this is that earnings can go up over time, but the quality of earnings can go down. So many people can be fooled by increasing earnings in an increasing stock Price, only to later realized that the businesses underlying fundamental have actually deteriorated.

IT reminds me of the conversation I had with Chris mayer about his book, how do you know back on episode five, sixty nine, you want to understand what the numbers mean, not just what the numbers are. It's not important necessarily what the E, P, S. Number is to the exact figure, but what IT really means for the business is what you you really wanna drill down to.

Why is that number? What IT is one example that foreign shares with regards to this company called boldon united. This company's core offering was a single premium defer unity, which was sold by some of the nation's top entrance brokers.

In march one thousand nine hundred and eighty two, boldwood acquired M, G, I, C, investment corp. For one point two billion dollars, and they borrered six hundred million dollars to make the purchase. M.

G, I C was the nation's largest non governments and sure of home mortgage. After the acquisition, the stock took off for the following year. For the first nine months of thousand nine hundred eighty two, E, P, S. Before realized gains were up by seventy five percent year over year. And a closer look at the earnings release tells a different story.

Almost all of the company's earnings were attributed to a tax credit they received in certain highlighted in his quality of earnings report that if you took out all of the non recurrent items, the company actually had a net loss of nine million dollars for the first nine months of that year. Another big problem is that tax credits are not cash. Tax credits are nice to have if you're profitable business, but this wasn't the case with boldon.

Tax credits can be used to pay employees. They can be used to pay big deaths, one analyst had said. Tax credits are filed for impressing shared ers, but they're not real money.

You can pay the bank with them. Over the months that followed, the stock fell from fifty dollars to below ten dollars in one thousand nine hundred eighty three. Not long after the acquisition, the company filed for bankruptcy.

Done right here at the end of the chapter, the calculation of non Operating income requires digging into the reports and looking into the nukes and crAnnies and the notes. It's all there to be seen, laid in front of you, but all too often ignored by readers. As the log k homes once said, IT is hidden in plain sight, and investors must behave like detectives and fairing out the information.

Also, as a chapter here on the impacts of declining or increasing expenses, which helps us further understand the quality of the earnings were reviewing and how we can peel back the layers of understanding what the numbers really mean for us as investors. For example, investors might look at the reported E, P, S numbers and see that earnings have grown by ten percent and believe that they're in good shape. However, you'll one understand the reason for the increase energy.

And if you do, you might come to realize that the growth isn't necessarily sustainable or won't be persistent due to factors that are contributed to that growth. Sometimes companies have a tail wind on E, P, S. Due the changes and currency exchange rates.

If apple, for example, sells millions of phones in china and the chinese union appreciates, first is the us. Dollar, then the U. S. Dollar terms, E, P, S, might get a boost simply due to factors that are totally outside of apples control. Thorn tells the story of another short seller named to burn arr.

Smith, who was nicknamed selba, who was allegedly going from broker to broker in nineteen nine, telling them to sell all of their stocks because they weren't more than anything during the bear market of the great depression. There was one industrial company which was bucking the trend and their stocks was rising. This peaks miss the interest, so asked to see the managment team only to be turned away at the production facility.

So smith, he wizzled his way into the plan to take a look at what was going on inside. They had five big machines inside. And he noticed that in the middle of the day that only one of them was running.

So Smith took this as a sign that things worn as good as they seemed. So he went ahead and shorted the stock with much success as they promptly fell on his next earnings released. Although markets are slightly more complex today, thorn shares that one of the simple ways to receive potentially disappointing earnings that lies ahead is a carefully analyze accounts receivable and inventory.

Accounts receivable is the money due to the company from customers for good ship or services performed, but accounts receivable isn't itself necessarily a problem, has about every company has some level of IT. When asked about why account receive analysis is useful, he essentially explained that abNormally high account or receivable can signal that management is having trouble selling their eventful in image al signs of things like more liberal credit terms and or difficulty in obtaining payment from customers. When we consider the piece on more liberal credit terms, you can think about something like the auto industry, which is subtitle to swings in the broader economy.

If the economy is weak, then they may make IT easier for less credit worthy buyers to purchase a new car, which may then translate to a higher account receivable. IT may also provide a clue as the weather management is simply shifting inventory from the corporate level to its customers because of a hard cell campaign, costly incentives, these types of issues might constitute that the company is borrowing from the future, so to speak, to help boost their short term performance. In most instances, it's important to note that the sale is recorded by a company when the goods are shipped to the customer.

As for inventories, he shared that higher trending inventories relatively to sales can lead to inventory markdowns or write offs if they're having trouble getting those goods actually sold to customers. Taking a close look at inventories and accounts receivable can especially be useful in industries subject to rapid changes and products and tests such as high fashion seasonal goods fs are emerging trends. The example that foreign chairs in the book was coma or international, which refer to here as cbu.

And this company produced micro computers in the ninety eighties, which made for a prime candidate to look for irregularities and account receivables and ebata ies, because products in this industry could be made absolutely in a matter of months. In the q two, one hundred and eighty four figures for sales and earnings IT showed a lot of promise. Sales were one point three billion dollars and earnings were hundred and forty three million, both of which had increased rapidly from the previous year.

Thorn, however, saw a number of warning science the companies is founder had exited the business in a closer look at the financial statements, painted a different story about their future. He laid out this simple table in the book that shows the net sales, the accounts or receivable in the inventories for cbu from one thousand hundred and eighty two to nine hundred and eighty in the first year, sales had increased by over one hundred percent, and then sales growth slow to just sixteen percent the following year in nineteen. And meanwhile, accounts receivable grew by five percent the first year and thirty four percent in the second year. So with some basic common sense, as a shareholder in this business, I would prefer to see solid sales growth that coincides with the steady or stable accounts receivable increase.

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All right, back to the show. I think it's probably fine to see accounts or save ables arise alongside sales. But in one hundred and eighty four, it's troubling to see that sales growth is slow dramatically and an account receive picked up. This shows that there might be some weakness in the business in getting customers to pay for what was being sold or potentially they've loosen the credit standards if customers are paying. With credit throwing right here, C, B, S, account receivable rose twice as fast as the company s sales.

This is a clear sign that cbs retailers, we're moving out its products at a slower than usual pace while the company was shoveling out its old products in what looks like an attempt to dump them on the market in the advance of new introductions and quote, he also took a closer look at inventories. So inventories overall didn't look too concerning with a motor increase of nine percent in nineteen before. But if you pull back one layer deeper, you'll see that raw materials inventories were down while finished goods inventories were up.

So I was pretty easy to see that finished goods mentor's were too high in the company, maybe stuck with a lot of products that they might not be able to sell for decent profit. 3 doesn't stop there though。 In the q 30 hundred ninety three report， he notes that the company had a note that stated that they were gearing up for strong sales growth for the near future.

They were wrapped up production, but just two quarters later, the company didn't make a similar reference. So presumably, since they removed this no from forecasting these solid sales in the near future, one must assume that they must be having rough quarters that were just around the corner. Thorn promptly role in the quality of earnings report that he expected to considerably lower per share earnings when they reported their full fiscal year in june of thousand nine hundred and eighty five, jumping to their q one release in one nine hundred and eighty five, things started to turn sour.

Over the previous six months, sales were down, finish good inventories were up by over eighty percent. Year over year, work in progress inventory was also up over thirty percent, which meant that there were more finish goods that were still in the pipeline to come in the future and the market wouldn't be able to absorb these products. So in the quarters that followed, thorn stated that a title wave and the inventory write downs arrived in the county reports a loss of one hundred and twenty four million dollars in just one quarter.

So it's interesting how with these companies that sell a physical products and have these eventful ies, we're able to get somewhat of a glimpse into what the future might look like, especially when we see a sharp irregularity in the account receivables line or the inventory line next year. Let's chat about debt and cash flow analysis. So debt, of course, this is part of most companies Operations.

So it's important to understand the companies is capacity to cover their interest costs over time and to cover their debt levels. Store shares, three ratios that we can add to our investing tool kit and assessing the capital structure of a business. So first, we have the long term debt equity ratio.

This is simply the long term debt divided by the shareholders equity. Second, we have the total data equity ratio. So this is the same formula accepted, just adds the current liabilities in the numerator. And then for the third equation we have here, we have the interest cover ratio. This is simply the Operating income divided by the annual interest payments.

These ratios can help us understand the extent to which debt is used in financing a business and the long term ability of a firm to be able to service those dead payments over time. Another metric that certain likes to keep an eye is the interest spence as a percent of Normalized net income and how that ratio sort of events over time. So if this percentage is increasing, that either means that entry payments are increasing faster than income, which typically is in a great sign, or that net income may even be dropping relative to that interest, which isn't a good sign either.

Personally, I try to avoid any company that has moderate or excessive levels of debt in order to minimize the risk of the company going bus during a recession. Howard Marks won't share that. When you go back and look at the bankrupts that have occurred during previous crises, excessive debt levels were essentially involved in every single one of them.

Many of us who own a home probably have a mortgages on IT. Or if they don't have a mortgage, they did at some point in the past. Think about how hard IT would be for the typical individual to not make their payments if they had their mortgage paid off.

That helped illustrate the strength of a financial position the company can be in if they have minimal or even in an appropriate level of debt in Morgan housel wisely said that the more debt you have, the narrower the range of volatile outcomes one can endure. One great example of a company that is a great baLance year and is nearly instructive is copa, which is the company have discussed previously on the show. Copa is a business that is a global online auction platform that specializes in the sales of used salvage and repossessed vehicles.

They connect buyers and sellers and offer a wide range of vehicles on their platform. And they owe thirteen thousand acres of land as a part of their business model. And their main competitor decided to primarily laser land, which puts them at a disadvantage comparatively.

Copa is also an on a Operator business. The founder, Willy Johnson, still loans millions of chairs in the sun law. Jared, who's the CEO, owns over twenty five million shares worth over one billion dollars.

Now as we've discuss on the show, on a Operator, businesses tend to think on term and be more conservative when he comes to debt. So when we look at co parts baLance sheet, we can see that they have current liabilities of six hundred and twenty eight million, and they have zero long term debt. And we also have seven point five billion dollars and shareholders equity.

This gives us a total debt to equity ratio of around eight percent. This is extremely low by most company standards and shows that from a depressed active, the managers Operate the business very conservatively. It's also worth th mentioning ing that they have one point five billion dollars in cash on the ballot, which essentially means that they have net cash position and they could easily pay off these curlies ilium should they want to.

Thorn includes a chapter here on dividends as well, which i'll briefly touch on when I first guy introduced to investing. Dividends were attractive to me because IT was actual cash being deposited into my account. And for good companies, they tend to increase their dividends year after year after year.

I have a different opinion on dividends today for two primary reasons. First, dividends are taxes and efficient, at least in the united states where I live. So the company you own pays taxes on the profits they earn.

And then when you receive your divided, you're also tax on that as well. So this is what is referred to as a double tax. And then the second reason is that I typically look for companies that have a capacity to reinvest at high rates of return internally.

So if the company can earn, say, twenty percent by reinvesting in new opportunities, then I don't want them to be paying me a divided. And if the company is paying a big dividend, IT typically signals that they don't have attractive opportunities to deploy that capital internally. Now with that said, there are gray companies that do pay out dividends.

Apples paid out a dividend for many years, and it's been an exceptional stock. Of course, there are many great businesses out there that have paid dividends for decades and have increased steadily over time, creating tremendous returns for shareholders along the way. So one thing i've noticed with some spectacular companies is the use of special dividends.

So instead of the company continually increasing their diving as much as they can, they play IT on more the conservative side. And when they have excessive levels of cash, they may decide to pay out that one time special divided. This shows that the business is doing an excEllent job at generating excess cash, and they aren't dogmatic about paying the best dividend they can every single quarter.

So when we look at costco, for example, they're currently paying a dividend of one dollar in sixteen cents per quarter, and they've done a number of special dividends along the way. So for example, in december of twenty three, they paid a special dividend of fifteen dollars a share. And then in december of twenty twenty, they played out a special dividend of ten dollars.

What you want to look out for in dividend payers are those that take IT too far. Sometimes companies can back themselves into a corner of having increased their division for many years and do everything possible to keep that division going, even if it's not in the best interests of shareholders to do so. And then eventually, they're just forced to cut the evidence significantly, went things really start to turn south.

I certainly don't want to have a company increasing their leverage just to ensure that a solid dividend is in place because IT puts them in a more vulnerable position. Paying out a dividend just for the sake of paying out a dividend can, of course, lead to disastrous capital allocation decisions. When we study exceptional capital, allocators, such as doctor herry single ten from teledyne see the power of more optimal capital allocation decisions.

Singleton made IT Crystal clear with shareholders that there would be no dividend, which was a contrarian strategy at the time, given that investors like bin gram often times favor dividends in the company, is he owned singleton instead went on what he called Operation shrink, which LED to a vastly reduced equity base as the shares outstanding declined from eighty two million in one thousand and seventy two to just eleven million shares at the end of one hundred and eighty four. And that's an eighty five percent reduction in the shared count. During this period, E.

P. S. Grew by over seventy fold, and the stock Price increased by over fifty six fold during that time.

So it's not that dividends are necessarily evil or we should never buy socks, I pay any dividends. They're just one way to allocate capital and return IT directly back to shareholders next year. Thirteen dives into the importance of accounting changes and understanding accounting more broadly, he writes here.

There's an old tale told with great relish by veteran accounting professors regarding a firm in search of an account. The field narrowed down to three, each of whom was interviewed and then asked to lick the books and calculate the firms taxable income for the year. The first candidate said IT was two point three million.

The second said IT was two point four million, and then the third glass. Round pulled down the blinds and ask the board, how much do you want to show? And then naturally, he got the job.

Now i'm sure this story is a bit tongue cheek, but IT helps show that accounting metrics such as net income are exactly objective measures. Or do they necessarily have to reflect economic reality? So to use a couple of examples here, generally accepted accounting principles permit firm to write off a factory over twenty years using straight line appreciation.

So if the company bought a property for twenty million dollars, there would be one million dollars and depreciation per year. So the companion books would suggest that after fifteen years, the property would be worth around five million dollars, but at that point, the property might be able to be sold for thirty million dollars or more. Or we can consider what constitutes an asset.

Intangible assets are in increasingly becoming a more and more important part of a company's value, and companies will often times understate the true value of things like patterns. For example, sorn jokes here in the chapter that the care for an aling P. E ratio is simply an accountant with a sharp pencil in a sharper mind.

Artha Anderson is an accounting firm that put out a piece on the accounting magic that can be performed. And I can paints a completely different picture for two similar businesses. The accounting rules or illustrations the highlighted might be outdated, but the basic idea, I think, remains here.

IT showed how earnings of two businesses could have E, P, S. Figures that vary by more than one hundred percent. All mention a few ways in which earnings can be different based on how accountants are applying their methods.

So two different ways to account for inventory is less than first out and first in, last out. And depending on how the inventory values are changing over time, the E, P, S will move simply based on which method is being used. Another one they noted was how research and development was accounted force.

So one business might charge R N D as a one time expense, pushing IT through the income statement, while another company might advertized over a five year period. And then one moral mention here is the use of incentive. So one company might pay out bonuses in cash and then another might pay out using stock options, and that's going to affect your P.

S. So when you read through all of these examples, you can easily see just how E. P. S. Can vary dramatically, which really is nothing to do with the actual performance of the company, is all based on how the accountants are calculating. This is why I think selecting great managers is just critical. When i'm partnering with great managers who are ethical people, I hopefully don't have to worry about them trying to hide anything or trying to lead investors down a path that is just dishonest.

IT also brings the thought experiment to mind where if you know a manager is high quality and taking the business in the right direction and you're certain that there isn't any funny business with the accounting practices, then the market should value that company more on A P, E basis than a similar company where the management quality is in certain one also has to think about how many managers receive stock options, which may expire in one, two or three years. Changing the accounting practice seems to me that just be such an easy level that managers can pull to boost the E, B S, and thus boost the stock Prices so they can realize the value of those options. So the final chapter here all cover is on restructuring when the company needs to turn around in the most severe situations.

So perhaps management has faltered in the past due to incompetence, errors or poor forecasting or aggressive competitors have swept in and stole market share, or the company just got hit by some bad luck. Often times the business will be replaced with the fresh management team, who will come in and claim that IT turnaround is coming in. Some house cleaning is underway.

This is what thought refers to as a big bath, which consists of writing off every dubious asset inside marginal Operations are sold for whatever they can get for an existing plan. An inventory are written down to a lower level as management can defend to its outside auditors. This tends to be accompanying by a falling stock Price in some poor earnings reports, while management claims that the worst is over and Better times or right around the corner.

Now sometimes these restructurings are nothing more than an accounting manager. In other times, there will be real reform taking place that leads to a brighter future. Companies will realize all of the restructuring costs typically in one quarter one year.

While the benefits will be realized for the years that follow, wall street generally tends to favor a big sweep of ride, ffs, all IT wants, rather than a series of them over time, because I can tarnish the company's reputation, and sometimes the news of restructuring can actually lead to an increasing stock Price, because IT illustrates management ability to admit to their mistakes and act on them. Plus a lot of times you're going to see cost cutting initiatives. They're implementing layoff s, which in the short term is going to boost E, P.

Dorn came to the conclusion that typically restructurings are usually assign that in the improvement will soon transpire, and it's a signal tone investors that a careful monitoring of the stock is in order. Upon preparing for this episode, I reached out to a member of R T I P. Aster, my community. He spent the past three decades Operating his own forensic accounting firm to help crack down on accounting, male practice, fraud and corporate examinations. He is absolutely an expert when he comes to detecting fraud and imation.

To me, that forensic accountants are looking for anomalies and that most cp s will accept whatever answer that management gives them when they ask them about the numbers for the business and people like this member, the community they have, really dig a layer deeper to really get to why the animal does exist. He pointed me to another resource called quality of earnings in ema, the ultimate guide. And this was published by the president of Morgan and westfield, which i'll be sure to get IT linked in the shown OS.

For those who might be interested and for those in the audience to Operate in the private equity industry or or they are buying private, you might also like this resource in doing due diligence on that front. Since this report focuses on ema and this book quality of earnings. And they also reminded me of a book I covered earlier this year called the investment checklist by Michael sharing.

And this covered the r of in depth research for stock investing. And I covered this book back on episode six, fifty six case you miss that and you're interested in checking IT out. This book by thorn really highlighted some of the red flags to look out for, but I didn't touch too much on what necessarily makes for quality earnings.

So I wanted to touch just a little bit here on that as well. So chapter six and Michael chance is probably a good place to start for this as he discusses evaluating the distribution of earnings. So one simple check is to simply compare the cash flow in that income.

So management has less and manipulating cash flow and net income can be more subjective if the two a line fairly closely over the past five years. And I think there's less of a chance that earnings are being manipulated. Generally, recurring revenue is more desirable than one time sales.

So recurring revenue is easier to value because it's more predictable. IT might be difficult to predict how many cars foreign is going to sell next year, but IT may be easier to predict the insurance premium of an honor insure because a lot of their business is recurring in nature. It's also desirable to have revenues that are recession resistant.

And again, because they're more predictable, the market generally values companies higher, which are able to weather through recessions just fine. And we would also prefer capital light business models, you know, businesses with low fix costs and low capex requirements. So companies with high fixed cost tend to have a higher volatility in their earnings because they have Operating leveraged.

So when you think about a company like a airline or hotel or commodity producer, they seem to have higher fixed costs. So just a small change in revenue can impact the earning significantly. And then one more point here, understanding working capital is usually important and understanding the quality of earnings.

So companies with negative working capital can help fund their growth with little additional capital outlet. So this makes their earnings much more desirable or higher quality relative to accompany with high working capital needs. So there's a lot of other factors I could get into and thinking about the quality of earnings, but I think i'm going to leave IT at that and link you to episode six, fifty six in the shuttles as well because this is a good expansion of this discussion.

So thanks so much for tuning, and I hope you enjoy this episode. And if you're looking for a network of like minded value investors, you may consider checking out R T I P master, my community. This is her stick coloni host, weekly life zone calls.

We have a few live events each year in person in new york city, on a high and london, and we talk stock ideas in the group. And we have a community of over one hundred veit members, which are typically private investors, portfolio managers in high network of individuals. So were actually looking to on board five more great members here in novembers.

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