This past summer, I decided to up my investing game by reading some accounting books. I had a good handle on the basics, but the kind of knowledge to really cut right to the bone of a filing was lacking. Accounting really should count as a foreign language in school. I was actually quite surprised when I opened up Thornton O'glove's Quality of Earnings. My impression that it would be a painful, but necessary experience. I don't know if I would call it a beginner level book, but anyone with some SEC file reading experience would not find it cryptic. I haven't read any accounting textbooks, but I found this book approachable and worth my time.
The first chapter of the book is one of the best short descriptions of the pitfalls of the Wall Street analyst community. Reading it, the phrase plus ça change, plus c'est la même chose kept going through my head, because this was written in the 80s and really, the more something changes, the more it is the same thing.* All the same conflicts of interest and bullish biases existed then as they do now. I realize that this isn't anything novel, but evidence of it solidifies what was previously just a strong intuition that Wall Street is any better/worse than it ever was. There's also a story about a 24 year old analyst named Jim Chanos making a controversial short call on Baldwin-United, which induced a "its a small world after all" chuckle out of me. Obviously he has stuck to his knitting all these years and called Enron and was one of the first to start calling China out of being on a "treadmill to hell."
One of the types of analysis O'glove highlights is looking at what the balance sheet indicates about the quality of earnings. When a company's accounts receivables are growing faster than sales, that can be foreshadow problems to come. He looks at the increases in percentage terms, so that everything is proportionate. The same can also be said for inventory. If sales seem to be growing at a slower pace than inventory, that can indicate that a company will have to markdown the inventory and its earnings will be lower than indicated. It is important to look at the raw material/finished products components of inventory gain insight into disproportionate changes in inventory. A large increase in finished products inventory can indicate that new products aren't selling. These are by no means rules, and O'glove provides plenty of examples to show how to understand the nuances of what he is talking about. I definitely found that it upped my investing game with a bunch of small stuff to make my analysis of a company better. I will highlight some more stuff from the book in the future, and highly recommend adding it to your investing library.
While these are the bread and butter of accounting analysis, Bronte Capital has been doing some neat things to note when analyzing (Chinese) companies. While the intention of his posts is to highlight a Chinese fraud that he is shorting, there are lessons worth learning in the process he conducts in his analysis. In this post, Hempton, the author, breaks down the company's employees and assets to establish that its stated productivity levels are not achievable.
While in this case it is evidence of a fraud, one could use this approach to compare companies operating in the same industry. I often see companies talk about how they are such lean operators and devout followers of kaizen. Without factory visits or really good industry knowledge, it is hard for an individual investor to have direct knowledge if the company really walks the walk. This could be one way to check it. Sales volume/employees or sales volume/machinery and equipment would be one approach, although it would clearly have to be tailored to the type of business and would be aided by more transparent filings.
This post is equally interesting. Hempton looks at where the company says its facilities are, as well as their size. He finds a discrepancy between a quarterly report and the annual report stating the size of the lease of a facility. He also finds that the exact amount of square footage from one of the filings matches a leasing ad in a newspaper, indicating that the company does not use the facility at all. He also compares a contract that the company has compared to the overall stated production of the company, which appears minimal in the grand scheme. All of these conclusions are ones an individual could reach with an internet connection. The problem is knowing what you would be looking for, and in this respect the post is helpful. I find that my biggest problem in investing is trying to figure out where and how to find information that I believe is out there. I highly recommend checking out his posts to see how/what he does to analyze a company, the informational aspect of (Chinese) frauds, and the overall logic presented.
Talk to Andrew about using accounting to analyze companies
*This is irrelevant to the general gist of this blog, but the movie Network was made in 1976 and rails on the infotainment inclinations of a corporate media. Other than being one of the more spectacular products of the golden age of film making, it has the similar effect as reading Quality of Earnings for a greenhorn like me (there's also the irony of a studio produced film railing on corporate media, and the film did have some trouble finding backing initially). From a very broad perspective, market history and history in general are invaluable tools, because these two examples clearly demonstrate that so much that is "wrong" with society today, has always been wrong with society. Being keenly aware not only of this phenomenon, but how problems have presented themselves in the past equips one to identify them in the future. While it doesn't make it any easier to predict outcomes, it can certainly let you know when to back away from an idea. Even though you aren't reading this for movie recommendations, I now have it in my head to discuss some other market history that has parallels to current events.
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