Measuring Financial Distress Chapter 4 of Quantitative Value

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The corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt. -Warren Buffett, “Shareholder Letter,” 1984

Cryin’ won’t help you; prayin’ won’t do you no good. –My Ex.

We take up from Chapter 3 and move to Measuring the Risk of Financial distress: How to Avoid the Sick Men of the Stock Market in Chapter 4 of Quantitative Value (which you have if you are in the Deep-Value group at Google Groups).   I will email Financial Shenanigans as a supplement to this chapter of uncovering distress/fraud.

Can one predict financial distress from the outside of a company BEFORE bankruptcy. Obviously, the first place to look is at the balance sheet for the quality of the assets vs. the terms and amount of the debt. Then look at the competitive nature of the company’s industry. Airlines tend to go bankrupt more than cola companies.

I think you must practice your skills as a financial analyst. When you read about a bankruptcy like Radio Shack, then download the financials for your records and look back for what signs you might have noticed.  I will have other tips below.

Several research papers and case studies mentioned in Chapter 4 below. Especially look at the WorldCom case.

JOIM

_predicting_financial_Distress Risk 2010

Forecasting Bankruptcy More Accurately

Predicting Bankruptcy for Worldcom Final

WorldCom1 Ethics Case Study

Litigation against WorldCom for Fraud

Enron CS

WorldCom_Case_Study_April_2009

WorldCom Accounting Fraud

WorldCom

Practice your skills

You can look at these research reports from Off Wall Street and then download the financials of the companies mentioned and see if you can recreate the analysis.

NEW_EXAM_7-4-11

NEW_HGG_7-5-10

NEW_WHR_5-4-10

NEW_STRA_3-15-09

NEW_PBI_1-19-09

Blood in the streets!

CRB-Index

Gold Mining a Crappy Business

Why Gold Mining is a Tough Business_Pollitt (An interesting insight into this industry)
SEE YOU NEXT WEEK as we go into Chapter 5 in Quantitative Value.

Practice Like Jonah!

Joel Greenblatt

Screening out Earnings Manipulators; Quality of Earnings

budget cuts

Accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)” –Warren Buffett, Shareholder Letter, 2000.

We pick up from the last lesson and read Chapter 3 in Quantitative Value: Hornswoggled! Eliminating Earnings Manipulators and Outright Frauds.

This is an important chapter for improving as an investor. Your goal might be to understand accounting up to the intermediate level so as to adjust accounting principles into economic reality. What story are the numbers telling you?

Think of this chapter as a way to build an early-warning system for companies with weak accounting.

The authors propose three ways to detect aggressive accounting that lead to poor quality of earnings:

  1. Scaled total accruals (STA), which uncovers early-stage earnings manipulations
  2. Scaled net operating assets (SNOA) which captures a management’s historical attempts at earnings manipulation.
  3. The third is the probability of manipulation, or PROBM, a tool that identifies stocks with a high probability of fraud or manipulation.

When the growth in cumulative accruals (net operating income) outstrips the growth in cumulative free cash flow, the balance sheet becomes “bloated.” Stocks with balance sheets bloated in this way find it difficult to sustain earnings growth.  When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

A warning sign is high accruals that show much higher income than cash flow. See pages 64 to 68 in Quantitative Value.

Though you should read this chapter carefully and for the nerds, dig into the research papers below, but I highly suggest studying Chapter 8 in Quality of Earnings, Chapter 8 (sent via email to Deep-Value at Google Groups).   A gem of a book. and Defining Earnings Quality CFA Publication

Earnings Management, Fraud Detection and Adjusting for Accruals

How a group of Cornell Students sold Enron before the collapse

http://www.valuewalk.com/2014/10/beneish-m-score-earning-manipulators/

http://www.valuewalk.com/2013/06/red-flags-fraud-detection-2/

Information in Balance Sheets for Future Stock Returns

Earnings Mgt and LR Stock Performance of Reverse LBOs

Earnings Mgt and LR Performance of IPOs 1998

Can Forensic Accounting Predict Stock Returns

Analysts do not adjust adequately for accruals 2004

After a few days of digesting this post, we will tackle Chapter 4: How to Avoid the Sick Men of the Stock Market, in Quantitative Value.

How can we avoid bad news as investors through our knowledge of financial statement analysis and human motivations (incentives)?

Sound Money

The-Age-of-Inflation-Jacques-Rueff

A Banker for All Seasons John Exeter

An American Original: Voodoo Child

Have a Great Weekend!

 

Tawes Hockey

Robert Rubin on Decision-Making. Risk vs. Uncertainty

uncertaintyRisk

 

 

 

 

The investment industry deals largely with uncertainty. In contrast, the casino business deals largely with risk. With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky. (page 11: More Than You Know–Mauboussin

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that is what it’s all about.” -Warren Buffett

 

Treasury Secretary Robert E. Rubin Remarks to the University of Pennsylvania Commencement Philadelphia, PA
5/17/1999

As I think back over the years, I have been guided by four principles for decision-making.

  1. First, the only certainty is that there is no certainty.
  2. Second, every decision, as a consequence, is a matter of weighing probabilities.
  3. Third, despite uncertainty we must decide and we must act.
  4. And lastly, we need to judge decisions not only on the results, but on how they were made.

First, uncertainty.

When my father was in college, he too had signed up for a course in philosophy with a renowned professor. On the first day of class, the professor debated the question of whether you could prove that the table at the front of the room existed. My father is very bright and very pragmatic. He went to the front of the room, pounded on the table with his hand, decided it was there — and promptly dropped the course.

My view is quite the opposite. I believe that there are no absolutes.

If there are no absolutes then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.

The business I was in for 26 years was all about making decisions in exactly this way.

I remember once, many years ago, when a securities trader at another firm told me he had purchased a large block of stock. He did this because he was sure — absolutely certain — a particular set of events would occur. I looked, and I agreed that there were no evident roadblocks. He, with his absolute belief, took a very, very large position. I, highly optimistic but recognizing uncertainty, took a large position. Something totally unexpected happened. The projected events did not occur. I caused my firm to lose a lot of money, but not more than it could absorb. He lost an amount way beyond reason — and his job.

A healthy respect for uncertainty, and focus on probability, drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments. And understanding that difference between certainty and likelihood can make all the difference. It might even save your job.

Third, being decisive in the face of uncertainty. In the end, all decisions are based on imperfect or incomplete information. But decisions must be made — and on a timely basis — whether in school, on the trading floor, or in the White House.

I remember one night at Treasury, a group of us were in the Deputy Secretary’s Office, deciding whether or not the U.S. should take the very significant step of moving to shore up the value of another nation’s currency. It was, to say the least, a very complicated situation. As we talked, new information became available and new considerations were raised. The discussion could have gone on indefinitely. But we didn’t have that luxury: markets wait for no one. And, so, as the clocked ticked down and the Asian markets were ready to open, we made the best decision in light of what we knew at the time. The circumstances for decision making may never be ideal. But you must decide nonetheless.

Fourth, and finally, judging decisions. Decisions tend to be judged solely on the results they produce. But I believe the right test should focus heavily on the quality of the decision making itself.

Two examples illustrate my point.

In 1995, the United States put together a financial support program to help Mexico’s economy, which was then in crisis. Mexico stabilized and U.S. taxpayers even made money on the deal. Some said that the Mexico program was a good decision because it worked.

In contrast, last year, the U.S. supported an International Monetary Fund program designed to strengthen the Russian economy. The program was not successful and we were criticized on the grounds the program did not succeed.

I believe that the Mexican decision was right, not only because it worked, but also because of how we made the decision. And I believe the Russian decision was also right. The stakes were high, and the risk was worth taking. It’s not that results don=t matter. They do. But judging solely on results is a serious deterrent to taking the risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated, affects the way decisions are made. I believe the public would be better served, and their elected officials and others in Washington would be able to do a more effective job, if judgments were based on the quality of decision-making instead of focusing solely on outcomes.

Time and again during my tenure as Treasury Secretary and when I was on Wall Street, I have faced difficult decisions. But the lessons is always the same: good decision-making is the key to good outcomes. Reject absolute answers and recognize uncertainty. Weigh the probabilities. Don’t let uncertainty paralyze you. And evaluate decisions not just on the results, but on how they are made.

The other thing I’d like to leave with you is that you will be entering a world of vastly increased interdependence — one in which your lives will be enormously affected by decisions made outside of our borders. We must recognize this reality and reject the voices of withdrawal to face the challenges of interdependence. Then, we can realize the immense potential of the modern era, for our economy and our society.

You’ve just completed an important milestone in developing your ability to deal effectively with the complex choices of the world in which you will live and work. By continuing to build on this foundation throughout your life, you will be well prepared for the great opportunities and challenges of the new century.

Congratulations and good luck.

 

Investment Checklists-Adapt Them for Yourself. GOODHAVEN

sacr

Someone sent me a postcard picture of the earth.
On the back it said, “Wish you were here.” — Steven Wright

Investment Checklists 

We left-off here Last Lesson on Gross Profitability and Magic Formula and in that post, the next focus would be on investment checklists.  We have been reading Chapter 2: A Blueprint to a Better Quantitative Value Strategy in Quantitative Value (I will email the Book to new students if they are in the Deep-Value Group at GOOGLE. Go here: https://groups.google.com/forum/#!overview then type: DEEP-VALUE and ask to join.).

On pages 56 to 59 of this chapter the author discusses the case for a checklist. Atul Gawande in his book The Checklist Manifesto: How to Get Things Right argues for a broader implementation of checklists. The author believes that in many fields, the problem is not a lack of knowledge but in making sure we apply our knowledge consistently and correctly. 

The Quantitative Value Checklist

  1. Avoid Stocks that can cause a permanent loss of capital or avoid frauds and financial distress/bankruptcy.
  2. Find stocks with the cheapest quality.
  3. Find stocks with the cheapest prices.
  4. Find stocks with corroborative signals like insider buying, buyback announcements, etc.

Below are several books on checklists.

As students may know, I throw A LOT of information at you to force a choice on your part.   You have to focus on what material can be adapted to your needs. In the three books above, you will find many interesting ideas that may be helpful in learning how to build your own list.

The more experienced you are, then the shorter the checklist.  The point of a checklist is to be disciplined and not overlook the obvious while freeing up your mind for the big picture.   Yes, you check off if there is insider buying, but if insiders are absent, but the company has a strong franchise and the price is attractive, then those factors may be overwhelmingly positive.  You may ask, “Do I understand this business?” Then it may take weeks of industry reading to say yes or no.

Checklists are helpful, but only if you adapt them to your method.

Next, we will be reading Chapter 3, Eliminating Frauds in Quantitative Value. We are trying to improve our ability to build a margin of safety.

goodx

The Problem with Investor Time-frames

Note the dark line in the chart above representing the returns of the Goodhaven Fund. Two analysts/PMs split off from Fairholme and started in mid-2011. They had a big inflow in early 2014 and then some of their investors panicked as they vastly “underperformed the market.”  I don’t know if these managers are good or bad but making a decision on twelve to twenty-four months of data is absurd unless the managers completely changed their stripes (method of investing).  Therein lies opportunity for those with longer holding periods like five years or more.

holding-period

Shareholder_Message_1114 (Some investors run for the door)

2014_AR

2013_AR

HAVE A GREAT EASTER and WEEKEND!

fredgraphcreditmarketdebtgdp

So How Does This Happen to a Country? On the Road.

cuba-vs-singapore_03252015

Ask how can a country become wealthier or poorer?

Ideas?

I am on the road but will be back later on in the week.

Meanwhile, listen to this harmonica:

 

 

RISK! A Reader’s Question

Long-Term

The view from Grant’s (Mar. 20th, 2015) is that risk can usually be found where you aren’t looking for it. You get to thinking, for example, that government bonds are perfectly and unconditionally safe. You would so conclude after 33.5 years of a bond bull market. Yet, the same asset struck many as perfectly and unconditionally unsafe at the 33.5 year point in the preceding 1946-81 bond bear market. Nothing in investing is for certain or forever, “Many shall be restored that now are fallen, and many shall fall that are now in honor,” wrote Horace (65 B.C. to 8 B.C.).

 

download

A reader asked about the 

sharpe_ratio.asp. I think any metric that uses volatility as risk is absurd. The video below will give you a better understanding of what REAL risk is–permanent loss of life! I know some may disagree–see: FAJ My Top 10 Peeves and a value investor’s view: Risk Revisited

 

A Reader’s Question

I’m a value investor from Italy, and I’ve been following your blog since a few months ago. I appreciate a lot your work and the way you share your knowledge with the others. I’ve been doing my own research in American stocks, and create a portfolio that I think is doing well.

I’m a retail small value investor with no MBA, or any especial degree in accounting.

How can a “middle class working hero” approach the world of finance? Do you think any money manager be interested in my research, or I’m only wasting my time?

My advice: First, you can post this to the deep-value@googlegroups.com because there are many smart, experienced investors who may offer another perspective.

First, why American stocks (especially now since many are high-priced?) versus Italian or Greek stocks? Can you develop an area of expertise NEAR where you are?  In other words, what makes YOU unique where you can add unique value? Where can you find the biggest edge. Do you have expertise or experience in a particular industry?   Have you spoken to or research Italian Money Managers? Send your write-up to a few of them. The worst that can happen is they give you a thumbs down but you obtain feedback/and learn.

Not having an MBA is no big deal, but you should learn accounting up to the intermediate level so you can translate the financial information into information useful for an investor.  GAAP earning don’t always equal owner’s earnings. Study online for free or attend a class or grind through a textbook but do ALL the problem-sets.

If you know your portfolio is doing well, keep good records that you can show to potential investors or employers. Do you have a clear investment process that you can follow?

Ask further questions in the comment section.

Good luck!

How Markets Work; A Case Study in Pundits: Savaged by the Truth: Jim Cramer

How Markets Workusd1

Bull-market-top-in-for-the-u-s-dollar/ (Video-Market Psychology)

3-DXY-CoTs-1024x645

Jim Cramer at his best

 

https://www.deepcapture.com/jim-cramer-is-a-complicated-man/

In short, Maier is contending that advice Cramer was giving the public under the guise of helping them manage their savings (“SmartMoney“) was actually being driven by Cramer’s need to dump his own positions without cratering the market. When a trusting public acted on Jim’s tip and bought shares, he dumped his shares onto the public. The only lesson Cramer learned from the “four orphans” incident, Maier claims, was that he, Cramer, had the power to move stocks through the press.

And: https://www.deepcapture.com/how-cnbc-becky-quick-jim-cramer-and-joe-kernan-can-solve-its-collapsing-viewership/

The link above has an amazing article written by Patrick Byrne on the slimy sleaziness of Jim Cramer.

Ignore pundits!

 

Shareholder Maximization-The Dumbest Idea in the World; Is Skill Dead?

CRB 2015 long term

JM_The Worlds Dumbest Idea_1214

Video: http://eic.cfainstitute.org/2014/10/23/shareholder-value-maximization-the-dumbest-idea-in-the-world/

Excellent video on Austrian economics and entrepreneurship:

http://mises.org/library/entrepreneurship-austrian-economics-and-cryptorevolution

Advice

I am a first year MBA student in XXXX. I am from a background of (being) a software engineer and an equity researcher in China. I was very interested in Value Investing and tried to apply it to personal investment in past 8 years. Currently, I am exploring career opportunities in the Investment Management area and see that you have been working and teaching in this area for a long time. I would learn more about your experience in this area and get some advice from you.

I would write-up investment ideas within your circle of competence to show fund managers your critical thinking skills and approach to investing.  Or if you have a great understanding of a particular industry or company that is public you can present your ideas to the fund managers who own the company.   Show your past investment results. Why did you make the decisions you made?  Try to sell your ideas to the appropriate money managers.   But only you can determine what your strengths particular interests.   Your reports should meld your interests with your skills.

Icahn

Our activist friend, Carl Icahn’s High River LP, Icahn Partners LP and Icahn Partners Master Fund LP collectively bought 6.6 million Chesapeake shares on March 11 at $14.15 each, bringing the investor’s total stake in the company to 11 percent, according to a filing on Monday. Prior to the purchases, Icahn controlled about 9.9 percent of Oklahoma City-based Chesapeake. That compares with an 11.11 percent stake owned by Southeastern Asset Management Inc. as of Dec. 31, the largest holding according to the latest filings.

The Forgotten Depression (Video)

Forgotten-depression-1921-crash-cured-itself

Commodities Carnage; Reversion to the Mean and the Growth Illusion; Net/Nets

Reuters

CRBSearch Strategy: Go where the outlook is bleakest (John Templeton). Keep his wisdom by your side: Sixteen Rules for Investment Success_Templeton

Commodities (CRB Index) fall back to a 40-year support zone ($185/$205)

while:Commodities-Sentiment

As global commodities prices plummet, it’s incredibly convenient to pronounce the commodities super-cycle dead, isn’t it?  Yet banks from Goldman Sachs to Citigroup to Deutsche Bank are on record as saying it’s over.   http://www.wallstreetdaily.com/2014/12/08/jim-rogers-commodities-interview/

The point is not to follow the “experts” but search where there is carnage. I am looking at Templeton’s Russian and Eastern Europe Fund TRF Semi Annual Report because:

  • Hated Countries (Russia, Ukraine)
  • Currencies Down,
  • Commodity Exporters and
  • trading at a 10% discount so the 1.4% management fee is covered for six years.
  • Poor performance for the past few years

Things can and will probably get worse. So please don’t follow the blind (me) off the cliff. This is meant as an example of a SEARCH STRATEGY.

More on Reversion to the Mean and the Growth Illusion

We are beating this subject to death but you can’t understand how investing in bargains works without grasping these concepts.

Contrarian Strategy Extrapolation and Risk  Abstract: Value strategies yield higher returns because these strategies exploit the sub-optimal behavior of the typical investor and not because these strategies are fundamentally riskier.  Yes, this is an academic paper, but worth reading to understand WHY and HOW value (buying stocks with low expectations/and low price to business metrics like earnings, cash flow, EBITDA, etc.) provide better returns.

Growth Illusion

The Two Percent Dilution It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900–2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.

value-vs-glamour-a-global-phenomenon (Brandes Institute)

Thick as a Bric by Efficient Frontier

Does the Stock Market Over React

Discussion of Does the Stock Market Over React

Criticism of the Over Reaction Theory

The above is meant to supplement your reading in Deep Value Chapter 5, A Clockwork Market

 

Ben Graham’s Net-Net Strategy Revisited

Ben Graham Net Current Asset Values A Performance Update