Sunday, October 16, 2011

Quality of Earnings: Chapter 4

Investors rely heavily on the financials that companies release. But managements have significant leeway when it comes to creating its results. In this book, Thornton O'Glove tells investors how to judge the quality of a company's earnings, in order to both protect against fraud and find value.

O'Glove recommends reading everything the company puts out. While much of it is marketing puffery, there is also a lot that companies disclose because they have to by law. The company will bury it in a document it doesn't think you're going to read, because it doesn't want you to know some of this stuff. It is precisely for this reason that you need to read it.

What you are looking for is what O'Glove calls "differential disclosure". This is where the company says one thing and does or says another somewhere else. O'Glove describes several cases where he uncovered such occurrences that foreshadowed trouble ahead, despite a stock market that treated these companies like gold.

For example, in one company he looked at, the annual report sounded downright bullish, whereas the 10-K warns of upcoming product delays. In another example, a company downplays its reliance on a single customer (calling it "more than 10% of sales") whereas the 10-K warns of a customer that is responsible for 46% of sales!

In a particularly egregious example, the stock market was gung-ho on a Texas bank which had made a significant number of its loans to officers and directors. The bank claimed the loans were on the same terms as those with third parties of similar risk and collateral, even though the regulator disagreed. When some of the loans went bad, either the company's loans with third parties were suspect, or it was dishonest with respect to loans to insiders. Either way, outsider shareholders were not in a good position!

O'Glove's message is to stay away from companies with differential disclosures!

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