Sunday, November 13, 2011

Quality of Earnings: Chapter 12

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.


This final chapter of the book is about the big bath, the accounting charges a firm takes that result in lower current profit but higher future profit, as assets are often written down by more than they should be. Sometimes, the big bath will take place as a result of a new management team that seeks to downplay what it is inheriting and talk up what it has accomplished years later (i.e. "Look at the profits when I started versus now!"). Other times, continuing managers will seek to start fresh after a lackluster year or quarter, by throwing in additional charges that make the next year's returns look good.

In either case, investors should understand what's happening, as there may be ways to profit. O'Glove quotes studies which demonstrated that stocks fall in anticipation of write-downs, but rise shortly following their announcement. It is interpreted from this that the market likes certainty, and so investors wishing to outperform may wish to buy in advance of write-downs. (This can only occur, of course, if the write-downs are anticipated. This often does occur, however, as managers hint at future restructuring etc.)

Another opportunity for investors occurs in companies where the restructuring transforms the business into a more profitable one. Charges and write-downs can make a company's stock price drop, but where managers are actually making the company more efficient, this can result in out-sized gains for investors in the long-run. O'Glove provides a few examples where this has occurred. Some common themes involve the cutting of unprofitable divisions, resulting in cases where firm-wide assets and revenue can even fall, but where profits hold steady or even increase.

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