Saturday, October 8, 2011

Quality of Earnings: Chapter 1

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.

The theme of this chapter is that your analyst is not to be trusted. The only person you can count on to do the work is yourself.

It's tempting to consult "experts", but it's unhelpful. Opinions quoted in the popular press are extreme viewpoints; wishy-washy commentators don't get any airtime.

As for the analysts paid to follow particular companies, O'Glove spent many years as an analyst and witnessed first hand that they don't do their homework. Few actually read a company's prospectus from front to back, and so as a researcher O'Glove was always at an advantage.

Furthermore, analysts are under a lot of pressure to be positive. The firms with research analysts covering companies are the same firms that would like to receive lucrative underwriting business from the same companies. This leads to a conflict of interest where analysts are afraid to be negative, even when justifiable. O'Glove argues that this is why there are always so many more "buy" than "sell" ratings. A few examples are described where analysts (including a young Jim Chanos) lost their jobs and reputations for warning on stocks that turned out to be real duds.

There is also a herd-like mentality in the field which causes everyone to think the same way. This can lead to gross misjudgments. O'Glove provides evidence that analyst picks, even for the very best of them, underperform the market severely.

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