Sunday, October 30, 2011

Quality of Earnings: Chapter 8

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 argues that best method to predict future downward earnings revisions from analysts is careful monitoring of inventory and accounts receivable balances. He takes the reader through numerous examples where stocks were high-fliers, but where investors were ignoring red flags in these accounts. A couple of short quarters later, company earnings were dramatically reduced.

It's important to note that different companies in different industries have different inventory requirements. For example, a service company's inventory levels will be tiny in comparison to those of a manufacturer. Therefore, it's not about the absolute inventory levels, it's about how they change in relation to sales in year-over-year comparisons.

Monitoring of these two accounts is also much more important in industries that are subject to rapid changes in products and taste. Examples of such industries include fashion, seasonal and high-tech industries. Most of O'Glove's examples are in these industries, and most follow the template of increasing sales, but increasing inventory and/or A/R at much higher rates. This almost invariably leads to declining sales (as sales were "borrowed" from the future) or writedowns (inventory can't be sold at expected prices).

It's not just negative news that results from such analysis. By watching for divergence in the type of inventory that a company is carrying, good news can also be inferred. For example, if raw materials are growing faster than finished inventory which is growing slower than sales, orders are likely on the increase, suggesting earnings may be as well.

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