Book-review: Quality of Earnings by O’Glove

The investor’s guide to how much money a company is really making.

If you prefer to read the pdf version click here. (links may not work in pdf)

IMO: A great read about the quality of earnings and how to think about reported earnings, adjustments, and true underlying earnings. I think this book was recommend to me during an application process.

(as in my previous book review I focus more on my learnings/insights/personal summary vs writing style etc.)

Most people prefer illusion to reality, if it confirms to a view to which they are committed.

Don’t trust your analyst
Celebrities are famous for being famous.
Investment analyst celebrities talking on business TV and being quoted in reports are not different.
Sell side analysts have many incentives, but not necessarily writing truth. Almost always, it is very much too positive.

And don’t trust your auditor
Auditors are paid by corporations and pretty much have to do what they tell them, because, otherwise they lose profitable other business as tax consulting, etc.
The situation is comparable to sell side analysts. It is about incentives.

Person to person: a shareholder letter
Shareholder letters offer more freedom to management (or their PR officers) since the form is not set by the SEC like for 10-Ks etc. This can result in a very much too optimistic wording. Shareholder letters should be checked against statistics or financial reportings.
For example if the letter highlights a reduction of (Net) debt over a certain period, it is worth to zoom out and check if this certain period was a ‘well picked’ short term development within a rather bad longer term development of rising debt levels. The same is true for earnings and many other financial measures.
A good letter does not promote euphoria but confidence, though not necessarily in buying the stock. It should discuss problems and solutions.

Differential disclosure
Reading both shareholder letters, annual and quarterly reports which are for shareholders; and 10-Ks and 10-Qs which are written according to strict guidelines is advisable. The two groups should be checked. The former might be written much more optimistic but might also include background information and reason. The latter, is more truthful since management might go to jail otherwise.
The word challenge might be read as trouble, since this might be what managemt means.
The annual report of CVGT mentioned that one customer accounted for more than 10% of sales. The 10-Ks mentioned the more precise and helpful figure of 46%.
A bank made loans to its directors and stated these were made on comparable terms, which would be fine. But, a huh portion of these loans were deemed non- performing, signaling trouble within the total loan book or undermining trust in management.

Nonoperating/nonrecurring income
Casualty insurances were bought to report earnings from realized investment profits whenever needed.
Selling real estate or other assets for a profit and many other NO/NR business transactions mug result in higher reported earnings that are to be taken with a grain of salt.

Declining and decreasing expenses
Wholesale prices for chicken can make a big difference in fast food restaurants’ gross profits and margins. So can changes in the tax code.
It is prudent to investigate expenses development and honking about future developments.

Shareholder reporting vs tax reporting
Some tax filings are not available to ordinary investors.

Two key ratios: Accounts receivalbe and Inventories is probably the most important section and the concepts were underutilized at least at the times of his Quality of Earnings reports.
If Accounts receivalbe (AR) and/or inventories increase much faster then sales this might indicate problems for future earnings. This is especially true if the inventory build up is driven by finished goods which are not selling and indicate a slowdown of manufacturing/production in periods to come and/or write offs. This is called negative inventory component divergence. The high tech sector is a prime candidate for looking at unduly AR and inventory increases since products can become obsolete quickly. AR increases might indicate hard sales tactics with bad incentives (ie later payments) to shift inventory from the producer to its customers, ie distributors.
If inventory increases mostly due to raw materials and semi-finished in process goods this can actually be bullish and indicate acceleration of business as management draws down finished goods to serve customers orders and increases raw materials to fulfill future demand, called positive inventory component divergence.

Debt and cash flow analysis
Understanding Cashflows and if necessary recreating a cashflow statement is vital.

Dividends: The tender trap
There is a view that good businesses don’t pay dividends, since according to Peter Drucker all revenues of a healthy company are used for past, present and future expenses — past (interest charges), present (wages, rent and raw materials), and future (research and development and expansion).
Dividends are used to prop up low PE stocks, usually lower quality businesses, through dividend yields.

The importance of understanding accounting changes
Accounting changes such as slower asset depreciation, even implying longer asset lives than officially guided, can enhance reported earnings.

Coming clean after the big bath and/or restructuring
New Management tends to set a really low bar for future results by reporting one very bad period and talking of becoming clean of past mistakes. Writing off assets and taking many negative one offs.


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