Don't trust brokerages. Find stock cues in quality of earnings, and how!

Veteran investor Thornton O’Glove says there are a lot of profitable insights an investor can derive from reviewing a firm’s publicly-disclosed financial statements, which can help make right investment decisions.

Thornton O’Glove is a Wall Street veteran and author of the book, Quality of Earnings: The Investor's Guide to How Much Money a Company Is Really Making. An MBA from Haas Business School at UC Berkeley, O’Glove started his investment journey at the age of 18. He has also worked as an analyst for some of the top investment firms in New York. He now comments on markets occasionally, and his work continues to influence students of finance and professionals around the world.

While reviewing a company’s financial statements is only one perspective of investment research, these filings are full of useful information that can help understand the company’s future potential earnings, which can have a huge impact on the stock performance, O’Glove says.

“Proper analysis of a firm's corporate filings can help investors focus on spotting and avoiding troubled companies and find potentially strong investments,” he said in a presentation at Talks at Google.

• Don’t trust analysts

O’Glove says investors should not trust research analysts as they deliberately provide good recommendations for companies. They are expected to be in good terms with company managements that they cover, so they can scout for other business for the firm.

A company’s management rewards research firms giving them good ratings and asking them to underwrite its issue of stocks or bonds or carry out other functions e.g. M&A. This puts more pressure on analysts to provide supportive commentaries on companies they cover, says he.

Being negative or giving negative commentaries on a company after earlier being positive on a stock runs the risk of analysts jeopardising their terms with the management, and switching positions also makes it tough for brokers, because they have to tell their clients to sell a stock they recently recommended.

O’Glove says analysts are also wary of giving a negative recommendation as they do not want to spoil a good relationship with the executives and PRs who often provide them with tips, hints and valuable information that makes the job easier. A negative commentary by analysts can lead to companies isolating them and withholding information from them.

“The analysts are trapped. They’ve got to be bullish. If they’re negative, they may lose their job. The corporation may shut them out of seminars. Most of them are involved with underwriting. That’s why the company calls up the research firm and they say, no more underwriting. So the research firm has no choice but to either get rid of the analysts or silence them,” he says.

Be wary of auditors
O’Glove has a similar view for auditors too. He says investors should not blindly trust the auditors’ report while making an investment decision, as many companies have often received a clean outlook in their most recent reports prior to collapse.

This is so not due to just incompetence, but because the client pays the bill for an independent audit and would be displeased if the auditor discovers irregularities, which can prevent them from offering a clean opinion. This could also lead to a loss of an account in an industry full of intense competition and low fees, and so auditors are pressured to comply with client demands, he says.

Also, a full audit can open more opportunities for other services and fees such as consulting, taxes, government related work, feasibility studies, and actuarial services which have larger fees. “Auditor's reports may not be reliable also because financial operations are very complex and there’s a lot of leeway. You’ve got thousands of pages of regulation. So the bottom line is a corporation can tell the accountant to either be aggressive, not fraudulent, middle of the road, or conservative. So you read about these corporations, and they’re dodging tax, they’re doing this or that. You can't blame them. They've got thousands of pages to work with. A lot of it is a gray area. And here again, they’re paying the accountant to eliminate as many taxes as they can,” he says.

Insights from shareholder letters
O’Glove says a YoY/QoQ comparison of a company's financial reports can give a clear picture of the management’s credibility. Going over shareholders’ letters thoroughly in the reports of past few years can help investors spot contradictory or overly optimistic views of the management.

He says investors should never believe managements that have been often wrong in their projections, as it may indicate that the company is not in a healthy position.

Also, he advised investors to compare management statements in the shareholder letters with statistics from the financial statement to see if there are any discrepancies. If yes, one to look for more inconsistencies in the reports.

Investors should also try and ascertain why the management believes their projections are reasonable. If a management is frank about its problems and discusses a proper solution in the shareholder letters, it makes the projections more convincing and gives confidence to the investors about the credibility of the company, O’Glove points out.

He cautions investors to be careful when a management uses the word ‘challenge’ in its letters as it often means ‘bad news’, as managements tend to downplay problems.

After reading an annual report, an investor should have a much improved picture of the company’s true prospects and also some idea as to where its stock might be headed. Otherwise, the whole exercise is futile, he says.

“The chief executive's annual letters are very interesting. If you own a stock and you read the annual report each year, the president’s letter might constantly make predictions that go astray. So that is a stock you wouldn't want to own. Or they’ll be very bullish as usual, but in the back of the annual report, you look at the financials and so on and you’ll see the company, the quality of earnings is deteriorating. In other words, a positive picture in the front, weak financials in the back indicate warning signs,” he says.

Differential disclosures
O’Glove says often some firms project something in one financial document, which is markedly different from what they reveal in another. He says he has often seen significant differences between what is mentioned in the annual and quarterly reports and the government-mandated documents.

He advises investors to be careful in such situations as firms do it deliberately to hide the true picture of the company. They know that annual reports are meant to be read by stockholders, but official reports like 10Ks and 10Qs are filed with exchange commissions. Shareholder letters have the liberty to predict a rosy future in the face of declining business and stiffer competition as no management can go to jail for that. But they can get into trouble if the regulatory filings do not conform to the guidelines.

So, investors should read the regulatory filings carefully for any discrepancy from the story told in the annual report.

O’Glove lists out some key aspects to look at in a financial report to determine the true health of a company.

• Look at non-recurring gains in earnings
  

Investors should become careful when a company's management shows an improvement in earnings due to some non-recurring gains. If there are a lot of non-recurring gains causing earnings to improve when operating earnings have fallen, then it indicates that the company may not be actually doing well.

Investors should check if changes in earnings come from non-operating business-related items and adjust operating earnings accordingly. He also emphasises the need to compare cash flow to operating earnings to make sure earnings are not just shown on paper.

Investors should also observe these gains on an incremental basis to have a better chance to determine if future earnings will be impacted positively by non-operating/non-recurring earnings, and make investment decisions accordingly.

• Check for reliability of suppliers/customers

Investors can find out whether any particular supplier or customer is contributing a large percentage to the bottom line. If yes, then one should check their reliability and any recent problems related to them as the company may run the risk of losing that business which can have a very negative impact on the stock.

If a company is optimistic about a particular new product or division then investors should check the regulatory filings to ensure there aren’t any big potential problems awaiting them and whether things are as good as mentioned in the shareholders letters.

• Check where majority of earnings are coming from

Investors should see where the majority of increase in earnings are coming from by checking the trend of percentage of earnings coming from different divisions in the past years/quarters. If any core divisions are not doing well, but remain hidden by overall results, which are helped by non-core divisions, then the prospects of the company may not remain very bright in the future.

• Use a different PE ratio for different divisions

Investors should use different PE ratios as benchmarks for different divisions operating under different industries by comparing with firms in relevant industries. They should check whether the overall weighted average PE ratio is justified for a firm with many different divisions as a company might downplay the fact that the portion of earnings coming from a troubled business is increasing.

• Read the footnotes carefully

Investors should always keep an eye on footnotes in a financial report as there might be disclosures of investigations by state agencies in the filings. They should check whether the company makes loans to related parties like directors and if yes, are the loan terms fair.

• Study other important financials

O’Glove further emphasises the importance of really digging deep into and looking through some of the important financials of the company like debt, taxes, cash flow statement, dividends, financial ratios, accounts receivable and inventories report before making an investment decision, as these are crucial data that can indicate the health of a company and its stock value.

If one can spare some time to carefully go through the financial information mentioned in annual reports, it can go a long way in helping her make the correct investment decisions, says O’Glove.

(Disclaimer: This article is based on Thornton O’Glove's book of Quality of Earnings: The Investor's Guide to How Much Money a Company Is Really Making and his presentation at Talks @ Google).