Value Investing -9 Forensic Analysis

Hello friends,

Through this series of blogs, we have covered the major guiding principles of value investing. However, we still need to dive deep into some of the finer aspects of study principles to select stocks through the lens of value investing. Forensic analysis of a company is certainly a major one.

Quality of the management is very important in the journey of a company towards excellence but the integrity of the management is far more important than the quality. What one can do if the captain himself rocks the boat?

You’re looking for three things, generally, in a person: intelligence, energy, and integrity. And if they don’t have the last one, don’t even bother with the first two. 

– Warren Buffett

Forensic analysis is a technique that enables investors to analyse the company’s accounting thoroughly to ensure that the management is true to the investors, no money is being siphoned out through financial shenanigans and the earnings are real earnings. There are many ways shady managements use to fudge the accounts in one way or the other and at times it is really difficult to find out but one can get some subtle indications.

“There is never just one cockroach in the kitchen.”

– Warren Buffett

There are quite a few books on the subject, the notables among them are “Financial Shenanigans” by Howard M. Schilit, “Accounting for Growth” by Terry Smith and the subject is also touched upon by Saurabh Mukherjee in his book “Diamonds in the Dust” and a checklist is also provided. Further, Ishmohit Arora of SOIC has explained many of these beautifully, with examples of Indian companies in his video on the subject. He too provides a checklist.

So let’s have a look at the major ones of these shenanigans.

Inflate earnings: All companies look to report maximum earnings so that the stock price is pushed up. companies resort to many tactics to achieve this end, some subtle, some blatant. Inflating receivables and inventories is one of the most common methods. Profit inflation in the P&L has to be matched in the balance sheet by increasing inventories and receivables on the asset side as the earnings go to the liability side of the balance sheet. Therefore, an increasing trend of these two as a percentage of total revenues must be looked at with suspicion. One can also check trends in the cash conversion cycle. Companies may even inflate fixed assets artificially to match inflated earnings in the balance sheet. One must also check if receivables are old and if there is history of writing off receivables. If the receivables are old and substantial, one must check if necessary provisions are made against such receivables.

Companies, at times, resort to increasing sales volume by just keeping extra goods with dealers and showing that as sales. This is called channel stuffing and is difficult to find out.

A good way to keep a general check is to compare operating cash flow to PAT. Depreciation is a non-cash item that aids the operating cash flow and the changes in working capital reduce the operating cash flow. Still, the CFO to PAT ratio should be at least 60%.

Goodwill: While money can be siphoned out on a regular basis through inflating earnings, Goodwill could be a way to siphon it out in bulk. When an acquisition is made, excess cash, over and above the net asset value of a company acquired, goes as goodwill in the balance sheet. IT companies have small assets and in IT acquisitions, the major amount is goodwill.

An impairment test is carried out for this goodwill every year and if the auditors feel that the assumptions on the returns by the acquired asset are not met, some of it is impaired or written off. So it is quite easy for dishonest management to acquire a new company at a much higher price and then impair the goodwill progressively. Investors must check goodwill as a percentage of net worth. Investors should be especially wary of acquisitions made in non-core areas.

Intangible assets include patents, copyrights, goodwill, know-how etc. While the goodwill is quantifiable and known, the valuation of these other intangibles has a lot of subjectivity. So the percentage of intangible assets to net worth should also be checked. Lesser this percentage, the better.

Employee compensation: One should check the number of employees and total compensation amount to ensure that the compensation per employee is not abnormally high.

Depreciation: Companies resort to methods such as increasing the useful life of an asset midway and increasing the residual cost to decrease the per-year rate of depreciation. This results in enhancing profits. One should also check the depreciation method applied. Generally, linear depreciation is more trustworthy than depreciation based on the expected pattern of consumption but again companies may have good justifications to choose a particular method of applying depreciation.

Auditors: Investors must go through the auditor’s report, especially the key observations, any adverse observations and statements on financial control etc. If the companies have subsidiaries, it is always better that the parent and subsidiaries are audited by the same auditor. If a different auditor audits the subsidiaries and the parent company auditor accepts the findings as it is, there is scope for hiding facts.

Auditor Compensation: Investors should check if there is an abnormal hike in auditor’s compensation over the years. Such a hike could be an indicator of keeping the auditor silent about the anomalies.

Related Part Transactions: These are transactions made with people with an interest in the main business. These could be promoters, directors, their relatives etc. It is mandatory for companies to report such transactions and one can find these details in annual reports. The transactions could be regarding sales and purchases of goods, loans, deposits, rentals, investments etc. with promoters or their relatives. Promoters sometimes rent out their properties to the company at higher than normal rents, give loans to private companies where they have a stake, buy goods from companies they have a stake in and so on. All such transactions need to be carefully examined. In any case, the fewer such transactions the better it is.

Pilfirage: Investors need to look at miscellaneous expenses to check if these are excessive. one should compare these yearly as a percentage of sales. Also, check the yield on cash and investments to be sure that the investments do actually exist. The yield should be at least 7%. Companies are known to keep cash in current account or in foreign exchange or cheques in hand but such practice creates doubts about the existence of such cash. Auditors are supposed to check all such things but it is better for the investors to be sure themselves.

Contingent liabilities: These are liabilities based on the occurrence of certain events and are not a part of the balance sheet but can have catastrophic effects if the event in question actually happens. These can be tax liabilities, liabilities arising out of legal suits, corporate guarantees, letters of credit (LCs) etc. Investors must check the quantum of such contingent liabilities as a percentage of the net worth of the company (Equity + Reserves). Such a percentage ideally should not be more than 5-10%.

Equity write-off: There are instances of companies and especially banks adjusting losses arising out of NPAs by writing off equity (From reserves) and not showing in the P&L account so that it would not affect their profits. So check reserves accretion to match with retained earnings and depreciation.

Corporate structure: Conglomerates and big companies often have complex corporate structures and it is well nigh impossible to track inter-company transactions for such companies. They also have a lot of corporate guarantees and related party transactions. Often the subsidiaries are audited by different auditors than the company auditors. For this reason, it is difficult to be sure of management integrity and it is better to avoid companies with complex corporate structures as far as possible.

Once the business analysis is done for any company, it is good to carry out these checks to be sure of the management integrity before the investment decision is made. One can develop a good checklist to go through for this purpose. And as Buffett has said, one adverse finding is likely to lead to others.

I thought of attaching a checklist for forensic analysis covering the above points. However, on second thoughts, it would be better for the reader to make his own checklist so that he can make a mental note.

Often the journey is more interesting than the destination

Yours truly

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Disclaimer: The content does not constitute a buy or sell recommendation. Readers are advised to consult their investment advisors for any investment-related decisions.