We Study Billionaires - The Investor’s Podcast Network - TIP672: Quality of Earnings: Uncovering Hidden Red Flags w/ Clay Finck

Starting point is 00:00:00 You're listening to TIP. Many investors who analyze stocks take the numbers provided by the company at face value. But there are times when this can be a massive investing mistake. To help shed light on what the earnings provided by a company really means for us as investors, I picked up this book called Quality of Earnings by Thornton O'Glove. Thornton is a Wall Street veteran known for pioneering of red flag deviation analysis. This book is an indispensable guide to determining how much money a company is really making to help us avoid making costly blunders.

Starting point is 00:00:36 During this episode, we'll cover why you shouldn't trust your analyst or auditors, what to keep an eye on when reading an annual report, red flags to look out for when analyzing a company's filings, how managers and accountants can legally manipulate earnings per share however they see fit, the impact of dividends on your returns as an investor, and much more. Increasing my understanding of accounting is a skill set I've long wanted to fine-tune in this book is certainly a step in the right direction. So with that, let's dive right into today's episode covering quality of earnings by Thornton O'Glove.

Starting point is 00:01:15 Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. Hey, everybody, welcome to The Investors Podcast. I'm your host, Clay Fink. On today's episode, I'll be covering this book called Quality of Earnings by Thornton O'Glove, The Investor's Guide to How Much Money a Company is Really Making. This book was published back in 1998, and it might seem a bit outdated, but I've seen it recommended a number of times, and I just recently had lunch with Chris Mayer, and I had asked him for some book recommendations related

Starting point is 00:02:10 to accounting. And this is one of the books that he mentioned to me there. I'll also just provide a brief disclaimer here that some of the accounting references that are made during this episode may be a bit outdated since the book was written over 25 years ago. So please take that into consideration as I'm not a trained accountant and don't have a CPA license. So the purpose of this book is really to better understand and make use of the reports and other documents that public companies are required to file. Thornton sort of has a bit of a different writing style because he has a background of looking for companies to short, or he's betting on companies who stocks that he thinks is going to go down rather than up. So rather than

Starting point is 00:02:52 trying to find the positives in a company, he's looking for any clues that a company might be in deep trouble and is trying to cover up what's really happening underneath the surface. He points out that most investors won't bother to read the reports published by companies, and understandably so because it's really a lot of work. And he came to the conclusion that since most investors didn't do the necessary due diligence on stocks, then some crazy things can happen with stock prices, and the price can easily detach from the fundamentals to the upside or to the downside. Thornton writes here, because the documents were lengthy, very few brokers would take the time to read them. Accordingly, I concluded that

Starting point is 00:03:37 one could obtain some edge on the market by diligently reading a prospectus from cover to cover. By the way, this is still true today, even though the institutions dominate the market to a far greater degree than in the past." He also believed that there was no substitute for doing the work yourself, and we'll get into why you really shouldn't rely on other people to determine what stocks you should or shouldn't buy if you're really taking stock investing seriously. Thornton points out that investors often look at the earnings presented by a company and simply take it at face value. Perhaps the company has an earnings per share of $2. Few are going

Starting point is 00:04:18 to stop to consider what if the company had a reason to understate or even overstate the earnings? Perhaps the management team knows that tough times are ahead, so they want to understate earnings this quarter. So next quarter doesn't look nearly as bad. Or perhaps management is trying to hit their short-term guidance in sacrificing the long-term earnings potential. These things clearly matter and simply aren't being included in the EPS figure that's being presented. So since Thornton was a short seller, he looks at the reports as if management is trying to hide something from him. If one assumes the worst, then they're more likely to see the bad things when they're actually there. However, most of the time, the closet isn't going to have a skeleton inside for us

Starting point is 00:05:03 to discover. In the intro, Thornton gets a little bit into his background in finance. He graduated with an MBA in the late 1960s, and he got a job as an analyst at Bank of America. Bank of America didn't really like Thornton because he would get really deep into the weeds of the financials of the business, and he wanted to really understand the company rather than just blindly handing out another buy recommendation for the stocks that Bank of America was selling to customers. He had assumed that being a critical analyst was simply a part of his job, but apparently not because six months into the job, they let him go.

Starting point is 00:05:39 He writes here, this was the greatest break in my life, because otherwise I might still be at Bank of America going through the motions. But after being fired, I was even more intrigued with the concept of contrary opinions. I had been given a clear demonstration of the fact that most people prefer illusion to reality if it conforms to a view to which they are committed. This is still the case. Changing people's minds about their investments remains a most difficult task, end quote. And then sometime later here, he was able to get to another firm that really just much better suited the type of work that he wanted to do. It turns out that at that time, it really wasn't easy to find a job that told people what stocks not to buy.

Starting point is 00:06:28 So then he started putting out this institutional research referred to as the quality of earnings. report. In over 25 years into his career, he ended up writing this book that we're discussing today. He rightly points out that as investors, we try to gather information from all sorts of sources, whether that be social media, newspapers, the news or CNBC, research by analysts or publications. All of this information largely comes from other people. And we oftentimes assume that these other people, which many people would tout themselves as experts, people assume that these people have the answers we're looking for. He claims that too often, this simply isn't the case. He believes that with some effort, the best expert that can be trusted and counted on the most

Starting point is 00:07:16 is in fact yourself. It's cliche, but if you give a man a fish, you will feed him for a day. If you teach him how to fish, he'll feed himself for life. And that's essentially why Thornton ended up writing this book. One of the things that he helped me realize is just the perverse incentives at play with people in the finance industry. For example, if you turn on CNBC, oftentimes you're going to see someone interviewed who has very extreme views. Perhaps they're calling for a stock to increase by 10x within the next two years, or perhaps they're calling for a collapse of the stock market because this is what drives views for CNBC. So the incentives are really just broken with a lot of these firms, and they're in the business of sparking people's

Starting point is 00:07:58 emotions rather than sharing sound analysis. So Thornton's first tip for a improving your analysis is to simply not trust your analyst. Analysts, along with many other people in finance, tend to have a bullish bias. Nobody wants to pay somebody else to tell them what stocks not to buy. They want to be told what stocks they should buy. Zach's investment research out of Chicago found that from 1981 to 1984, 86% of brokerage house recommendations were either neutral or buys. 12% were sales, and 2% were strong cells.

Starting point is 00:08:35 For many analysts, being neutral on a stock is about as bearish as they'll ever get. This data doesn't align well with the research that Hendrick Bessonbinder released, who I spoke to on the show here just a few weeks ago. And his research found that most stocks, in fact, underperform U.S. treasuries. So while most analysts are issuing buy recommendations on stocks, the reality is that most stocks actually end up doing pretty poorly. Thornton has a quote here in the book from an unknown source, if you put out a negative on a stock, people who own the stock hate you, management hates

Starting point is 00:09:07 you, and the people who don't own the stock don't care. Professor William Sharp from Stanford Business School believed that this bullish bias can actually cause many stocks to become overvalued. He illustrated a very simple example here. Let's say you have 10 market participants, each of which have a different opinion on a stock. The first one thinks it's worth $1. The second one thinks it's worth $2, the third, $3, and all the way up to the 10th person believing it's worth $10. So the consensus stock price comes out to around $5 per share. The first four people, of course, aren't going to buy it because

Starting point is 00:09:43 it's above what they believe it's worth. And this leaves us with the other six participants. So the stock price may actually turn out to be $7 because the most optimistic participants are willing to drive the price up above what the consensus believes it's worth. The way he puts it is that price will not reflect all available information, but only that which was held by Optimus. And this is one reason why short sellers can be such critical players in the markets, as they can help bring some rationality to market prices. Turning back to his points here about analysts, analysts go through a lot of work to get to know

Starting point is 00:10:21 management, get to know a company. but at the end of the day, the analyst is working for the company that they're with, and not those that might be reading their buy recommendations. Oftentimes, the analyst is expected to be on good terms with the managers he's in touch with, which means that they're less likely to make a sell recommendation, even if they believe that that's the right decision. And if you spend so much time getting to know a company and interacting with the investor relations person and the management team as well,

Starting point is 00:10:50 many have a tendency to fall for the liking bias or simply fall in love with the company they're analyzing. And to add to the problem, the analysts might get most of their information from the company itself, which oftentimes tends to be bullish. Jim Chanos is highlighted in the book here. He's a well-known short-seller and had a very successful career with short-selling. Chanos would rarely speak with management, and he doesn't even visit a company that he's even bullish on. He believes that it's just too easy to get blindsided by management, and he prefers to stick with the information that the company is required to file with the SEC. In 1982, Chanos was just 24 years old, and he made his sell recommendation on a company

Starting point is 00:11:35 called Baldwin United. Chanos received a ton of pushback from the finance industry and even from Baldwin's CEO. And one Wall Street veteran even warned Chanos against ruining his reputation at such a young age. Then, much of the claims that Chanos had made at the time came to light as Baldwin was investigated by regulatory agencies and the stock ended up falling by 90% from $50 a share to under $5 a share. However, Thornton points out that we aren't looking for the blemishes in everything we look at. What he shares in the book is intended to help us avoid disasters and catch some of the warning signs before others realize what lies ahead.

Starting point is 00:12:16 Just as our analysis can uncover undervalued hidden gyms, it can also be used to spot losers in overvalued situations or companies we should proceed with more caution. So to wrap up this point on not trusting your analyst, Warren Buffett is happy if he can find just one or two great ideas per year. And he isn't finding these ideas by reading analyst reports. He's pouring over documents that are provided directly by the company. There's also a chapter here on not trusting your auditor. Oftentimes, you'll see auditors sign off on reports filed by the SEC, which essentially

Starting point is 00:12:53 says that everything that is supposed to be disclosed is disclosed and that the numbers are not materially incorrect. It doesn't mean they're 100% right, of course, but there hasn't been a major error. But Thornton cautions us that we shouldn't just assume that all auditors do a good job and actually assessing the accuracy of the reports. Just because an auditor signed off on the accuracy of the reports isn't a guarantee that the company isn't trying to hide something with respect to where the company is heading in the future.

Starting point is 00:13:25 Yet again, we can look at none other than the incentives that are in place. Oftentimes, it's in the interest of the auditors to maintain good relations with the company they are auditing. So first here, the client pays the bill to have the independent audit done and will likely be quite upset if the auditor discovers some irregularities that might prevent him from offering a clean opinion. Professor Abraham Brilloff shared a story that Thornton told in the book that I thought was quite funny. I quote here, the president figured he'd make the rounds asking CPA firms how much is two plus two? Invariably, they all said four. Finally, when he gets to the last firm on his list,

Starting point is 00:14:07 he poses a question once again, how much is 2 plus 2. This time, the response is more to his liking. What did you have in mind? When the auditor is interested in winning business, it might not be in their best interest to find things that you as an investor might be interested in. In many firms, treat audits like a commodity. They just need a reputable firm to sign off on it, so firms will go price shopping,

Starting point is 00:14:31 making it difficult for some firms to differentiate themselves. Now, think about it. If a company doesn't want to pay up for their audit work, then that might mean that the auditors aren't going to do the proper due diligence because they need to cut corners just to turn a profit. And then one last issue that I'll mention here with auditors is that the auditing services can serve as a gateway to pitch other services the firm offers, things like consulting, taxes, executive recruiting, and actuarial services.

Starting point is 00:14:58 And to the best of my knowledge, the big four accounting firms here in the U.S. have their toes in all sorts of industries. not just accounting and auditing. So if the firms decide to uncover these irregularities in the accounting statements, then they risk losing those other services that they might offer to the firm. So Thornton made the case that we can't trust the analysts, we can't trust the auditors, so he uses the rest of the book to give us the tools to do the analysis ourselves. So I'll do my best here to highlight many of the high points in the rest of the book.

Starting point is 00:15:30 The next chapter here is on the shareholder letter. Public companies are required by the SEC to file a number of documents. This includes the 10K, the 10Q, and then the proxy statement. All of these reports are open for anyone to view, thanks to the internet, making it readily available. In the early spring, companies also send out their annual reports to give an overview of the previous year, which is also a requirement. Many companies put a big focus on the annual report because it's the primary way for the company

Starting point is 00:16:01 to be able to communicate with the public at large. One thing I've noticed about annual reports and the shareholder letters is that the management team likes to paint an optimistic picture of the company, sharing just about how great they are and how good they're doing with little focus on what they've done wrong and where things might go wrong in the future. So Thornton puts it so eloquently here. The annual report, with its glossy pictures, upbeat pros, tables, and notes should be looked at as one might a possible minefield. Before you is a verdant meadow, but you know there might

Starting point is 00:16:37 be explosives under all of that greenery, end quote. One of the things Thornton recommends looking out for in the report is whether the company mentions their problems and if they do, see if possible solutions are discussed. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the

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Starting point is 00:20:51 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Warren Buffett gladly points out the mistakes he's made in what Berkshire will do to address big problems going forward. This builds trust with shareholders because they know that he's going to clearly communicate how the company is at.

Starting point is 00:21:14 actually performing and how they should interpret the financial statements. Part of a manager's job is to ensure that the documents they receive from the company clearly show how they're doing today and what the plans are for the future. You also want the shareholder letter from the management team to be jargon-free and easy to understand for your average investor. A capable manager can not only recognize the problems, but they have the ability to solve them, and also recognize the new opportunities to deliver superior results relative to their competitors. What you can almost be assured of is that with most companies, if things are going well, they're going to be happy to pat themselves on the back, sharing more about how great their performance

Starting point is 00:21:57 has been. And if things are going not so hot, then surely they're going to tell you that better years are going to lie ahead, and the company is making strides to improve. All companies want to try and put their best foot forward, whether they're doing so honestly, Honestly or not. One of the things that Buffett would often do is that if his results looked better than they actually were, then he would explain in simple terms how good the quarter actually was what sort of adjustments we need to make from an investor's standpoint when looking

Starting point is 00:22:27 at these gap accounting earnings. Unfortunately, most managers aren't like Buffett. They aren't as transparent, so we'll need to dig deeper ourselves oftentimes to understand what's really happening underneath the surface. Thornt also talks about how most of these shareholder letters are signed by the chairman or the president, but they're usually written by the PR team. The managers typically don't want to give too much insight into the inner workings of the business if they don't have to. One red flag we can look out for is to look at past reports, and if anything stands out from them. Perhaps a past report shows way overly optimistic

Starting point is 00:23:05 expectations for the future that ended up not being met, or the forecasts they provided in the past are no longer included in the reports because they aren't performing as well. Thornton shares the example of a company called International Harvester, which was a component of the Dow Jones Industrial Average. He claims that their 1980 shareholder letter is one of the most flagrant examples of attempts to minimize difficulties that he's ever seen. In 1980, the company had a tough year and the stock was down 50%. But if you read the letter to shareholders, you would have thought the company was doing quite well. It discusses their improved cost structure, their accelerating progress, and how well positioned the company was for the future. If an interested shareholder were to

Starting point is 00:23:49 continue flipping through the report, they would find that the 1980 results were quite troublesome, with earnings down significantly from the prior year. Just by simply reading the shareholder letter and then looking at the company's financial statements should have put off many red flags. as an investor. So two years later, the stock was down to under $3 a share over a 90% decrease from its high in 1979. Another example, Thornton shares is Kaleco, which is a video game company that saw its stock rise from $3 to $65 in less than a year from 1982 to 1983. This company is known for releasing video games like Donkey Kong and Pac-Man. Anyone who followed Thornton's methods would have steered clear of this stock.

Starting point is 00:24:34 He writes here, an analysis of the balance sheet in 1983 would have indicated trouble ahead since Calico had an abnormally large inventory, one of the most certain signs of trouble ahead, end quote. Also, if we were to look back at past reports, you would have maybe recognized some other red flags. So in the 1973 letter, management touted their great year with significant progress, both in terms of sales and earnings, but the income statement showed their earnings fell by 50%. In 1974, management predicted an increase in earnings for the following year, and then in 1975, the company had one penny in EPS for the year, but managers remained confident in the future. After a history of poor predictions in terms of the business's performance,

Starting point is 00:25:21 they had yet another miss in their predictions, but for this one, their revenue targets were far exceeded. The video game market was taking off at the time, and Calico was along for the ride. In 1982, they predicted sales of $300 million, and actual revenues came in at over $500 million. Calico was now a darling on Wall Street, soaring sales, soaring earnings, and a soaring stock price. Calico was the only company producing home video game software for three systems, their own, Atari, and Mattel. There was also the talk of the Adam Home Computer, which the company would sell during the Christmas rush.

Starting point is 00:26:00 In the 1982 shareholder letter predicted revenues of $800 million for the following year, and one might infer record earnings as well. Now let's think about if you were a regular everyday investor at this time. You might pull up their annual report and see their rosy forecast predicting record sales, record earnings. You might see Calico on the front page of the Wall Street Journal talking about how hot the video game industry is and how all of the analysts that are following it are recommending investors to buy the stock. And you might even know somebody who got rich watching their portfolio

Starting point is 00:26:34 value skyrocket within weeks holding this stock. And you might also have your broker calling you, telling you to buy the stock. So when we look at the first nine months of 1983, Kaleiko earned $1.71 per share down from $1.93 per share from the following year. So the stock had fallen around 50% from the high, but the Bulls still had hoped. because Christmas season was going to hopefully bail them out. There were rumors that the Adam computer was having production issues to which management quickly denied. After a poor Christmas performance from the Adam computer, management said that sales would

Starting point is 00:27:14 pick up during the first quarter after the production issues had been addressed. When it was all sudden done, Colaco posted a 48-cent loss for 1983, and in 1984, the company had a $119 million ride-off on the Adam computer and a $4.95 per share loss. From the stock's high of $65 in 1983, it proceeded to trade down to below $10 per share. Had an investor been diligent in reviewing the filing sent out by the company and done proper analysis, they likely would have quickly ignored the buy recommendations put out by analysts and hung up on the brokers that called them pitching it for their accounts. Jumping here to a chapter on differential disclosures that I'd like to touch on here,

Starting point is 00:28:02 differential disclosures is simply a fancy way of saying what the company says in one document is substantially different than what's said in another document. It's a big red flag if you're able to catch this, and investors should proceed with caution. The reason this can exist is that some reports sent out by the company are meant to be read by stockholders or prospective stockholders with the intention of impressing them with charts that go up and to the right, big total addressable markets, and the company's amazing ability to execute. And then when you contrast that with things like the 10K and the 10Q, these are official reports that are filed with the SEC and they must conform to SEC guidelines.

Starting point is 00:28:43 Another way to put it is that the narrative portion of the annual reports is crafted by the PR team and the financial reports are compiled by accountants. That's not to say that the narrative portion isn't important because it can shed light on the company's strategy. They have the opportunity to share what numbers are in the financial statements and what they mean for the business and his future prospects. So I wanted to share an example he used with convergent technologies. The company reported 40 cents in earnings per share in 1983.

Starting point is 00:29:14 That was slightly down from the 1982 figure. The management team was quite optimistic. about the future of the company. They painted a very rosy picture, but the 10K wouldn't have excited investors nearly as much. The shareholder letter stated, 1983 was a year of progress and challenge for convergent technologies. And I immediately love the reaction that Thornton has here. He writes, now this word challenge always puts me on guard. Management often uses the word challenge to mean trouble. So while the shareholder letter left the subtle clues of the company going through a challenging situation, they didn't necessarily highlight what sort of challenges they were facing. Once you read

Starting point is 00:29:57 the 10K, you would have noticed that the ambitious goals in the entrepreneurial spirit would be significantly limited based on the information that was provided in the 10K. The point is that the SEC reports might require the company to release information that they would rather the shareholders not know, but they must release it in order to comply with regulations. Next year, let's talk about non-operating and non-recurring income. It's pretty self-explanatory, but non-operating income is simply income that is earned outside of the business's normal operations. I think we can all agree that Alphabet's normal operations include ad revenue from Google

Starting point is 00:30:37 Search or ad revenue from YouTube, but if they were to sell off one of their data centers for hundreds of millions of dollars, this should probably be considered a non-operating activity. Usually, it's fairly easy to tell what is operating and what is non-operating for a lot of businesses, but the difficulty lies when it's really up to the judgment of the accountants. What if Alphabet happens to sell off a portion of their data centers every few years? Perhaps it should be a part of their normal operations. The reason this is important to understand is because as an investor in a company, I want to know how the core operations of the business are doing. If there's a big non-recurring charge that significantly moves the earnings per share,

Starting point is 00:31:20 then I want to be able to make adjustments so I can see a clearer picture of what's actually happening with the core operations. This can also be tricky if you have a management team who's trying to intentionally hit their earnings targets or hit a certain number. So, for example, before the accounting rules were changed around how capital gains flow through the income statement for a company like Berkshire Hathaway, companies would be able to sell off a portion of their investment portfolio if they wanted to incur capital gains and then boost earnings. This, of course, can't be done forever, but it's another example of how management can sort of manufacture an EPS figure. Another great point by Thornton as it relates to this is that earnings

Starting point is 00:32:02 can go up over time, but the quality of earnings can go down. So many people can be fooled by increasing earnings in an increasing stock price, only to later realize that the business's underlying fundamentals have actually deteriorated. It reminds me of the conversation I had with Chris Mayer about his book, How Do You Know, back on episode 569? You want to understand what the numbers mean, not just what the numbers are. It's not important necessarily what the EPS number is to the exact figure, but what it really means for the business is what you really want to drill down to.

Starting point is 00:32:37 Why is that number what it is? One example that Thornton shares with regards to this company called Baldwin United, this company's core offering was a single premium deferred annuity, which was sold by some of the nation's top insurance brokers. In March of 1982, Baldwin acquired MGIC Investment Corp for $1.2 billion, and they borrowed $600 million to make the purchase. MGIC was the nation's largest non-governmental insurer, of home mortgages.

Starting point is 00:33:09 After the acquisition, the stock took off for the following year. For the first nine months of 1982, EPS before realized gains were up by 75% year over year, and a closer look at the earnings release tells a different story. Almost all of the company's earnings were attributed to a tax credit they had received, and Thornton highlighted in his Quality of Earnings report that if he took out all of the non-recurring items, the company actually had a net loss of nine months. million dollars for the first nine months of that year. Another big problem is that tax credits are not cash. Tax credits are nice to have if you're a profitable business, but this wasn't the case

Starting point is 00:33:48 with Baldwin. Tax credits can't be used to pay employees. It can't be used to pay big debts. One analyst had said, tax credits are filed for impressing shareholders, but they're not real money. You can't pay the bank with them. Over the months that followed, the stock fell from $50 to below $10, and in 1983, not long after the acquisition, the company filed for bankruptcy. Thornton writes here at the end of the chapter, the calculation of non-operating income requires digging into the reports and looking into the nooks and crannies and the notes. It's all there to be seen laid out in front of you, but all too often ignored by readers. As Sherlock Holmes once said, it is hidden in plain sight and investors must behave like detectives and ferreting out the information. Thornton also has a

Starting point is 00:34:36 chapter here on the impacts of declining or increasing expenses, which helps us further understand the quality of the earnings we're reviewing and how we can peel back the layers of understanding what the numbers really mean for us as investors. For example, investors might look at the reported EPS numbers and see that earnings have grown by 10% and believe that they're in good shape. However, you'll want to understand the reason for the increase in earnings, and if you do, you might come to realize that the growth isn't necessarily sustainable, or it won't be persistent due to factors that are contributed to that growth. Sometimes companies have a tailwind on EPS due to the changes in currency exchange rates. If Apple, for example, sells millions of phones in China,

Starting point is 00:35:20 and the Chinese yuan appreciates versus the U.S. dollar, then in U.S. dollar terms, EPS might get a boost simply due to factors that are totally outside of Apple's control. Thornton tells the story of another short seller named Bernard Smith, who was nicknamed Sellum Ben, who was allegedly going from broker to broker in 1929, telling them to sell all of their stocks because they weren't worth anything. During the bare market of the Great Depression, there was one industrial company which was bucking the trend and their stock was rising. This peaked Smith's interest, so he asked to see the management team only to be turned away at the production facility, so Smith, he wheezzled his way into the plan to take a look at what?

Starting point is 00:36:03 was going on inside. They had five big machines inside, and he noticed that in the middle of the day, that only one of them was running. So Smith took this as a sign that things weren't as good as they seemed. So he went ahead and shorted the stock with much success as it promptly fell on his next earnings released. Although markets are slightly more complex today, Thornton shares that one of the simple ways to foresee potentially disappointing earnings that lies ahead is to carefully analyze accounts receivable and inventory. Accounts receivable is the money due to the company from customers for goods shipped or services performed.

Starting point is 00:36:39 But accounts receivable isn't itself necessarily a problem, as about every company has some level of it. When asked about why accounts receivable analysis is useful, he essentially explained that abnormally high accounts receivable can signal that management is having trouble selling their inventory. And it may show signs of things like more liberal credit terms and or difficulty in obtaining payment from customers. When we consider the piece on more liberal credit terms, you can think about something like the auto industry, which is susceptible to swings in the broader economy. If the economy is weak, then they may make it easier for less credit-worthy buyers

Starting point is 00:37:19 to purchase a new car, which may then translate to a higher accounts receivable. It may also provide a clue as to whether management is simply shifting inventory from the corporate level to its customers because of a quote-unquote hard sell campaign for costly incentives. These types of issues might constitute that the company is borrowing from the future, so to speak, to help boost their short-term performance. In most instances, it's important to note that the sale is recorded by a company when the goods are shipped to the customer. As for inventories, he shared that higher trending inventories relative to sales can lead to inventory markdowns or write-offs if they're having trouble getting those goods actually sold to customers. Taking a close look

Starting point is 00:38:01 at inventories and accounts receivable can especially be useful in industries subject to rapid changes and products and tastes such as high fashion, seasonal goods, fads, or emerging trends. The example that Thornton shares in the book was Commodore International, which I'll refer to here as CBU. And this company produced microcomputers in the 1980s, which made for a prime candidate to look for irregularities in accounts receivables and inventories because products in this industry could be made obsolete in a matter of months. In the Q2, 1984 figures for sales and earnings, it showed a lot of promise. Sales were $1.3 billion and earnings were $143 million, both of which had increased rapidly from the previous year. Thornton, however, saw a number of warning signs.

Starting point is 00:38:48 company's founder had exited the business and a closer look at the financial statements painted a different story about their future. He laid out this simple table in the book that shows the net sales, the accounts receivable, and the inventories for CBU from 1982 to 1984. In the first year, sales had increased by over 100 percent and then sales growth slowed to just 16 percent the following year in 1984. Meanwhile, accounts receivable grew by 5 percent the first year and 34 4% in the second year. So with some basic common sense as a shareholder in this business, I would prefer to see solid sales growth that coincides with the steady or stable accounts receivables increase. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:42:44 other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. I think it's probably fine to see accounts receivables rise alongside sales, but in 1984, it's troubling to see that sales growth, it slowed dramatically, and then accounts receivable picked up. This shows that there might be some weakness in the business in getting customers to pay

Starting point is 00:43:12 for what was being sold, or potentially they've loosened the credit standards if customers are paying with credit. Thornton writes here, CBO's accounts receivable rose twice as fast as the company's sales. This is a clear sign that CBO's retailers were moving out its products at a slower than usual pace, while the company was shoveling out its old products in what looks like an attempt to dump them on the market in advance of new introductions, end quote. He also took a closer look at inventories. So inventories overall didn't look too concerning with a moderate increase of 9% in 1984. But if you pull back one layer deeper, you'll see that raw materials inventories were down while finished goods inventories were up. So it was pretty easy to see that finished goods

Starting point is 00:43:59 inventories were too high, and the company may be stuck with a lot of products that they might not be able to sell for a decent profit. Thornton doesn't stop there, though. In the Q3, 1983 report, He notes that the company had a note that stated that they were gearing up for strong sales growth for the near future and they were ramping up production. But just two quarters later, the company didn't make a similar reference, so presumably, since they've removed this note from forecasting these solid sales in the near future, one must assume that they must be having rough quarters that were just around the corner. Thornton promptly wrote in the Quality of Earnings report that he expected considerably lower

Starting point is 00:44:40 per share earnings when they reported their full fiscal year in June of 1985. Jumping to their Q1 release in 1985, things started to turn sour. Over the previous six months, sales were down, finished good inventories were up by over 80% year over year. Work in progress inventory was also up over 30%, which meant that there were more finished goods that were still in the pipeline to come in the future, and the market wouldn't be able to absorb these products. So in the quarters that followed, Thornton stated that a tidal wave and inventory write downs arrived, and the company reports a loss of $124 million in just one quarter.

Starting point is 00:45:21 So it's interesting how with these companies that sell a physical product and have these inventories, we're able to get somewhat of a glimpse into what the future might look like, especially when we see a sharp irregularity in the accounts receivables line or the inventory line. Next year, let's chat about debt and cash flow analysis. So debt, of course, is part of most companies' operations. So it's important to understand the company's capacity to cover their interest costs over time and to cover their debt levels. Thornton shares three ratios that we can add to our investing toolkit in assessing the

Starting point is 00:45:54 capital structure of a business. So first, we have the long-term debt to equity ratio. This is simply the long-term debt divided by the shareholders' equity. Second, we have the total debt to equity ratio. So this is the same formula except it just adds the current liabilities in the numerator. And then for the third equation we have here, we have the interest coverage ratio. This is simply the operating income divided by the annual interest payments. These ratios can help us understand the extent to which debt is used in financing a business

Starting point is 00:46:25 and the long-term ability of a firm to be able to service those debt payments over time. metric that Thornton likes to keep an eye on is the interest expense as a percent of normalized net income and how that ratio sort of evolves over time. So if this percentage is increasing, that either means that interest payments are increasing faster than income, which typically isn't a great sign, or that net income may even be dropping relative to that interest, which isn't a good sign either. Personally, I try to avoid any company that has moderate or excessive levels of debt in order to minimize the risk of the company going bust during a recession. Howard Marks once shared that when you go back and look at the bankruptcies that have occurred during previous crises,

Starting point is 00:47:10 excessive debt levels were essentially involved in every single one of them. Many of us who own a home probably have a mortgage on it, or if they don't have a mortgage they did at some point in the past, think about how hard it would be for the typical individual to not make their payments if they had their mortgage paid off. That helps illustrate the strength of a financial position the company can be in if they have minimal or even an appropriate level of debt. And Morgan Hausel wisely said that the more debt you have, the narrower the range of volatile outcomes one can endure. One great example of a company that is a great balance sheet and is nearly indestructible is Copart, which is a company I've discussed previously on the show.

Starting point is 00:47:53 Copart is a business that is a global online auction platform that specializes in the sales of used, salvaged, and repossessed vehicles. They connect buyers and sellers and offer a wide range of vehicles on their platform, and they own 13,000 acres of land as a part of their business model, and their main competitor decided to primarily lease their land, which puts them at a disadvantage comparatively. Copart is also an owner-operator business. The founder, Willis Johnson, still owns millions of shares and his son-in-law, Jay Adair, who's the CEO, owns over 25 million shares worth over $1 billion.

Starting point is 00:48:30 Now, as we've discussed on the show, owner-operator businesses tend to think long-term and be more conservative when it comes to debt. So when we look at Copart's balance sheet, we can see that they have current liabilities of $628 million, and they have zero long-term debt. And then we also have $7.5 billion in shareholders' equity. This gives us a total debt to equity ratio of around 8%. This is extremely low by most company's standards and shows that from a debt perspective, the managers operate the business very conservatively.

Starting point is 00:49:03 It's also worth mentioning that they have $1.5 billion in cash on the balance sheet, which essentially means that they have a net cash position and they could easily pay off these current liabilities should they want to. Thornton includes a chapter here on dividends as well, which I'll briefly touch on. When I first got introduced to investing, dividends were attractive to me because it was actual cash being deposited into my account, and for good companies, they tend to increase their dividends year after year after year. I have a different opinion on dividends today for two primary reasons.

Starting point is 00:49:36 First, dividends are tax inefficient, at least in the United States where I live. So the company you own pays taxes on the profits they earn, and then when you receive your dividend, you're also taxed on that as well. So this is what is referred to as a double tax. And then the second reason is that I typically look for companies that have a capacity to reinvest at high rates of return internally. So if a company can earn, say, 20% by reinvesting in new opportunities, then I don't want them to be paying me a dividend. And if a company is paying a big dividend, it typically signals that they don't have attractive opportunities to deploy that capital internally. Now, with that said, there are great companies that do pay out dividends.

Starting point is 00:50:19 Apple's paid out a dividend for many years, and it's been an exceptional stock, of course. There are many great businesses out there that have paid dividends for decades and have increased steadily over time, creating tremendous returns for shareholders along the way. So one thing I've noticed with some spectacular companies is the use of special dividends. So instead of a company continually increasing their dividend as much as they can, they play it on more of a conservative side. And when they have excessive levels of cash, they may decide to pay out that one-time special dividend.

Starting point is 00:50:52 This shows that the business is doing an excellent job at generating excess cash, and they aren't dogmatic about paying the best dividend they can every single quarter. So when we look at Costco, for example, they're currently paying a dividend of $1.16 per quarter, and they've done a number of special dividends along the way. So, for example, in December of 23, they paid a special dividend of $15 a share, and then in December of 2020, they paid out a special dividend of $10. What you want to look out for in dividend payers are those that take it too far. Sometimes companies can back themselves into a corner of having increased their dividend for many years

Starting point is 00:51:30 and do everything possible to keep that dividend going, even if it's not in the best interest of shareholders to do so. And then eventually they're just forced to cut the dividend significantly when things really start to turn south. I certainly don't want to have a company increasing their leverage just to ensure that a solid dividend is in place because it puts them in a more vulnerable position. Paying out a dividend, just for the sake of paying out a dividend, can of course lead to disastrous capital allocation decisions. When we study exceptional capital allocators, such as Dr. Henry Singleton from Teledyne, we can see the power of more optimal capital allocation decisions.

Starting point is 00:52:10 Singleton made it crystal clear with shareholders that there would be no dividends, which was a contrarian strategy at the time, given that investors like Ben Graham oftentimes favored dividends in the companies he owned. Instead went on what he called Operation Shrink, which led to a vastly reduced equity-based as the shares outstanding declined from $82 million in 1972 to just 11 million shares at the end of 1984, and that's an 85% reduction in the share count. During this period, EPS grew by over 70-fold, and the stock price increased by over 56-fold during that time.

Starting point is 00:52:49 So it's not that dividends are necessarily evil or we should never buy stock. that pay any dividends. They're just one way to allocate capital and return it directly back to shareholders. Next year, Thornton dives into the importance of accounting changes and understanding accounting more broadly. He writes here, there's an old tale told with great relish by veteran accounting professors regarding a firm in search of an accountant. The field narrowed it down to three, each of whom was interviewed and then asked to look at the books and calculate the firm's taxable income for the year. The first candidate said it was $2.3 million. The second said it was $2.4 million.

Starting point is 00:53:25 And then the third glanced around, pulled down the blinds and asked the board, how much do you want to show? And then naturally, he got the job. Now, I'm sure this story is a bit tongue-in-cheek, but it helps show that accounting metrics such as net income aren't exactly objective measures, or do they necessarily have to reflect economic reality? So to use a couple of examples here, generally accepted accounting principles permit a firm to ride off a factory over 20 years.

Starting point is 00:53:53 years using straight line depreciation. So if a company bought a property for $20 million, there would be $1 million in depreciation per year. So the company's books would suggest that after 15 years, the property would be worth around $5 million, but at that point, the property might be able to be sold for $30 million or more. Or we can consider what constitutes an asset. Intangible assets are increasingly becoming a more and more important part of a company's value, and companies will often understate the true value of things like patents, for example. Thornton jokes here in the chapter that the cure for an ailing PE ratio is simply an accountant with a sharp pencil and a sharper mind. Arthur Anderson is an accounting firm that put out a piece on the accounting magic

Starting point is 00:54:39 that can be performed and it can paint a completely different picture for two similar businesses. The accounting rules or illustrations they highlighted might be outdated, but the basic idea I think remains here. It showed how earnings of two businesses could have EPS figures that vary by more than 100%. I'll mention a few ways in which earnings can be different based on how accountants are applying their methods. So two different ways to account for inventory is last in first out, and first in, last out. And depending on how the inventory values are changing over time, the EPS will move simply based on which method is being used. Another one they noted was how research and development was accounted for. So one business might charge R&D as a one-time expense,

Starting point is 00:55:25 pushing it through the income statement, while another company might amortize it over a five-year period. And then one moral mention here is the use of incentives. So one company might pay out bonuses in cash, and then another might pay out using stock options, and that's going to affect your EPS. So when you read through all of these examples, you can easily see just how EPS can vary dramatically, which really has nothing to do with the actual performance of the company. It's all based on how the accountants are calculating it. This is why I think selecting great managers is just critical. When I'm partnering with great managers who are ethical people, I hopefully don't have to worry about them trying to hide anything or try and lead investors down a path that is just dishonest. It also brings the thought

Starting point is 00:56:10 experiment to mind where if you know a manager is high quality and taking the business in the right direction, and you're certain that there isn't any funny business with the accounting practices, then the market should value that company more on a PE basis than a similar company where the management quality isn't a certain. One also has to think about how many managers receive stock options, which may expire in one, two, or three years. Changing the accounting practices seems to me to just be such an easy lever that managers can pull to boost the EPS and thus boost the stock prices so they can realize the very

Starting point is 00:56:45 value of those options. So the final chapter here I'll cover is on restructuring when a company needs to turn around in the most severe situations. So perhaps management has faltered in the past due to incompetence, errors, or poor forecasting, or aggressive competitors have swooped in and stole market share. Or the company just got hit by some bad luck. Oftentimes, the business will be replaced with the fresh management team who will come in and claim that a turnaround is coming and some house cleaning is underway. This is what Thornton refers to as a big bath, which consists of riding off every dubious asset in sight. Marginal operations are sold for whatever they can get it for, and existing plant, equipment, and inventory are written down

Starting point is 00:57:28 to as low a level as management can defend to its outside auditors. This tends to be accompanied by a falling stock price and some poor earnings reports, while management claims that the worst is over and better times are right around the corner. Now, sometimes these are, restructurings are nothing more than an accounting maneuver. In other times, it will be real reform taking place that leads to a brighter future. Companies will realize all of the restructuring costs typically in one quarter or one year, while the benefits will be realized for the years that follow. Wall Street generally tends to favor a big sweep of rideoffs all at once rather than a series of them over time because it can tarnish the company's reputation. And sometimes the news

Starting point is 00:58:10 of restructuring can actually lead to an increasing stock price because it illustrates management's ability to admit to their mistakes and act on them. Plus, a lot of times you're going to see cost-cutting initiatives. They're implementing layoffs, which in the short term is going to boost EPS. Thornton came to the conclusion that typically restructurings are usually a sign that an improvement will soon transpire, and it's a signal to investors that a careful monitoring of the stock is in order. Upon preparing for this episode, I reached out to a member of our TIP Mastermind community who spent the past three decades operating his own forensic accounting firm to help crack

Starting point is 00:58:49 down on accounting malpractice, fraud, and corporate examinations. He is absolutely an expert when it comes to detecting fraud, and he mentioned to me that forensic accountants are looking for anomalies and that most CPAs will accept whatever answer that management gives them when they ask them about the numbers for the business and people like this member of the community, they really dig a layer deeper to really get to why the anomaly does exist. He pointed me to another resource called Quality of Earnings in M&A, the Ultimate Guide. And this was published by the president of Morgan and Westfield, which I'll be sure to get linked in the show notes for those who might be interested.

Starting point is 00:59:29 And for those in the audience who operate in the private equity industry or they're buying private businesses. You might also like this resource in doing due diligence on that front since this report focuses on M&A. And this book, Quality of Earnings, it also reminded me of a book I covered earlier this year called The Investment Checklist by Michael Schern. And this covered the art of in-depth research for stock investing. And I covered this book back on episode 656 in case you missed it and you're interested in checking it out. This book by Thornton really highlighted some of the red flags to look out for, but it didn't touch too much on what necessarily makes for quality earnings. So I wanted to touch just a little bit here on that as well. So Chapter 6 in

Starting point is 01:00:12 Michael Scherner's book is probably a good place to start for this, as he discusses evaluating the distribution of earnings. So one simple check is to simply compare the cash flow to net income. So management has less flexibility in manipulating cash flow, and net income can be more subjective. If the two align fairly closely over the past five years, and I think there's less of a chance that earnings are being manipulated. Generally, recurring revenue is more desirable than one-time sales, so recurring revenue is easier to value because it's more predictable. It might be difficult to predict how many cars Ford is going to sell next year, but it may be easier to predict the insurance premiums of an auto insurer because a lot of their business is recurring in nature.

Starting point is 01:00:58 It's also desirable to have revenues that are recession-resistant, and again, because they're more predictable. The market generally values companies higher, which are able to weather through recessions just fine. And we would also prefer capital light business models, you know, businesses with low fixed costs and low CAP-X requirements. So companies with high fixed costs tend to have a higher volatility in their earnings because they have operating leverage.

Starting point is 01:01:25 So when you think about a company like an airline or hotel or commodity producer, these tend to have higher fixed costs. So just a small change in revenue can impact the earnings significantly. And then one more point here, understanding working capital is usually important in understanding the quality of earnings. So companies with negative working capital can help fund their growth with little additional capital outlay. So this makes their earnings much more desirable or higher quality relative to a company with high

Starting point is 01:01:55 working capital needs. So there's a lot of other factors I could get into in thinking about the quality of earnings, but I think I'm going to leave it at that and link you to episode 656 in the show notes as well, because this is a good expansion of this discussion. So thanks so much for tuning in. I hope you enjoyed this episode. And if you're looking for a network of like-minded value investors, you may consider checking out our TIP Mastermind community. This is where Stig, Kyle, and I host weekly live Zoom calls. We have a few live events each year in person in New York City, Omaha, and London. And we talk stock ideas in the group, and we have a community of over 100 vetted members, which are typically private investors, portfolio managers, and high net worth individuals.

Starting point is 01:02:39 So we're actually looking to onboard five more great members here in November. So feel free to add your email to the wait list. That's at theinvestorspodcast.com slash mastermind. And you'll hear back from us shortly. That's Theinvestorspodcast.com slash mastermind. There you can learn more and add your email to the wait list as well. Feel free to also shoot me an email. That's at Clay at theinvestorspodcast.com. I'd be happy to get back to you when I have a chance to. With that, I hope to see you again next week. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts, or course go to the Investorspodcast.com.

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We Study Billionaires - The Investor’s Podcast Network - TIP672: Quality of Earnings: Uncovering Hidden Red Flags w/ Clay Finck

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