Create articles from any YouTube video or use our API to get YouTube transcriptions
Start for freeIntroduction
As value investors, we're always looking for ways to gain an edge in analyzing companies and making investment decisions. One critical skill is the ability to look beyond headline earnings numbers and assess the true quality of a company's earnings. In this article, we'll explore key concepts from Thornton O'Glove's book "Quality of Earnings" and provide practical tips for evaluating financial statements.
The Importance of Quality Earnings Analysis
Earnings can increase over time, but the quality of those earnings may deteriorate. Many investors are fooled by rising earnings per share (EPS) and stock prices, only to later realize that the underlying business fundamentals have actually worsened.
As O'Glove states:
"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."
Simply looking at headline EPS figures without digging deeper can lead to poor investment decisions. We need to understand the drivers behind the numbers and assess their sustainability.
Don't Trust Your Analyst
One of O'Glove's first tips is to be skeptical of sell-side analyst recommendations. There are several reasons for this:
- Analysts tend to have an inherent bullish bias. People don't want to pay for advice on what stocks not to buy.
- From 1981-1984, 86% of brokerage house recommendations were either neutral or buys. Only 12% were sells.
- Analysts often need to maintain good relationships with company management, making them less likely to issue negative reports.
- Spending a lot of time with a company can lead to analysts falling in love with the stock due to the liking bias.
- Analysts may get most of their information directly from the company, which tends to paint an overly optimistic picture.
Instead of relying on analyst reports, O'Glove recommends doing your own deep analysis of company filings and financials. This allows you to form an independent view.
Be Cautious of Auditor Opinions
While audited financial statements provide some assurance, O'Glove cautions against blindly trusting auditor opinions. Some key points:
- Auditors are paid by the company they are auditing, creating potential conflicts of interest.
- Firms may treat audits as a commodity and go "price shopping," potentially leading to lower quality audits.
- Audit firms often use audits as a gateway to pitch higher-margin consulting services.
- Finding irregularities could jeopardize other business with the client.
The takeaway is that we need to do our own analysis rather than simply relying on the auditor's sign-off.
Analyzing the Shareholder Letter
The annual shareholder letter can provide valuable insights, but needs to be read critically. Some tips from O'Glove:
- Look for discussion of problems and potential solutions. The best managers, like Warren Buffett, are transparent about mistakes and how they'll be addressed.
- Be wary of excessive jargon and overly optimistic language.
- Compare past letters to see if rosy forecasts came true.
- Watch for removal of previously included metrics that may signal deteriorating performance.
O'Glove provides an example of International Harvester's 1980 letter, which painted an overly optimistic picture despite the company's struggles. Reading between the lines and comparing to the financial statements would have revealed red flags.
Differential Disclosures
O'Glove coined the term "differential disclosures" to describe when a company says substantially different things in different documents. This is a major red flag.
For example, the narrative portion of an annual report (written by PR) may paint a rosy picture, while the 10-K (compiled by accountants) reveals serious issues. Carefully compare different company communications to spot inconsistencies.
Non-Operating and Non-Recurring Income
It's critical to distinguish between a company's core operating income and one-time gains or non-operating income. Some key points:
- Non-operating income comes from activities outside normal business operations (e.g. selling off assets).
- Management can use non-recurring gains to manufacture earnings and hit short-term targets.
- Focus on the quality and sustainability of core operating income.
- Be wary of companies relying heavily on non-operating or one-time gains to meet earnings expectations.
Analyzing Expenses
Closely examine expense trends to understand earnings quality:
- Watch for declining expenses that may not be sustainable long-term.
- Currency fluctuations can provide temporary earnings boosts.
- Cost-cutting initiatives may provide short-term EPS gains at the expense of long-term competitiveness.
Debt and Cash Flow Analysis
Understanding a company's debt levels and ability to service that debt is crucial. O'Glove recommends these key ratios:
- Long-term debt to equity ratio = Long-term debt / Shareholders' equity
- Total debt to equity ratio = (Current liabilities + Long-term debt) / Shareholders' equity
- Interest coverage ratio = Operating income / Annual interest payments
Also monitor interest expense as a percentage of normalized net income over time. An increasing percentage may signal trouble.
Companies with minimal debt tend to be more resilient during economic downturns. As an example, Copart (CPRT) has an extremely conservative balance sheet with no long-term debt and $1.5 billion in cash.
Dividends
While dividends can be attractive, O'Glove cautions against focusing too heavily on them:
- Dividends are tax-inefficient in many jurisdictions.
- High dividends may signal a lack of attractive reinvestment opportunities.
- Some companies back themselves into a corner trying to maintain unsustainable dividends.
- Special dividends can be a good way to return excess cash without committing to ongoing payouts.
Focus more on the overall capital allocation skills of management rather than dividend yield alone.
Understanding Accounting Changes
Accounting rules allow for significant discretion in how earnings are calculated. Some examples:
- Inventory valuation methods (LIFO vs FIFO) can significantly impact reported earnings.
- R&D expenses can be charged immediately or amortized over time.
- Stock options vs cash bonuses have different EPS impacts.
This flexibility means reported earnings don't always reflect economic reality. Having high-quality, ethical management becomes even more critical.
Restructurings and "Big Bath" Accounting
When companies announce major restructurings, be cautious:
- The "big bath" involves writing off every questionable asset at once.
- Benefits are realized over future years while costs are taken upfront.
- Sometimes restructurings are more accounting maneuvers than real reform.
- Cost-cutting and layoffs can boost short-term EPS at the expense of long-term competitiveness.
Carefully monitor companies post-restructuring to see if real improvements materialize.
Characteristics of High-Quality Earnings
While O'Glove focused more on red flags, it's also helpful to understand what constitutes high-quality earnings:
- Cash flow closely matches reported net income over time
- High percentage of recurring revenue
- Recession-resistant business model
- Capital-light operations with low fixed costs
- Negative working capital to help fund growth
Companies exhibiting these traits tend to have more predictable, sustainable earnings that the market often values more highly.
Conclusion
Developing the ability to analyze earnings quality is a critical skill for value investors. By looking beyond headline numbers and digging into the details of financial statements, we can gain insights that the market may be missing.
Remember O'Glove's core message - don't blindly trust analysts, auditors, or management. Do your own deep research and form independent views. With practice, you'll be better equipped to spot both red flags and hidden gems in the market.
While it requires more work than simply looking at P/E ratios, quality of earnings analysis can provide a real edge. In a market where most stocks underperform, having the skills to identify truly high-quality businesses can lead to superior long-term returns.
Article created from: https://www.youtube.com/watch?v=xfrlfeeD2gM