Deep Study Of The Financials Pays Off

On August 2, 2017, shares of M/A-Com Technology Solutions Holdings (MTSI) plummeted by 25%. The semiconductor’s third-quarter revenue, gross margin and adjusted earnings per share all came in below consensus estimates. M/A-Com surprised the market with new fourth-quarter revenue and earnings guidance well below prevailing consensus forecasts.

Not everyone was surprised by these developments, however. In February 2015, analyst Sam McBride of the independent research firm New Constructs had pointed out that M/A-Com’s adoption of a new “sell-in” method for recognizing sales to semiconductor distributors raised the possibility that the company was engaging in channel-stuffing. A tipoff, said McBride, was that the company’s days sales outstanding increased by 14% year-over-year in 2015’s second quarter.

Two-and-a-half years later, when MTSI lost a quarter of its market value in one day, Cowen’s Paul Silverstein reported that channel checks indicated that M/A-Com had experienced a larger-than-expected inventory buildup in China. That was consistent with a channel-stuffing explanation for the guidance shock, if not necessarily definitive proof. A year-and-a-half later, when the company’s chief financial officer resigned, management felt compelled to specify that the abrupt departure was not related to any matters involving financial statements or accounting practices.

This vignette is one of many in Financial Statement Analysis: A Practitioner’s Guide, Fifth Edition, published this month by John Wiley & Sons, that affirm the value of digging deeply into the numbers. The case studies provided by my coauthor Fernando Alvarez and I challenge the notion that securities prices invariably reflect all publicly available information. Sometimes, vital information is available only after conscientious analysts look beyond companies’ rosy depictions of reality. Furthermore, the market does not always pay attention to the resulting revelations before the chickens come home to roost.

Consider the February 8, 2012 announcement by Diamond Foods (DMND) that it would restate its earnings for the previous two years. The stock fell as much as 44% in afterhours trading that day. One day later, both the chief executive and the chief financial officer were fired.

Were the problems in the snack food producer’s financial reporting unforeseeable? Hardly. Five months before the massive destruction of shareholder value, Off Wall Street Consulting analyst Mark Roberts had questioned Diamond’s accounting. He estimated that proper booking of costs would have produced earnings per share as much as 47% lower than the company had reported for fiscal 2011. Using the Department of Agriculture’s estimate of the size of the 2010 walnut crop and prices he obtained from walnut growers, the Wall Street Journal’s John Jannarone generated an estimate, which subsequently proved fairly accurate, of the amount that Diamond subsequently admitted was booked in the wrong period.

Another example of painstaking financial statement analysis that paid off handsomely involved Globo, an Athens-based producer of mobile-device software. In January 2014 Ennismore Fund Management reported it had discovered a number of errors in the company’s audited financial statements, as well as instances of unclear disclosure. In a classic red flag, Globo fired its auditor in 2014’s first quarter.

Investors who paid attention to these signs of trouble were not caught off guard when, in October 2015, Globo requested a suspension of trading in its shares. By then, the company’s share price was down by more than 50% from its peak of four months earlier. Events came to a head when a research report by Quintessential Capital Management labeled Globo a fraud. Four days later after that report appeared, Standard & Poor’s drastically downgraded the company from BB- to CCC.

These are not instances of 20/20 hindsight, but quite the opposite. By rolling up their sleeves and applying basic techniques such as ratio analysis and by searching for internal discrepancies in financial statements, fundamentally focused analysts detected trouble well ahead of time. They refused simply to take companies’ reported profits at face value, with good reason. Experience teaches that some corporate managers knowingly misrepresent their results if it will boost their companies’ share prices and, by extension, inflate the value of the stock option component of their compensation.

In this age of high-frequency traders whose algorithms respond in fractions of a second, it is all but impossible for ordinary investors to get an edge by adjusting their portfolios for news flashes. Paradoxically, some of the best trading opportunities arise from information that has long since been available, but has not yet been incorporated into securities prices. Ferreting out that valuable information by scrutinizing financial statements is an arduous process, but the examples discussed above show that the payoff can make it well worth the effort.

Martin Fridson is editor of Forbes/Frisdon Income Securities Investor.