Company Reports

What should I invest in?

Invest in a good company with excellent long term prospects and whose share price is undervalued...

And what does that actually mean?

Well, a long term prospect would be a 'non-bubble' — i.e. something that has a continuing steady growth potential. These are the best investment opportunities for the small investor — he can simply buy and hold, ignoring market turbulence. But it is a lot harder to identify these companies than you would think. Undervalued, simply means cheap by whatever definition of cheap you find meaningful; in truth it is an arbitrary and meaningless phrase. Identifying a company that you would want to invest in needs some consideration of how businesses start and grow.

The dynamics of business competition tends to follow a pattern; the initial discovery or invention, followed by the creation of a new market, the initial innovators expand quickly, fast growth follows, and profits rise; the profitability of the sector leads other competitors to enter it and competition grows. Because of this competition, prices fall, as do profit margins; the market reaches saturation, with some of the competitors dropping out, and winners emerging, tending to either form a monopoly if there is only one, or a cartel if more than one; once this happens, prices will be hiked and the consumer bled white. At this — quite natural endpoint — government action is necessary, and may intervene in order to artificially create competition (if they have not been persuaded otherwise by the companies lobbyists).

If you can identify the future winners in this cycle of development, then you have found an investment opportunity. The two main players of interest would be the initial innovators who will make a lot of profit in their early growth phase, and of course, the eventual winners. But again, identifying these is not easy, and so what is an attractive share price is highly questionable; even if one can reliably identify a future growth area, e.g. genetic medicine will become huge in the coming decades — predicting who will succeed with it is very difficult. Consider the change in the number of computer manufacturers between today and 1975 — many of these '1975 firms' have gone bust or been taken over, despite (sometimes) having good/superior technology and decent management.

StockWave, of course, pushes a certain agenda; and we are upfront about it — the private investor should trade actively, using sophisticated strategies, doing his own analysis, on his own behalf, and keeping well-clear of fund managers, stock-pickers, and all the various gurus. Having accepted this argument to a large extent, the user may wish to only go half-way, i.e. to try and do DIY trading, but only using a long-term buy and hold strategy, with very little active trading, as it seems so much safer and easier. We believe this is a fallacy — while it is easier, it is by no means safer, and the returns are unlikely to be spectacular. We are not against this strategy per se, but simply point out that choosing the 'right company' to use with this strategy is not any easier than opting for the active-sophisticated approach. If you can spot the next Microsoft, then by all means, pile in with your cash. Good luck!

What is a 'good' company?

Check the numbers — do they add up? Check the bottom line!

And where do I find the numbers? Where is the bottom line?

Difficult to say really.

The usual answer is in the Company Report — this is its purpose at least; the company puts together a report so that its shareholders and potential investors can see what it is doing and how well it is being run, and thus evaluate its prospects as an investment in an accurate manner, from a thorough analysis of its cash-flow and so on, its so-called 'fundamentals'. Truthful and accurate company reports should, in theory, be the principal tool for the investment scenario of section one, alas, recent events have made these claims somewhat laughable, and there are those who would claim that this has always been so.

The harsh truth about Company Reports

Company reports are full of lies.

Sometimes it is a small piece of spin-doctoring, at other times it will be a black enormous falsehood — but reports are full of them.

Consider the ideal simplicity of company reporting — take the money you got from what you sold — subtract from it what it cost to make your product, and this is your profit. Now pay tax on this at the going rate, and what is left is your net profit. Shareholders buy stock to have a share in this profit, and the share price should reflect the ability of a company to make profits — simple really. Good companies make money, bad companies lose it. Ultimately, the value of a share in a company has to be related to the ability of the company to make this profit. (The slippery word in this sentence is the word ultimately, but it would take too long to discuss.)

This is simple arithmetic an 8-year-old could do, and a fact so obvious it is never stated — so why does an entire profession exist to calculate these numbers? Why does it take 7 years to become an accountant? The only conclusion one can make is that company accounts and reports are designed to hide the truth rather than reveal it. So what can the ordinary investor do against this Priesthood with its arcane and confusing language and rituals? Is there any point in even reading a report? Perhaps. Despite the obscurantist nature of the company report, there are fairly strict rules which govern what can be presented as fact. Obvious blatant lies are illegal, of course, and even within the rules a company still has great scope for presenting itself as being well-run, efficient, profitable, visionary, etc. We must assume that any company of any size has the resources to employ 'good' accountants and has stretched the rules to their very limit to present themselves positively. Once one realises this one can try to correct for the spin which is present.

Lets look at a specific example to watch out for — exceptional items.

Exceptional items are, well, exceptional. one-offs, highly unusual, special events. Presenting something as an exceptional item is meant to say that it is not something which would normally happen. Consider the case where a company has made a small loss — 'bad' we say, but the loss was due to an exceptional item. We could then say, this is a 'good company', and really, it makes a strong underlying profit.

The trouble with this is that certain companies have a habit of reporting large exceptional items year in, year out, making them rather, er, un-exceptional. 'Extraordinary items' is another similar kind of thing, coming from US accounting practice.

The point is that we can get something useful from the report, if we read it in a certain way, always aware of the usual tactics, and looking for that which is anomalous — in the report, watch for negative and positive language; the tense involved, blatant fluff, obscure and meaningless phrases, management-bullshit-corporate-speak, lack of discussion of certain things, hype-ing of other things. Overall, the individual numbers will mean nothing, only taken together do they have meaning. A good forensic accountant will be able to smell a company report and know intuitively what is really going on. We don't have the experience or training, but with sufficient exposure, one will develop this intuition. Trust your hunches, and do some detective work — look for evidence which corroborates what they are saying. Once you grasp this simple fact, things should fall into place for you.

Of course, there are those who may point out that there are an enormous amount of rules regarding proper accounting, and in particular, US style quarterly reporting with simultaneous release of information to the market, seems much fairer to the private investor, but the more rules, the more possible loopholes there can be. A particularly shady practice is Programme Accounting, the use of which makes the accounts almost meaningless — what this allows you to do is to book all future expected profits upfront, and book costs incurred as depreciation over a period of years. This, have-your-cake-eat-it-now-pay-later idea, can be used to massively inflate profits. A number of large US companies use this.

In general we expect everything in the company's own report will be presented in the best possible light — any bad news will only be reported in the financial and general press; the 'books are cooked', whether lightly simmered, or flame-roasted, but they are cooked.

What this means is that starting from the report we have to do some detective work to assemble our jigsaw of information.

So what are these, pieces of the jigsaw, these pieces of information?

  • The company report, i.e. what it is that they say about themselves

Now add in what other people say about them — this must corroborate what is in the report, and if it doesn't then we know something is wrong.

  • News stories
  • Layoffs and expansions
  • Court cases, especially in the fantastically litigious USA
  • New products
  • Management changes
  • Industrial disputes
  • Share dealings, especially directors
  • Borrowings
  • Investments
  • Spend on plant, R & D
  • Governments grants, loans, subsidies, tax breaks, write-offs
  • The status of their competitors
  • Unreported stuff — but present in newsgroups, bulletin boards (but always accepted with some skepticism)
  • Potential risk exposure, e.g. derivatives, lawsuits, investments

And for each piece of information one must also ask

  • Where did it come from? When did it originate? Is this reputable? Could the story be planted?
  • Who said it? What are their motives? Is it malicious scare-mongering or honest journalism?

When you gather all these pieces together, and arrange them just-so, a strange thing can happen; suddenly, 'it all becomes obvious'. The important thing is to ask the right questions and to keep asking them, and to get answers from as many sources as possible, until you get to this point of insight.

Post Enron, WorldCOM, Andersen, Parmalat...

The above was written before the Enron, WorldCom, Marconi, Andersen affairs.

At the time, the views expressed would have been regarded by most commentators as controversial, not to say 'cynical', and many who would broadly agree with the sentiment would nevertheless have felt that the forthrightness of its expression was unjustified. Alas, given recent events, my comments seem quite tame in hindsight — that, broadly speaking, corporate figures are massaged and spun, but that blatant corruption is only occasional and infrequent.

It was Joseph Goebbels, the infamous Nazi propagandist who developed the notion of the Big Lie — i.e. that the more outrageously untrue something was, the more likely it was to be believed; now apply this to your companies accounts, do not bother with the cheap tax dodge, the paltry massaging of a few hundred thousand in the right direction, the spurious expenses claim, the business item that was used for personal use; instead why not simply eliminate all costs from your balance sheet — don't bother with a measly 850K scam, go for the 850 million!

Alas, it seems that accountancy and auditing malpractice is systemic, at least within the US; and I would believe also the UK and the rest of Europe is unlikely to be significantly better placed. It is likely a lot more large companies will find themselves in trouble as it becomes their turn to face the spotlight. Currently, there is much talk of reforms and new laws, but little practical efforts — it looks like a couple of high profile scapegoats will be turned out for public consumption, then back to business as usual.