Thematic summaries
Hire and Fire: Employment as a guide to growth, creativity and performance - March 2018
Since 2011, aggregate real revenue growth has been mixed, ranging from up 2.7% in Japan to down 2.7% in Europe. Real profit growth shows a similar spread, negative in North America and Europe, positive in China. The vast majority of companies that grew hired more staff. Very few, typically under 10% of companies improved profits solely thanks to improved productivity or efficiency. The strong relationship between headcount, revenue and profit growth suggests hiring plans are a good lead indicator for growth, a sanity check for valuations/unrealistic expectations and a potential red flag for creative accounting. We learnt five important lessons ...
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Since 2011, aggregate real revenue growth has been mixed, ranging from up 2.7% in Japan to down 2.7% in Europe. Real profit growth shows a similar spread, negative in North America and Europe, positive in China. The vast majority of companies that grew hired more staff. Very few, typically under 10% of companies improved profits solely thanks to improved productivity or efficiency. The strong relationship between headcount, revenue and profit growth suggests hiring plans are a good lead indicator for growth, a sanity check for valuations/unrealistic expectations and a potential red flag for creative accounting. We learnt five important lessons ...
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Creative accounting: A rising tide does not lift all boats, some still sink - November 2017
Even in a bull market, some stocks will fall. Since November last year, the S&P is up 18%, the DAX 24% and the Nikkei 25%. Nonetheless, 27% of our core focus stocks fell and 31% underperformed their index by 10% or more. Some of this is industry related, but much of it is company specific, often where dubious accounting has been found out. Our creative accounting test, the GAP score, flagged many of these companies, which meant that, in a global portfolio, our low scores (good) performed well, up 9.5% vs the index, and high scores badly, up 0.8%. We missed some losers, particularly commodity stocks, because we don’t forecast revenue change and some others which we flagged, rose. Nonetheless, our key thesis, that creative accounting leads to losses and underperformance, seems intact. In this report, we analyse the factors that worked best and introduce modest weights to help pick next year’s worst performers...
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Even in a bull market, some stocks will fall. Since November last year, the S&P is up 18%, the DAX 24% and the Nikkei 25%. Nonetheless, 27% of our core focus stocks fell and 31% underperformed their index by 10% or more. Some of this is industry related, but much of it is company specific, often where dubious accounting has been found out. Our creative accounting test, the GAP score, flagged many of these companies, which meant that, in a global portfolio, our low scores (good) performed well, up 9.5% vs the index, and high scores badly, up 0.8%. We missed some losers, particularly commodity stocks, because we don’t forecast revenue change and some others which we flagged, rose. Nonetheless, our key thesis, that creative accounting leads to losses and underperformance, seems intact. In this report, we analyse the factors that worked best and introduce modest weights to help pick next year’s worst performers...
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Ratings vs. reality: Credit spreads vs. credit quality - November 2017
Most of the time, bonds trade broadly in line with their credit rating, only to drop suddenly when troubles arise. We suspect that the reason that ratings follow rather than anticipate problems is partly because rating agencies are paid by the companies they cover and partly because their metrics are well publicised. This gives the enterprising CFO plenty of opportunity to game the system. In this report, we use our creative accounting metrics to search for bonds where it looks as if the company’s credit rating and its business reality have diverged. We test for window dressers by comparing interest costs to coupon payments, and for profit creativity by cross-referencing profits with cashflow, taxes and auditing costs. We then compare credit ratings with our GAP scores and re-rate the bonds. Our Companies to be investigated lists the investment grade bonds that are in danger of being downgraded...
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Most of the time, bonds trade broadly in line with their credit rating, only to drop suddenly when troubles arise. We suspect that the reason that ratings follow rather than anticipate problems is partly because rating agencies are paid by the companies they cover and partly because their metrics are well publicised. This gives the enterprising CFO plenty of opportunity to game the system. In this report, we use our creative accounting metrics to search for bonds where it looks as if the company’s credit rating and its business reality have diverged. We test for window dressers by comparing interest costs to coupon payments, and for profit creativity by cross-referencing profits with cashflow, taxes and auditing costs. We then compare credit ratings with our GAP scores and re-rate the bonds. Our Companies to be investigated lists the investment grade bonds that are in danger of being downgraded...
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Tax matters: Creative accounting and tax laundering - September 2017
Tax matters because not only does it affect shareholder returns and valuations, it also gives a good indication of the real level of cash earnings behind profits. For most companies, their tax expense is close to their national tax rate, but we have found disparities. Part of this is geographic. The spread in tax rates between countries means that Internationals and Domestics often legitimately pay different rates. Some of the variance is also industry-driven. Moreover, tax expensed is not the same as tax paid. While there are multiple reasons for tax deferrals, most are short-term and wash out quite quickly. However, at some companies, even when we adjust for geography and industry, the discrepancies persist. At these companies, we think investors should start asking why and how the company is constantly able to book non-taxable profits. Finally, we have a look at the OECD’s Base Erosion and Profit Shifting (BEPS) programme. This was set up in the wake of various profit shifting scandals and aims to prevent jurisdiction ‘shopping’, where companies seek to declare their profits in places with the most favourable tax rates. BEPS will make it harder, and more tax will be paid where revenue is generated...
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Tax matters because not only does it affect shareholder returns and valuations, it also gives a good indication of the real level of cash earnings behind profits. For most companies, their tax expense is close to their national tax rate, but we have found disparities. Part of this is geographic. The spread in tax rates between countries means that Internationals and Domestics often legitimately pay different rates. Some of the variance is also industry-driven. Moreover, tax expensed is not the same as tax paid. While there are multiple reasons for tax deferrals, most are short-term and wash out quite quickly. However, at some companies, even when we adjust for geography and industry, the discrepancies persist. At these companies, we think investors should start asking why and how the company is constantly able to book non-taxable profits. Finally, we have a look at the OECD’s Base Erosion and Profit Shifting (BEPS) programme. This was set up in the wake of various profit shifting scandals and aims to prevent jurisdiction ‘shopping’, where companies seek to declare their profits in places with the most favourable tax rates. BEPS will make it harder, and more tax will be paid where revenue is generated...
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Debt manipulation: Flushing out window-dressing and overvaluation - July 2017
A debt manipulator has one great advantage: the balance sheet is only valid for a single point in time. Using some relatively simple techniques, the creative accountant can turn working capital into cash, de-gear the balance sheet and produce cash flow out of thin air, resulting in a set of accounts that meet credit requirements and keep investors happy, while glossing over the reality. Fortunately, such manipulation does leave tracks; excessive debt churn (the constant raising and repayment of debt), unusual working capital ratios and higher than expected credit costs. We have built benchmarks for all these measures and created some appropriate credit ratings. For each region, we have 10 investment grade companies that should be downgraded and 10 others whose accounts look rather unusual...
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A debt manipulator has one great advantage: the balance sheet is only valid for a single point in time. Using some relatively simple techniques, the creative accountant can turn working capital into cash, de-gear the balance sheet and produce cash flow out of thin air, resulting in a set of accounts that meet credit requirements and keep investors happy, while glossing over the reality. Fortunately, such manipulation does leave tracks; excessive debt churn (the constant raising and repayment of debt), unusual working capital ratios and higher than expected credit costs. We have built benchmarks for all these measures and created some appropriate credit ratings. For each region, we have 10 investment grade companies that should be downgraded and 10 others whose accounts look rather unusual...
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Pension problems: Sacrificing the staff for bigger bonuses - May 2017
Falling interest rates and ageing populations that live longer are proving to be a toxic combination for defined benefit pension plans and, despite many plans being closed, pension deficits continue to grow. Although deficits are no longer a surprise, we suspect investors and pensioners have yet to focus on the detailed assumptions used by managements and how they might affect pension solvency, valuations and corporate strategies. In many cases, pension discount rates and forecast returns have fallen, but nowhere near enough. We are particularly concerned that some companies appear to be intentionally understating their deficits and, in the worst cases, managements are also levering up their businesses to raise stock returns and thus their own compensation, while running a deficit. We think such strategies put both pensions and companies at risk...
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Falling interest rates and ageing populations that live longer are proving to be a toxic combination for defined benefit pension plans and, despite many plans being closed, pension deficits continue to grow. Although deficits are no longer a surprise, we suspect investors and pensioners have yet to focus on the detailed assumptions used by managements and how they might affect pension solvency, valuations and corporate strategies. In many cases, pension discount rates and forecast returns have fallen, but nowhere near enough. We are particularly concerned that some companies appear to be intentionally understating their deficits and, in the worst cases, managements are also levering up their businesses to raise stock returns and thus their own compensation, while running a deficit. We think such strategies put both pensions and companies at risk...
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Boards, not turkeys: Stop the stuffing - December 2016
In this report, we compare board size and company performance around the World. We note that the largest company by market capitalisation only has 8 directors and the largest by revenue only 16. It is, therefore, hard to see why anyone needs more. Large boards are not only unnecessary, the companies they manage typically have worse performance than their smaller peers, whether compared by country or industry. We also check for creative accounting using the Bucephalus G.A.P. Scores and see that larger boards usually have higher, or worse, Governance, Accounting risk and Peer performance scores...
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In this report, we compare board size and company performance around the World. We note that the largest company by market capitalisation only has 8 directors and the largest by revenue only 16. It is, therefore, hard to see why anyone needs more. Large boards are not only unnecessary, the companies they manage typically have worse performance than their smaller peers, whether compared by country or industry. We also check for creative accounting using the Bucephalus G.A.P. Scores and see that larger boards usually have higher, or worse, Governance, Accounting risk and Peer performance scores...
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Exposing creative accounting: It's not just fraud - December 2016
Our analysis shows that, across the spectrum, changes in profits are the single most reliable driver of long term portfolio performance. Unfortunately, future earnings are far more difficult to forecast if you’ve been misled about the present. Company management has incentives to inflate profits and asset values, while obscuring liabilities, and this is exacerbated by performance-related pay. Audit fees would suggest that auditors are unlikely to challenge management, whether it be over-optimistic assumptions, the choice of flattering accounting treatments, and/or selective disclosure, and this, combined with legally correct but potentially misleading language, can eventually carry a heavy cost. In the end, reality always trumps the accounting fiction, and investors lose out...
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Our analysis shows that, across the spectrum, changes in profits are the single most reliable driver of long term portfolio performance. Unfortunately, future earnings are far more difficult to forecast if you’ve been misled about the present. Company management has incentives to inflate profits and asset values, while obscuring liabilities, and this is exacerbated by performance-related pay. Audit fees would suggest that auditors are unlikely to challenge management, whether it be over-optimistic assumptions, the choice of flattering accounting treatments, and/or selective disclosure, and this, combined with legally correct but potentially misleading language, can eventually carry a heavy cost. In the end, reality always trumps the accounting fiction, and investors lose out...
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Important
This note is written with the sole purpose of highlighting some issues we think are important.
It is not a recommendation to BUY or SELL any of the securities mentioned and should not be taken as such.
Readers should form their own opinions about the company and seek appropriate advice.
Please read the Bucephalus disclaimer.
This note is written with the sole purpose of highlighting some issues we think are important.
It is not a recommendation to BUY or SELL any of the securities mentioned and should not be taken as such.
Readers should form their own opinions about the company and seek appropriate advice.
Please read the Bucephalus disclaimer.