Monday, August 24, 2015

August 24 2015 Special: Volatility + Fear is a good combination for long term investors

What exactly happened today? Near the open, the futures were pointing to a negative start to the day but nothing too extreme. The S&P 500 was down 2-3% but the decline accelerated to near 5% at the opening bell. Stocks rallied heavily until losses were less than 1%. However, by the closing bell, stocks began to show losses again with major indices closing about 4% lower. A ride of down 5%, up 4% and then down 3% in a matter of 6.5 hours is not normal. It's no wonder that the CBOE VIX Index, nicknamed the "fear gauge", soared to levels not seen since spring of 2009 (even higher than the U.S. debt ceiling crisis in 2011). Fear was evident in the market.

Potential Explanations:
Most market commentators and analysts would point to China, which set the stage for today's turbulence. The Shanghai Composite lost another 8.5%, erasing most of the gains it made this year. The fact that the government was unable to stop the market from declining, even with hundreds of billions of dollars pumped into the system, made investors extremely nervous. With the recent Yuan (RMB) devaluation and a slowing PMI number that came out late-last week, investors worry that a Chinese economic slowdown would significantly impact global growth. 

Investor's fear about China also leads them to evaluate some of the other potential negatives in the market such as weak earnings growth and the negative effects from oil's rapid decline from $60 (late June) to below $40. The large capital expenditure reductions by many energy companies have been impacting growth numbers in Canada and as well as United States. The high yield market has also been hurt by the increased distress in energy names and we just saw the bankruptcy of Samson Resources last week. 

Investor's confidence was pretty shaky to begin with. After a 8.5% decline in Chinese markets and the continued decline in oil, many investors would prefer to sit this one out and run for cover. 

A Lehman Moment:
Some analysts argued this could a Lehman moment brewing. I think that's an overstatement. 

First, the fact that the Dow dropped 588 points - more than the 508 point it lost on September 15,2008 after Lehman was bankrupt - doesn't mean we're in a crisis. The index was at a much lower level back then and in percentage terms, today's 3.6% decline was much lower than the 5% decline on September 15, 2008. 

Second, it's important to understand that the Lehman failure caused a credit crisis, not a stock market panic. The credit crisis stopped the credit market from functioning properly, a key criteria for a prosperous economy. When money markets, which are suppose to guarantee your principal, lose money (due to Lehman debt), that's when credit/bond investors get really nervous and essentially refused to re-finance the money market, which eliminated liquidity of many corporations. With no liquidity to pay bills, even corporate giants like GE and Honeywell faced bankruptcy even with enormous assets and future cash flow generation ability.  

It is worth noting that a credit crisis is less likely now because:
  • Better Bank Balance Sheets: Due to the new Basel III banking regulations, the need to deleverage balance sheet became important. Many banks already got ahead of regulator's time schedule of the Leverage Ratio (basically an asset to capital multiple) implementation and sold off risky assets to meet that new rule. Because banks are important credit and liquidity providers to the financial system, healthier banks means lower chances of a credit crisis. 
  • More liquidity at the banks: This point is very important. Before the financial crisis, many banks borrow extremely short funds in the repo market. When the credit markets froze, they couldn't refinance and faced a cash crunch. However due to new Basel III rules on the Liquidity Coverage Ratio, banks are holding liquid assets enough to fund cash outflows for a minimum of 30 days to a maximum of 1 year. This new rule reduces the risk of bank failures and decreases of credit in the economy. 
  • High Yield Spreads Looks Reasonable: High Yield spread provides a good signal to credit distress. Before the Lehman failure, the BoAML High Yield Masters II's OAS was about 850 basis points. Today, it was only 586 basis points before the big drop today. After factoring the credit distress of certain energy names, the overall high yield spreads looks reasonable.  
  • Libor-OIS spread also OK: The Libor-OIS is one of the best indicator of credit conditions. Libor is the interbank interest rate paid by banks while OIS is the Overnight Index Swap that is based on risk free instruments like the Federal Funds Rate. Despite the recent controversy with Libor, it still showed the cracks of the financial crisis of 2008 way before Lehman's failure. The spread was well over 150 basis points before Lehman failed. It's now at 30 basis points. While that figure is slightly high, it is not high enough for a credit crisis. 
While there is spillover risk from China, I think the Chinese government can be more effective stabilizing the economy than the stock market. It'a command economy and the government controls major credit sources like the banks. The reason that it failed to stop the stock market decline was because it was simply too hard to stop emotional retail investors (90% of the market participants) from rushing out at once. Chinese retail investors are clearly panicking but investors in developed market should be more mature and not let the panic in China cloud their judgement. 

A Logical Course of Action:
"Be fearful when others are greedy; be greedy when others are fearful"                    Warren Buffett 
After seeing the markets down over 5% with some names down more than 10%, my first reaction was to pull out cash to buy. Crazy? I don't think so.

My contrarian reaction was built over time. I was quite scared during the financial crisis seeing stocks dropping more than 10% in one day.  However, as I observe the market fluctuations over time and understand a company's fundamentals more, I have more reason to believe that investors should listen to Buffett's famous quote.

The illogical course of action would be to sell during these large market panics, provided that your holdings are of good quality. The illogical course of action was actually a result of our primitive senses.  Back in the caveman days, when one person sees a crowd running for whatever reason, that person would assume that the crowd is right. For the person that ran with crowd, he or she could have avoided being someone else's dinner. Even in present day, this social proof effect is still powerful as shown by Robert Cialdini (highly recommend his book "Influence"). Thus in the financial markets, when an investor sees everyone selling, the most logical sense is to sell as well. But that's exact the wrong course of action.

The reason is a stock is not a ticker that trades on an exchange. A stock is a fractional ownership in a business that produces cash flow and profit. Most of the time, a major stock decline does little to impact company's future earnings power in the long run.

It's also worthwhile to review my favourite paragraph from Ben Graham's The Intelligent Investor about "Mr.Market":

Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
Today, Mr. Market decided that some of the stocks I like are suddenly valued 10% lower because he was a bit moody. Most of time I do nothing but I did what Ben Graham said an Intelligent Investor should do when there is high market volatility such as a day like today's:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies. . (P.205) 

In sum: Volatility + Fear  = Opportunity

As Ben Graham stated many years ago, price fluctuations' main purpose is for investor to buy cheap and sell dear. It is not a negative thing as many investor think. In fact, if you are not close to retirement and in your accumulation stage, you should prefer declines over advances. If you love a 10% sale in the mall, why is that feeling different in the stock market? 

Of course, not all stock is a buy but today's selling was pretty wide spread, even in high quality stocks. Selected buying based on fundamental and patience will reward investors in the long run. Instead of viewing the high volatility as a negative thing, I think investors should change their prospective and think that Volatility + Fear = Opportunity. Of course, the volatility won't end that quickly and declines may continue but patience will be key riding out the storm.  

I'll end with an excerpt from Buffett's 1997 letter in a section called "How We Think About Market Fluctuation":

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.  
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices

Sunday, July 5, 2015

BlackBerry 2015 Annual Meeting and Latest Quarterly Result

Although I tried to keep this blog mostly focused on investment strategy, I do want to comment on BlackBerry (BB/BBRY) because it is one of the my larger positions. I have held it for about 2 years. Despite significant improvements in the company's financials and operating performance, the stock price continues to languish because of extreme viewpoints between the bulls and bears on the company and its stock price. Moreover, the latest NASDAQ short report shows 91 million shares are shorted, a figure that no doubt has gone up since the June 23rd earnings report, 

When I traveled to Waterloo on June 23rd for the annual shareholder meeting, I summarized the whole meeting into three takeaways, which I will explain below. Readers can view a recorded version here

Takeaway #1: Original Plan On Track
"The company continues to anticipate positive free cash flow. The company continues to target sustainable non-GAAP profitability some time in fiscal 2016." BlackBerry FQ1 2016 Outlook Statement 
The outlook statement issued two weeks ago is much more positive than the one issued a year ago (see below). The " flow" has been replaced with "positive FREE cash flow" [caps for emphasis]. 

FQ1 2015 Statement:
"The Company anticipates maintaining its strong cash position, while increasingly looking for opportunities to prudently invest in growth. The Company is targeting break-even cash flow results by the end of fiscal 2015."

Furthermore, readers should take note the use of the word "sustainable" in the outlook statement. From his past interviews, Chen has indicated he would follow the same playbook he used at Sybase before. When he has achieved profitability after stopping the bleeding, he wants it stay there. He has achieved 55 consecutive profitable quarters after stabilizing Sybase and the progress he made at BlackBerry has been impressive. He is carefully laying the that strong foundation to support sustainable profitability. 

With services revenues (SAF revenue) continues to decline at a rapid pace of 15% per quarter, execution risk is high. However, Chen's report card shown at the meeting displayed a good track record of execution in the past year. 

  • FY 2015 Break-even cash flow: Achieved. Of course, the cash balance increased significantly during the year from $2.7 billion to $3.1 billion by the end. However, since most of that was due to the land sales, the proper way to see the cash flow is consider the following:
    • Reported FY 2015 Cash Flow from Operations was $813 million
    • Capex consist of the $87 million for PP&E additions and $421 million for purchases of intangibles. Total $508 million.
    • Land sales (from the Proceeds from PP&E sale line) was $348 million. 
    • Net cash outflow was $43 million. While still negative, it is a remarkable improvement from the first quarter when Chen here when he had to report a quarter (2/3 of the quarter he wasn't in charge) with cash outflow of $1 billion. It should be noted that the purchases of intangibles has been reduced to $11 million or 90% on an annualized run-rate basis in the latest quarter (FQ1 2016). 
  • FY 2015 Cost Reductions:  Costs are down 58% (ex non-recurring items like restructuring charges) since Chen arrived. The cost base is well position for sustainable profitability. I expect it'll be around the $350 million level going forward. 
  • Launch New Products: Launched three new phones last year with new software offerings such as BES 12, Blend, VPN authentication, BBM Protected and BBM Meetings. 

Chen has been consistent at delivering results. Although he gave hints he would like to see more revenue, he never formally targeted for revenue growth. The tone of the MD&A has been for "revenue stabilization", which quite different from outright growth. The rate of decline has slowed, which is encouraging. 

Takeaway #2: Shifting Gears to Software 

Chen showed a pie-chart of the revenue mix in the recent FQ1 2016 quarter with 20% in software revenue. He said he'll need to "grow the size of the pie" since he understands the importance of replenishing the lost services revenues that are rapidly disappearing. While analysts were disappointed that the majority of the $137 million in software revenue was due to a patent licencing deal, $137 million in revenue (with gross margin around 90%) is still $137 million earned. 

Chen has shown he has many ideas on how to get to his $500 million software goal for this fiscal year. First, he has grown the customer list of BES by another 400 customers, stealing notable customers like RBS from key competitors like Mobile Iron.  Second, Chen told analysts that number of gold customers was roughly half of the installed base, which is a higher conversion rate than most expect. Expect those new gold customers to contribute to the future company. Lastly, the monetization of the patents could add considerable profitable dollars even if they are delivered in big lumps. Therefore, investors should watch that software line. 

Takeaway #3: Watch IOT

Chen has been straightforward about his strategy of leveraging the company's security and productivity strength into the IOT. There is now over 60 million, up from the 50 million figure released in January, cars using the QNX software and there could be billions of more potential devices need a BlackBerry solution to connect safely and securely. While IOT is a promising trend, there has been many resistance against this trend because of privacy and security concerns [The Globe and Mail has a good article series on IOT which document this concern].  Since BlackBerry is known for its "privacy" and "security", I think it'll be a major player if it can partner with the right tech companies to deliver IOT solutions. It announced a partnership with Intel on a more advanced connected car system and I expect to see more of those going forward. Chen has utilize partnerships well on many fronts to improve the company's financial position and reduce internal resource needs. 

In Sum:

Overall, I think Chen has the right strategy but the market has not rewarded the strategy yet because the revenue growth is still negative. He has executed well last year despite the tough operating environment. I look forward to his execution in fiscal 2016, which could be a key turning point in this BlackBerry turnaround. 

What now after the 10%+ Share Price Decline After Earnings and Annual Meeting? 

The stock declined on what has been perceived a weak earnings in the first quarter of the new fiscal 2016. However, I believe it was a decent quarter and the stock price decline is unjustified. I initially had a more negative view but after reading the MD&A and thinking about it from a second level, I believe the results aren't as bad as they appear. I will address two top concerns. 

About that Software Revenue....:

The stock initially rallied on the solid $137 million software but the stock dived when most of that number was revealed as licencing revenue, which are described as lumpy by Chen.

The concern here is about so called "core growth". Here is the math that Chen and his team fumbled a bit on the conference call:

  • Looking the revenue lines, software revenue was $54 million in FQ1 2015. Chen said the BES business, one that analysts consider "core", grew 23-24% in FQ1 2016. That would get the $54 million figure up in the range of $66-68 million, which is lower than $74 million reported in the previous quarter (FQ4 2015). 
  • Although Chen is comfortable with the number, analysts don't like the negative Q/Q growth from $74 million to $66-68 million.
Although I would like to see growth above the $74 million last quarter, I am pleased to see the 400 new customer additions. They will no doubt add revenue in the following quarters and I was also pleased with the conversion rate from silver to gold. In the past the mix was 30/70 for gold/silver and now it's at 50/50. I know the analysts are in the rush to see revenue results but I think they should read the section on pg 19 of its 40F filed in March:

"..Customers typically undertake a significant valuation process...can result in a lengthy sales cycle.". For the readers familiar with accounting, GAAP rules say you can only record revenue when the sales cycle is complete.

Also, like I mentioned above, the extra $70 million or so of licencing revenue is significant. It shows BlackBerry has a deep patient portfolio that can generate a stream of cash payments from established tech companies like Cisco . Chen is hinting for more deals later in the fiscal year. 

The hardware revenue is ridiculously low: 

The hardware revenue of $263 million was disappointing given it was down from $379 million in the same quarter last year. However, hardware was operating with positive gross margin and there is limited inventory risk. 

Here is another important point to consider:

  • In the last quarter before Thorsten Heins resigned, the hardware had a gross margin (my estimate) of -28% with 1.9 million devices recognized and ASP of $250. That means a gross profit of -$133 million on the hardware side. Even former Jim Balsillie admitted in a recent public appearance that "People thought we [RIM/BB] made money on handsets. It was all services money." 
  • In the latest quarter, the hardware had a gross margin of 2% with 1.1 million devices recognized and ASP of $240. That implies gross profit of $5.3 million. I would prefer $5.3 million than -$133 million but investors are not viewing in terms of gross profits. They prefer to see in revenue terms where the $475 million (1.9M x $250) is better than the $264 million (1.1M x $240). 

As Jim mentioned, the old model was building devices and earn the service revenue. However, since Chen realized this is not a viable strategy anymore, he has to optimize the device business to make it at least slightly profitable, which meant it had to get smaller and rely on partners like Foxconn to reduce fixed costs. He is now improving those efficiencies by partnering with Wistron and Compel, which could be a sign of plans to ramp up future production. Moreover, he is also right that BlackBerry should not sell the device business because it is a key offering that complements its security value proposition and act as "first gate" to the enterprise customer as Chen likes to say.  

A short technical note I would add is that the 90% year-over-year reduction in purchases of intangibles in the cash flow line. This means the cost of devices business, liscencing costs, has reduced significantly to reflect lower volumes. Since these costs are amortized over 2-3 years, the lifespan of the phone, the income statement's amortization line is much higher than in reality.  

Overall Conclusion:

In a press release announcement the share buybacks, Chen inserted a quite interesting phase. I asked him about this the Shareholder Meeting but he won't directly comment on the undervaluation of the shares but he does indirectly hinted that he standby the statement below. I agree and I'll wait patiently. The biggest asset for an investor is patience. As Ben Graham said, "You don't want to turn this basic advantage into your biggest disadvantage."

"We intend to take advantage of our strong cash position to purchase our shares when the market price does not reflect what we view to be the underlying value and future prospects of our business, without adversely affecting our strategic initiatives" 
John Chen  

Disclaimer: The author is long BB (TSX-listed shares). The author has added BB in the past 2 weeks and will continue buy if prices remain low. 

Saturday, February 28, 2015

On 2014 Berkshire Special Letter: Buffett's Confessions and Lessons

Berkshire released its annual chairman letter to investors today. This edition is a special 50th anniversary edition that included two special sections. These two sections are commentary written by Bufffet and his partner Charlie Munger on Berkshire's past, present and future. The letter overall is a great read and I highly suggest everyone to read it.

Below are some of my own commentary on the key points in Buffett's section, which included several lessons he learned and the lessons he wanted readers to comprehend. I will write a separate post for Munger's section. 

Lesson #1: Don't focus on eighth or a quarter of a point
Buffett is a better storyteller than me so I won't go into all the details but he got himself into a lot of trouble when he decided to put more money in a sinking ship (Berkshire) because he was offered 1/8 ($11.375 instead of $11.50) for the shares he owned in a tender offer. Angry over 1/8th of a dollar, he bought more shares (more than doubled his initial position) and went on to sack the CEO and tried to "turnaround" the company by appointing new management. Buffett found out that the extra money he plowed into Berkshire was hardly earning anything. It would be a miracle just to avoid losing money. All this trouble was due to a temporary anger over 1/8th of a dollar. If he had sold his shares, which he bought for $7.50, at $11.375, then he could have used the proceeds to invest in other assets and the money would have grown into vast sums given the law of compounding and his investment record of achieving returns of 20% per annum  (doubling every 3.5 years). 

What's the lesson here for investors? Never focus on the tiny quarter of a point. If you want to purchase stock X because it looks very attractive, it's tempting to wait until the stock drops before buying. However, if you feel stock X is worth $20 and the stock is $10, why wait till it drops $0.25 or $1? Paying attention to these small amounts can cause you to miss large gains. The point is also valid when considering selling positions. Overall, step back and you'll realize that some of these small things never really matter. 

Lesson #2: Don't mix good business with bad ones 

"When you mix raisins with turds, they are still turds" Charlie Munger

The best decision in the early days of Berkshire was Buffett's decision to buy National Indemnity (NICO). This was the first step into Berkshire's success by entering the lucrative insurance business, which provides interest-free cash up-front that can be used to invest. This was one of Berkshire's secret sauces. Use interest-free float to generate more money through investments than the potential future claims cost. 

If the purchase of NICO was a right decision, why did Buffett admit it was a mistake? His mistake was not regarding the acquisition but how he structured the acquisition. He merged NICO with Berkshire, allowing Berkshire's legacy shareholders to own 39% of the combined entity. By trapping lucrative cash flows in Berkshire's junky textile manufacturing business, growth of the combined entity was limited by the large bleeding within Berkshire's legacy business. The opportunity cost of this drag was estimated at $100 billion (with a B) by Buffett. Although he eventually closed Berkshire's textile business in 1985 (20 years too late by the way), the funds that were sunk into the textile business would have generated significant cash over time, through compounding, if he had just the nerve to close the business when he gained control. 

What's the lesson here for investors? Investors should avoid even the most wonderful businesses if they make terrible acquisitions by buying terrible businesses with low returns and suck cash out of the parent (requiring high re-investment with no free cash flow generating potential). Forget the "synergy" pitch (a.k.a. 2+2 = 5)  or the "cost savings" pitch (a.k.a. firing workers) management give investors when doing an acquisition, investors should always focus on the cash generating potential of the acquired asset. Although the monetary costs in present dollars may be small, the opportunity costs of mixing good businesses with bad ones can be huge in future dollars, especially because the funds used to buy the poor businesses could have been invested in other productive assets that compound over time. Buffett admitted that the attractive purchase of Waumbec Mills (another texile company) in 1975 fits this bill perfectly and added to his initial Berkshire mistake. 

Lesson #3: A good business can be wonderful
Buffett has mentioned plenty of times that his partner Charlie Munger has turned him into a better investor by buying "wonderful businesses at a fair price." The change took a while but was needed. As he admits in this letter, a cigarbutt approach (buying cheap businesses and selling them when they start to recovery) was fine for small amounts of capital but for larger sum of capital, a "good business" approach was needed. It's also something I think most fund managers need to understand. Their niche strategies - whether it is arbitrage, net-net, or spin-offs/corporate restructuring - may work well with small amount of AUM but cannot work at a high AUM figure. To perform successfully, buying good businesses with stable earnings, low leverage, and growing free cash flow is needed.  

Buffett always used See's candy as the example and I did too in a prior post. He reported that since Berkshire (or the predecessor Blue Chip Stamps) purchased See's in 1972, the business has earned $1.9 billion (or $1.25 billion assuming a 35% tax rate). That number is significantly bigger than the incremental $40 million that was plowed back into the business during the same time period. But wait, that's not all. These funds was re-invested in other assets so the overall future value of those cash flows are worth much higher than the sum of the cash flows received.

An investor who is investing in these kind of businesses would see exponentially higher dividends (more cash to re-invest with) or share repurchases (increase ownership and hence the claims of that company's future free cash flow) which enhances the value of their holdings. 

Lesson For the Reader: How to evaluate M&A and the dark side of M&A
To build on the lesson discussed above, buying bad businesses and mixing them with good businesses is especially dangerous when management use their own "stock" as currency. It doesn't make sense trading one $100 bill for four $20 bills. Yet management of corporations do that all the time because they focus on trading for the number, not the value, of the bills. The number in question is the "earnings per share" (EPS) that sell-side analysts and fund managers care about. Management even created a fancy term to justify their actions called "EPS accretion". 

Even Buffett himself was not error-free in this case. He bought a company called "Dexter Shoes" with Berkshire stock in the 1990s. That mistake was extremely costly because it diluted the shareholders and received essentially nothing for that pain. 

Furthermore, don't forget that management may become extremely sensitive to short term factors and become servants of the capital markets instead of the shareholders. Capital market participants, whether be the investment bankers or the corporate raiders (ahem...I mean activist investors), want a share of corporations' success by "encouraging" them to consider "strategic alternatives".  As Buffett outlines in the letter, there is so much indirect frictional costs that shareholders never benefit fully from the success of the companies they own. It is surprising how companies pay 20-50% premium for business T and then spin it off later as business S. Companies like Kraft, which was bought by Philip Morris and then spun out (first as Kraft and then it was separated again into two more pieces), is a good example of the pattern Buffett described. Another example is BHP Billiton. The 2001 purchase of Billiton was completely reversed after its recent announcement to spin them off as South32. 

The "helpers" - the bankers, consultants, lawyers - who propose the strategic alternatives will probably make more money than the shareholders in the company that undergoes such process. Companies should focus on the long term instead of considering all those strategic alternatives when the helpers come knocking at their doors.  

It is fine to use acquisitions as vehicles for future growth but it has to be part of a long term strategy. In fact, many businesses will have to use M&A as a viable future growth path. Therefore, investors should evaluate the acquisitions decisions of the companies they own. Do they make sense in terms of strategy, culture (this one is commonly forgotten) and of course the price. The price is essential because you don't want to pay more than what you receive. The evaluation on the price is hard especially for stock transactions that require an intrinsic value estimate for the buyer as well as the seller. Thus, dig deeper than common first level details such as "synergies", "cost savings", "EPS accretion", or "revenue growth".   

Lesson For the Reader: Capital Allocation and conglomerate
Buffett has gave a great lesson on conglomerates in this letter. On the surface, the structure is hardly efficient at all but there is a method to utilize its advantage. It is something that not many managers understand: capital allocation. 

Good capital allocation practices use free cash flows generated from stable businesses and re-invest them back into the most profitable opportunities. It's not rocket science: use free funds, that are generated from existing businesses,  to invest in companies/subsidiaries that can generate the highest returns. The glue that sticks the subsidiaries together at a conglomerate is the culture. Berkshire's culture is unique because every subsidiary is an independently-run business with no interference from head office in Omaha. Buffett has given his managers the mandate to manage their own businesses with the independence they need and shield them from the short-termism of the capital markets. He often tells his managers that the businesses they run is not for sale and its the only asset they have. With that kind of mindset and culture for achieving long term success, it's no surprise that Berkshire flourished. The success snowballs because Buffett wrote in this letter that Berkshire has become home to many wonderful businesses that would rather be owned under Berkshire than under an owner such as a private equity firm. Thus, with many good businesses to re-invest in and the large amounts of float generated by its insurance subsidiaries, Berkshire has the ingredients it needs to be successful. 

The lessons for investor here is good capital allocation and a strong culture is critical for any company. Berkshire won't have succeeded if it did not shut (although it was late) the cash bleeding textile businesses and re-allocated capital away from bad businesses. Moreover, Berkshire won't have succeeded if it did not have a cohesive culture that focused on the long term and ignored the noise from the short-term oriented capital markets. Investors want to invest in companies that can allocate capital efficiently and have a strong long term oriented culture. 

Lesson For the Reader: Preparing for the Future 
In his outlook for the next 50 years, Buffett said he is confident that the business he built is strong enough to outlive him and succeed. For more on this topic, please see Lawrence Cunningham's new book called "Berkshire Beyond Buffett: the Enduring Value of Values ."

One interesting point I want to direct readers is his point on cash. In many companies and even investment funds, managers want to minimize cash because it is an un-productive asset yielding near 0% or even negative percent in case of European cash equivalence. On the contrary, Buffett argues that cash is the best asset especially as insurance to protect the unknowable future. I fully agree with him. There is nothing wrong with a portfolio of 10% or even 20% cash in a portfolio. Future is inherently uncertain and I have realized over the years that forecasting the future with precision is a fools game. Quoting Howard Marks: "You can't predict but you can prepare." Investor can prepare by having some cash in their portfolio. Berkshire is preparing for the uncertain future by holding at least $20 billion in cash all the time. 

There is a lot of insights in Buffett's letters and his 2014 one isn't any different. Read it, study it and apply it. I'm sure readers will become better investors if they do. 

Sunday, January 18, 2015

How To Evaluate Opportunities After The Oil Price Slump

I apologize to my readers for not writing in a very long time but I will try to write a couple of insightful posts within the next week. Please stay tuned. 
The biggest surprise in 2014, other than abnormal rally in the long term treasury market, was the 50% decline in crude oil price. Whenever I see a price decline of such large magnitude in a very short amount of time, I investigate to see if there are opportunities to pick up cheap stocks. Since I'm a fundamental based value investor, I only buy if I see the intrinsic value of the business significantly higher (>33%, preferable >50%) than the current price. Thus, I need to estimate roughly what the intrinsic value is. Note, I used the word roughly. No one can know exactly the value of the underlying business. I prefer to be "approximately right than precisely wrong". 

This article will explain the NAV model, the most widely used method to value oil and gas companies. Then, I will explain why I believe the key input of the model is flawed. Finally, I will share with readers my methods to evaluate oil and gas stocks.

NAV Models: 
Analysts and industry professionals use a NAV (Net Asset Value) model to determine the intrinsic value of an oil and gas company. The NAV model is just a variation of the commonly used DCF model. The NAV model discounts annual free cash flows until the reserves of the company reach zero to calculate the present value of the operations. The value of equity is the sum of the present value of operations and net working capital minus all outstanding liabilities (bonds, short term paper and decommissioning liabilities).

The Most Ridiculous Input: The Long Term Commodity Assumption:
The most ridiculous input, in my opinion, into analysts' NAV models is the"long term" commodity assumption. For oil and gas valuations, it is the long term assumption for WTI Crude Oil (Or Brent) and NYMEX Gas (Henry Hub). This long term assumption is often used for year 3 and beyond in the forecasting model, which will have a significant impact on the intrinsic value estimate since around 90% of the NAV model's value depend on the cash flows from year 3 and beyond.

How is this long term oil assumption determined? Using economic theory, a commodity like oil should trade around the marginal cost of producing one addition unit. However, many professionals discard this theory and place more emphasis on the current price. Succumbing to anchoring and availability biases, analysts input these inappropriate price assumptions into their models to justify their current price targets. I can't blame them for using current prices. It is much easier to justify your financial model in front of institutional clients by using an oil price that is not too far away from the current one. It is the most available snapshot of crude prices and a good anchor to use. However, I believe too many investors fall for this anchoring bias by focusing on prices that are easily observable.

When oil peaked at $147 in 2008, some analysts had $150 as the long term oil assumption. Conversely when oil bottomed at $32 six month later, the long term oil assumption dropped to near $50. The meaning of long term is probably 12 or 24 month in the eyes of the most analysts compared to the theoretical meaning of 30 or even 50 years down the road.

My Method of Valuing Oil Companies: 
How do I value an oil and gas company? Since I'm not an expert in that field and isn't an engineer, I pay extreme attention to what strategy players pay for oil and gas companies. The multiples in those transaction can be calculated and I use those multiples as a starting point to estimate intrinsic value. The trick here is to choose relevant transactions. For example, transactions in early 2014, when oil was well above $100, may not provide the correct intrinsic value multiple. However, a transaction that caught my attention was the $13 billion takeout of Talisman (TLM) by Repsol in December when oil was near $50. Despite the outlook for oil was extremely dire, Repsol decided it was time buy. The assets acquired wasn't high in quality and 70% of the asset mix was natural gas, which was extremely surprising to me. Nonetheless, the multiple paid , on an enterprise basis, was $50,000 per production (BOE/d) and $12 per 2P reserves (BOE).

Second, I try to look at potential hidden items on the balance sheet. One item I look for is land holdings that may possess resources that are not converted into reserves. Since analysts only model value based on reserves, potential future conversion of resources into reserve is one catalyst for higher share appreciation. This analysis is a difficult one but data is widely available for the discovered resources and reserves in major oil plays such as Montney, Cardium, Shaunavon, and Viking in Canada or Permian, Bakken and Eagle Ford in the US. Another balance sheet item is debt. Debt-heavy oil and gas companies have been hit harder than peers that have less debt. Nevertheless, every company's debt is different and it is wrong to evaluate a company's debt level purely on financial ratio such as Debt-to-equity or Debt to cash flow. The covenants should be examined to see if the debt is cov-heavy or cov-lite. The former is significantly different than the latter. A relatively debt heavy company is still a feasible investment if it has plenty of assets. The two options would be either sell certain assets or sell the whole company. Talisman had a lot of debt but it still managed to sell itself due to high quality assets in North American (outweighing the poor quality of its Asian and North Sea assets). The low valuation for Talisman was a bonus too.

With the transaction multiples and the balance sheet analysis, I can roughly estimate the intrinsic value of the company. The last step I do is a rough NAV model but with more realistic assumption for oil long term oil prices. Let's not forget the concepts taught in  Economics 101. In a perfectly competitive industry, the price of the good should equal to its marginal cost, which is about $70-80 for oil. As oil prices reach below the variable cost (cash costs in the oil business), firms will close down, thus bring the market into balance. In the long run, market forces will balance out so price will reach near marginal cost. The industry has already slowed down with the number of rigs in North American dropping to the lowest since early fall 2014 according to Baker Hughes data. However in the short run, prices can be extremely volatile. Hence, the balance sheet must show strong signs that the company can at least survive a low price environment (e.g. having a good hedge book) for the next year or two.

The rapid decline in crude oil price since June last year has created an excellent opportunity to pick up a few beaten down energy stocks. All oil and gas stocks were sold, regardless of quality, valuation or potential hidden assets on the balance sheet. Thus, there are definitely few good names to buy.

I adhere to my motto: "Misconceived risk equals opportunity, miscalculated risk equals fiasco" as mentioned in my previous article. Misunderstood risks create opportunities but I need to complete a full analysis to make sure I didn't miscalculate any risks.

Friday, July 18, 2014

Essential Lessons From Ben Graham

I recently read Joe Carlen's book called "The Einstein of Money", a book on Ben Graham. The book was half bibliographical while the other half tried to explain his investing philosophy. It was a great read and I would recommend the book. 

I found myself looking back at the notes I made when I read The Intelligent Investor after I read Carlen's book. I would like to share some of the notes I made in this post. 

Buffett was absolutely correct in claiming that the book was "by far the best book on investing ever written." The principles advocated by Graham remains relevant today even though the first edition of the book was written in 1949. Buffett's quote in the preface proves this point: "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What is needed is a sound intelligent framework for making decisions and the ability to keep emotions from corroding that framework." (preface 4th edition revised, Graham 2003) Hence successful investing is about following a disciplined approach and controlling one's own emotion from getting too euphoric when the markets are rising and from getting to pessimistic when markets are falling. Investor may not realize this fact: an investor's worst enemy is himself/herself. Investors should note that no matter how intelligent or diligent they are, they will fall prey to their own emotions, which is often much harder to control and difficult to correct. Graham was correct when he stated, "the investor's chief problem - and even his worst enemy - is likely to be himself. (The fault dear investors is not in our stars - and not in our stocks - but in ourselves." (p.8) 

Buffett said that chapter 8 and 20 were his favorites. I would add chapter 1 to the list. Therefore I hope reader will enjoy my notes for these chapters. 

Chapter 1: Investment versus Speculation 
An investment operation is one which, upon thorough analysis, promises the safety of principal and an adequate return. Operations not meeting these requirements are speculative (p.18)
The quote above is one of Graham's best quote on investing. Many investment operations are essentially speculations because they do not require a thorough analysis of the underlying securities to ensure the safety of principal and an adequate return. Many investors believe the key to make money is to forecast what the stock market, or any other financial market, will do tomorrow. These forecasting approaches, while popular, are not the right method to make money in the long run. Without an examination of the underlying security, any fancy method, such as using complex formulas, that claims to have the ability to generate high returns should be taken with a grain of salt.  

What is "thorough analysis", "safety of principal" and "an adequate return"? Graham defined "thorough analysis" as "the study of facts in the light of established standards of safety and value." This simply implies the detailed study of the underlying security (stock or bond) with a close attention to the risks and facts relating to the intrinsic value of the security. His definition of "safety of principal" is "protection against loss under all normal or reasonably likely conditions or variations." Therefore, investors should ensure that all risks of the investment are analyzed and the price paid for the security is attractive versus potential risks that may result in a permanent loss of capital. Finally, his definition of "an adequate return is "any rate or amount of return, however low, which the investor is willing to accept provided he acts with reasonable intelligence." Thus, investors must make sure their investments can satisfied the minimum required returns in the long run.  

For defensive investors, Graham warned that going after "hot" issues is speculative. Since defensive investors want to achieve a satisfactory result without much effort, they need to keep their investment operation simple. Graham suggestion that they should (1) purchase shares of well-established companies (e.g. S&P500 companies) or well-established funds. He also suggested the use of "dollar cost averaging" in order to limit the number of shares/fund units when prices are high and increase the amount of shares/fund units bought when prices are low. 

For enterprising investors, there are three pitfalls Graham warned against:

  1. Trading in the market: He referred to this activity as "buying stocks when the market has been advancing or selling them after it has turned downwards." In today's terminology, this activity would be called "momentum chasing" or "trend following". Graham concluded that investors' overall of success in trading in the market is very low.
  2. Short-term selectivity: He defined this method as "buying stocks of companies which are reporting or expected to report increased earnings or for which some other favorable development is anticipated." Graham warned this approach is dangerous because (1) the prediction of near-term events could be wrong or (2) the current price may already fully reflect or "discount" good events like upcoming earnings. 
  3. Long-term selectivity: This approach is about picking companies with unusual high growth in the future or picking stocks that are expected to establish a high earnings power later. The biggest problem in this approach is the selection of the right stocks that will do well even if an investor has found the growth industry. 
Graham instead gave the following suggestion for enterprising investors: 
To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising and (2) not popular on Wall Street (p.31) 

My translation: (1) boring, but sound, investment approaches (like value investing) that are ignored because it is boring as watching paint dry (2) must go against the grain

Chapter 8: The Investor's and Market Fluctuations

This is an important chapter to understand and it took me years to understand the content because the principle espoused in this chapter is truly "unconventional" compared other finance theories.

Graham discussed the difference between the pricing and timing techniques. I explained these concepts in my prior post. The former is about trying to figure out the intrinsic value of the underlying business (pricing) and buy/sell dependent on the variance between price and value. The latter point is about timing the market or stock prices in order to profit from those forecasts. As stated above, Graham did not believe in market forecasting or timing because it is very competitive and no one seems to make right forecasts consistently over time. It is almost impossible to do that.

Graham advocated the pricing technique but many investors may not feel comfortable with the approach because of the wrong attitude towards price fluctuations. All investors should read the following paragraph carefully:
Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
As I stated in my prior post on intelligent investing, investors should transact with Mr. Market only if it is favorable to do so. Most of the time, investors should ignore Mr. Market. He'll just come back with another quote tomorrow and never feel bad when you ignore him. When discussing Graham's Mr.Market analogy, Buffett said: "the market is there to serve you, not to instruct you." Far too often however, investors cannot resist looking at daily quotations and trying to make a few quick bucks by looking at price trends because they believe Mr. Market can give them good instructions. Instead of trying to profit from price fluctuations, investors should keep the following Graham quote in mind:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies. (P.205) 

Chapter 20: Margin of Safety as the Central Concept of Investment 
Confronted with a like challenge to distill the secret of sound investing in three words we venture the motto, MARGIN OF SAFETY (p.512) 
I completely agree with Graham that the margin of safety principle is paramount for successful investing. Buying stocks near intrinsic or underlying value does not allow wiggle room if the appraiser has made a mistake. Therefore, an investor must purchase the stock at much lower prices than the calculated intrinsic value

On the margin of safety principle, Graham explains:
The margin of safety idea becomes much more evident when we apply it to the field of undervalued securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.... If these [value stocks] are bought on bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results (p.517-518)  

Hence a margin of safety is needed to prevent negative outcomes of the future and  provide a safety cushion if the estimated intrinsic value is correct. The key here is buying dollar bills for 50 cents. 

Graham stated the importance of considering the price paid when assessing the margin of safety for any investment: 
The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price and nonexistent at some still higher price. (p.517) 

The margin of safety principle is also applicable to bonds. A bond must meet the minimum coverage ratios, even in recession years, in order to qualify as an investment. Graham utilize both pre-tax and after-tax earnings coverage ratios, unlike most professionals who prefer using EBITDA coverage ratios. If Graham was still alive today, I don't think he would change his methodology since EBITDA coverage ratios overstate the cash generation capability of the business by not considering capital expenditures.

Investment is most intelligent when it is most businesslike (p.523) 
While most investors believe the most profitable method of investing is predicting future prices, it is not true. Trying to outsmart countless other geniuses who are trying to do the same will not yield handsome results. Instead, readers should realize that stocks are fractional ownership of businesses and investors should realize that the best results will be realized when they think like business owners. Hence I completely agree with Graham that "investment is most intelligent when it is most businesslike." Buffett also agree with Graham's conclusion and have referenced the same quote in many of his annual letters, including the most recent 2013 letter.

I hope this post was useful to readers. If you haven't read The Intelligent Investor yet, I hope this post has convinced you to at least try reading it.


Appendix (More Quotes from The Intelligent Investor): 

We draw two morals for our readers: (1) obvious prospect for physical growth in a business do not translate into obvious profits for investors (2) the experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.  (p.7) 
Comment: Be wary of investing in the next "hot" industry. Even if you can guess the industry, picking the winners is extremely hard. Although investors may hear success stories of Facebook, Twitter, Linkedin etc., there must have been over thousands of social media company that failed for each one that succeeded.

We hope to implement in the reader a tendency to measure or quantify. For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is offered is an invaluable trait in investment (p.8) 
 Comment: The attractiveness of a stock is always dependent on the current price. At some price, it is cheap enough to buy and at some other price, it is so expensive it should be sold.

Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience.And selling short a too popular and therefore overvalued issue is apt to be a test not only of one's courage and stamina but also the depth of one's pocketbook. (p.32)
Comment:  Buying undervalued securities requires a boatload of patience. Shorting overvalued stocks not only requires patience but also it requires a large amount of capital. Investors often forget the latter point and lose money shorting stocks that eventually collapsed.

Nearly all bull market had a number of well-defined characteristics in common, such as (1) a historical high price level (2) high price/earnings ratios (3) low dividend yields against bond yields (4) much speculations on margin (5) many offering of new common-stock issues of poor quality (p.193)
Comment:  Goods indicators Graham wrote on identifying overvalued markets. Intelligent investors do not try to time the market top or bottom. Nonetheless, if the market is overvalued, they should reduce current positions and raise cash levels.

A stock does not become a sound investment merely because it can be bought close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficient financial position and the prospect that its earnings will at least be maintained over the years (p.200) 
Comment:  I believe many readers of the book overlooked the quote above and confused Graham's purchase of net-nets with his idea of buying a good business. In addition to selling near tangible asset value (tangible book), the companies under consideration should be selling at a low price in relation to its future earnings power, have a healthy balance sheet (low debt) and the earnings should remain stable.

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider as a business owner (p.198)  
 Comment:  I believe this quote is more applicable to investors now than in 1972 when Graham wrote the 4th edition of the book. With the increased use of smartphones, investors have the convenience of checking prices no matter where they are. While technology has enriched our lives, I believe technology has also transformed many investors into speculators.

 The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding securities at suitable prices (p.205)
Comment:  Graham identifies the correct and incorrect method of thinking about market fluctuations.

Saturday, July 12, 2014

Kenny's Track Record of Value Investing (3-Years)

I began an investment account to practice my stock picking skills in August 2011. It has been an amazing experience and I learned a lot on the way. I fully understand why most successful investor say that experience is the most important asset to a money manager.

I have followed the markets since 2005 and picked stocks through the investopedia simulation. I also traded on my parent's account since 2006 but decided a long term investment approach is needed to build wealth. While trading can be profitable in the short-run (mostly due to good luck), it is not the right approach to consistently build long term wealth. That is why I decided to focus on value investing and to prove it is the best approach using my own hard earned money.

The reason I'm posting my track record is I want prove a point: value investing works if practiced correctly. What I mean correctly is that the investor should follow all principles stated in Graham's books, The Intelligent Investor and Security Analysis, very closely. Don't try fancy formulas, leverage or chase a quick return. Therefore, if you haven't read those books, I highly recommend them as summer reading! Lots of investor claim they read them but I doubt those claims. Several re-reads are needed to fully comprehend the knowledge presented in those books. For the record, I read The Intelligent Investor 5 times (1973 edition 3 times and 1949 edition 2 times) and Security Analysis (1940 and 1951 editions) twice. I plan to re-read them again.

Kenny's 3-year Return (Time Weighted Total Returns, the method advocated by GIPS) 

Some Items To Note:

  • Three year annualized return of 17.1% vs. 7.1% for TSX on a total return basis. Total 3 year return of 60.6% vs. 23% delivered by the TSX.
  • I used no fancy strategies, just plain old value investing (Graham/Buffett style).
  • No leverage to juice returns, no options or shorting. No micro-caps or small-caps because I wanted to operated in the mid/large cap universe (my circle of competence) 
  • Unlike most managers, I'm extremely concentrated. On average, I owned only 3 stocks most of the time (currently hold 3 as well). This is not ideal for a professional manager but I'll still own a very small number of stocks, say 10-30 stocks, if I manage other people's money. 
  • My monthly returns are sometimes volatile especially when I build a position (i.e. BBRY) on the way down. This is a problem facing all value investors but eventually patience will pay off. 
  • I'm extremely patient, especially for a 22 year old investor! I held one stock since I bought it in September 2011. My shortest holding period, among the 8 stocks I held, is 6 months. 
One message I want to deliver, value investing works! 

Thursday, May 15, 2014

Financial Shenanigans: A Deep Look At The Tricks Company Can Play With Its Accounting

The following is a talk I will present to a introductory financial accounting class. This piece is dedicated to Ms. Hopwood-Jones. 

The source for this discussion comes from a book titled "Financial Shenanigans" by Howard M. Schilit. The discussion is aimed at explaining accounting tricks public companies use to inflate their financial numbers in order to meet the expectation of analysts. Management of public companies are often pressured by analysts and investors to "make the numbers" every quarter. Therefore, some may cheat to meet a net income target for a certain quarter. A little cheating during one quarter can snowball into a lot of cheating (i.e. Enron is a famous example). How does these corporate executives cook the books? One may think they are rocket scientists but with a little accounting knowledge you learned from Ms. Hopwood-Jones's class, you too can detect accounting frauds.

Earnings[1] (Income Statement) Manipulations:
Investors often scrutinize a public company's quarterly earnings report very carefully. They often cheer when a company can meet or beat the consensus earnings (net income) estimate. If a company failed to meet the consensus estimate, the share price often declines.  How do corporate executives create "fake" earnings? They often just play around with the fundamental income statement equation as listed below.

Revenue - Expenses = Net Income

Since net income is calculated by subtracting expenses from revenue, corporate management can manipulate net income by inflating revenues or making expenses disappear.

Trick #1: Recording Revenue Too Soon

A common trick is to record revenue early before it is actually earned. In accounting, the revenue recognition rule is used to determine if revenue is actually earned (see table 1 below for more details). 

A common trick is to recognize revenues that belong to a future accounting period. For example, if company A is a magazine publisher that collected $100 for a 4-year subscription fee from a customer, how much revenue can the company recognize in year 1? The answer is only $25 because the other $75 should go into "unearned/deferred revenue" (a liability account) since the $75 does not meet the GAAP revenue recognition rule. Nonetheless, corporate executives often trick their auditors by using fancy wording to convince auditors that these 4-year subscriptions are actually 1 year subscriptions.  Therefore, it is vital for investors to read the footnotes to financial statements. Read the footnotes carefully!

One interesting method to boost revenue is by billing the customer for work not completed yet. In the real world, most transactions are not black and white as you see in accounting textbooks and revenue is often recognized over several accounting periods (construction industry is the common example). Since revenue is a credit account, they need a debit account to balance the books. Since customers generally don't pay cash unless the required work is completed, a common account to debit is account receivables. Therefore, be wary of any abnormal increases in accounts receivables or any receivable accounts. Also, if the accounts receivable turnover ratio (revenue/accounts receivables) starts to slow while revenues are still growing, it is a red flag and the company is probably inflating revenue by borrowing future revenue.

Table 1: Revenue Recognition under IFRS and US GAAP[2]
IFRS Revenue Recognition Criteria
US GAAP Revenue Recognition Criteria
(1) The amount of revenue can be measured reliably
(1) There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end
(2)  It is probable that the economic benefits associated with the transaction will flow to the entity
(2) The product has been delivered or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risk and rewards have not actually passed to the buyer
(3)  The stage of completion of transaction at the balance sheet date can be measured reliably
(3) The price is determined or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency
(4)  The costs incurred for the transaction and the costs to complete the transaction can be measured reliably
(4) The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay
Source: IASB and FASB

As shown in table 1, a company cannot recognize revenue unless the risk and rewards (economic benefits) is transferred from the seller to the buyer. A trick used in the 1990s by Sunbeam is to use a technique called "bill and hold." In essence, Sunbeam bills the customers and recognizes revenue despite the products were held in Sunbeam's warehouses. Although this trick is difficult to detect, a closer look at the revenue recognition footnote can discover aggressive revenue recognition. Below is the paragraph disclosed in Sunbeam's annual report:

"In limited circumstances, at the customers' request the company may sell seasonal products on a bill-and-hold basis provided that goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have been passed to the customer." 
With the grills sitting at Sunbeam's warehouses, there is no doubt that the economic benefits have not been passed onto the buyers despite Sunbeam tried using the words "risk of ownership and legal title have been passed to the customer." Also, customers often do not request goods on a bill-and-hold basis. Always be suspicious when the words "bill-and-hold" comes up in the financial footnotes.

Finally, another trick is to inflate revenues is to extend generous terms to buyers despite low creditworthiness, which fails criteria (4) listed in table 1 since the probability of collection is low. An acceleration of revenue along with growth in accounts or note receivable is a red flag. Although not all red flags imply revenue manipulation, investors should be careful when these red flag appear. If the company is showing abnormal growth in accounts or note receivable while also disclosing that it is extending credit to customers with generous terms, watch out!

Trick # 2: Boosting Income Using One Time Items
One-time items, also known as "extraordinary items", are often used to boost net income. By definition one-time items should occur infrequently such as gain/loss from sale of equipment[3] or damage incurred from a natural disaster.
Corporate management often tell investors to ignore one-time items because they do not reflect the continuous business operations.  They tell investors to focus on normalized income, which is often called "operating income." You will often see a corporate income statement organized as follows:

Table 2: Sample Corporate Income Statement[4]
Gross Profit

Operating Expenses
Operating Income
     One-time Items
Earnings Before Tax
     Income Tax Expense
Net Income

Investors do pay more attention to operating income than the net income number. Therefore, management has the opportunity to inflate operating income by shifting positive benefits from one-time items above the operating income line and shifting normal expenses below the operating line. The former outcome can be achieved by shifting a gain from the sale of an asset above the operating income line as reduction to operating expenses. For example in 1999, IBM sold a business to AT&T but instead of disclosing the gain on the sale in the one-time items line on the income statement, IBM decided to book the $4.06 billion gain on sale as a contra expense. The effect of IBM's accounting decision significantly reduced operating expense by $4.06 billion (reducing the $18.8 billion operating expenses to only $14.7 billion!). Investors thought IBM found a magic way to reduce operating expenses and decided to give a higher valuation[5] for the stock only to find out later that those expense reductions didn't continue into future periods. Savvy investors reading the financial footnote would have noticed this trick because the company, by law, had to disclose how the sale of a business is accounted for. Companies often bury these unwanted disclosures deep in the footnotes since they know most investors never bother to read 100 pages of financial footnotes. However, it pays to goes through the footnotes of financial statements!

Another genius method is to create a continuous stream of income from the sale of an asset. Because income from a one-time sale is less impressive than a continuous stream of income, corporate management will aim to create a continuous stream of income from the sale of an asset. Let's use the traditional debits and credits to explain this trick. Assuming an asset owned by company I is valued at $1,000,000 (fair-value). Instead of selling it at $1,000,000, company I sells the asset to company M at only $800,000. However, company I requires company M to pay for future products at above market prices to make up for the $200,000 difference. Table 3 shows the correct way to account for this transaction while table 4 shows the inflated approach.

Table 3: Correct way to account the transaction by company I


Receivable (from Company M)

            Asset Sold (Book Value)[6]

            Gain on Sale of Asset


When the inflated prices are paid by company M in the future, the following should occur:

            Receivable (from Company M)


Table 4: How to Create A Revenue Stream From One-Time Sale

            Asset Sold (Book Value)

            Gain on Sale of Asset


When the inflated prices are paid by company M in the future, company I records:



Magically, company I created $200,000 of revenue that should have been recorded as a gain on sale from a prior accounting period. To create a continuous revenue stream, the company could have recognized the $200,000 more slowly, such as $20,000 for 10 reporting periods.  

This example is actually real. Company I was Intel and company M was Marvell Technology and this transaction took place back in November 2006.  Again, the only way to have detected this fraud was to look in the footnotes when Marvell disclosed that it will pay above market prices for Intel's products in future periods. When analyzing any transaction, always try to understand the underlying economics and consider which accounts are affected. It's critical for investors to understand their debits and credits.

Trick #3: Shifting Current Expenses to a Later Period

Two examples will be illustrated for this trick. The first example is capitalizing expenses. In order to understand the nature of this action, let's review the fundamental accounting equation:

Assets = Liabilities + Shareholder's Equity[7]   (1)

Now we can expand equation (1) above by expanding the Shareholder's Equity section as follows:

Assets = Liabilities + Beginning Shareholder's Equity + Revenue - Expense (2)[8]

In order to decrease expenses, the asset side must increase in order for equation (2) to remain in balance. How can a company increase assets to reduce expenses? Let's step back and revisit the accounting rules for a fixed asset. When a fixed asset is purchased, is the entire amount expensed on the income statement? The answer is obviously "no" since that action would distort the trend in net income by having years with high net income when there are no purchases of fixed assets and years with low net income when there are purchases of fixed assets. Accounting rule states that a fixed assets must be capitalized (put on the balance sheet) and the cost of the asset is allocated, by reporting costs in the income statement, over its useful life. However, only assets that provide economic benefits for more than one accounting period can be capitalized. Normal operating expenses should be expensed on the income statement. Nonetheless, managers who wish to reduce expenses will often capitalize normal operating expenses in order to boost net income.

Let's use debits and credits to explain this trick. To account for $1 million of normal operating expenses, the following should be recorded:

Operating Expense

            Cash/Accounts Payable


To defer a portion of the $1 million expense, consider what happens if the $1 million is capitalized and recognized over 2 accounting period instead of 1.

Fixed Asset

            Cash/Accounts Payable


Depreciation Expense 

            Accumulated Depreciation


By recognizing the $1 million expense over 2 periods, net income is overstated in the 1st period by $500,000. Because the effect reverses in the 2nd period, a company that capitalize expenses is often forced to repeat the trick over and over again until it goes bust. This was the case with WorldCom in 2002.

Capitalizing expenses is a simple trick, but shrewd investors can detect this fraud by looking at the balance sheet instead of focusing exclusively on the income statement. If any fixed asset is growing out of control and there is no good explanation in the footnotes, management is probably capitalizing normal operating expenses. For those grade 12 students who understand the cash flow statement, another method to detect this fraud is look at free cash flow, which is defined as cash flow from operations minus purchases of fixed assets, a line located in the cash flow from investing section. If free cash flow declines rapidly, it is a red flag. 
Another method to defer expense is to recognize them more slowly. Recall that depreciation/amortization expense should be recognized by an amount equaling to [(cost-salvage)/useful life]  if the straight line method is used. The useful life number is often an estimate and accounting rules allow management to use its best estimate as a proxy. Therefore, management can record a lower expense by simply assuming a longer useful life of its asset. The only way to detect this fraud is to compare the useful life (estimated by cost/annual depreciation expense) one company compared to the industry average. If the assumed useful life of a particular asset is significantly higher than the industry average, the company is probably making an aggressive assumption regarding the useful life of its assets.

Trick #4: Hiding Expenses 
Similar to how a magician makes a rabbit disappear, corporate management often employ tricks to make expenses disappear. The most simple trick to hide expenses is simply failing to record accrued expenses. Let's apply what you learned in Ms. Hopwood-Jones class on accrued expenses in the following example: company X repaired a machine for company Y and bills company Y for $100. If company Y does not pay in the current accounting period, an accrued expenses must be recorded in Y's books.

Maintenance Expense

            Accounts Payable 


However, to avoid the recognition of an expense, company Y simply ignores this adjusting entry, which would boost income (by reducing expenses) for the current accounting period. Although outside investors cannot detect this fraud without looking at the internal books, the expense recognition footnote may provide clues about aggressive accounting for expenses.

Another method to hide expenses is making aggressive assumption on "soft expenses" like warranty expenses. Soft expenses often require the significant use of management's judgement in determining the amount booked in the financials. Let's illustrate with an example of warranty expense. Under GAAP,  the company must record a warranty expense for each accounting period using past experience as a proxy, similar to the accounting for bad debt.

To illustrate with an example of warranty accounting. Let's see the following entries:

Warranty Expense

            Warranty Liability 


Warranty Liability



The first entry records the $1,000 expense incurred while the second entry books the $900 actual claim during the period. The figures should be similar for the two entries. Nevertheless, a company wishing to reduce current expenses may book a lower warranty expense, such as booking only $500 in the prior example instead of the $1,000 justified using past experience. The easiest method to hide expenses is to assume a lower expense figure for these "soft expenses" like warranty expense or bad debt expense.  

Trick #5: Shifting Future Expenses to an Earlier Period

This trick is to incur the pain today while lowering expenses in future periods. Table 5 shows a two-step process for expense recognition for balance sheet items. By accelerating the expense recognition process, a company can recognize future expenses upfront and incur zero expense in the future. Let's illustrate with an example of an inventory write-down.

Table 5: Cost Recognition under a two-step progress
Step 1: Asset
Step 2: Expense
Prepaid Insurance 
Insurance Expense
Property, Plant & Equipment
Depreciation/Amortization Expense

Under GAAP, inventories on the balance sheet are accounted for using the LCM (lower of cost or market) approach. If the market value (market price less estimated costs incurred to sell) is lower than the book value on the balance sheet, the difference must be written down as an expense (often through COGS) on the income statement. However, the market value used in the write-down is estimated by management and they could use an unrealistically low number so the expense recognized is higher than it should be. By writing down inventories close to zero, similar to how Cisco wrote down $2.25 billion in 2001, companies can report very low COGS numbers in the future and inflate their profit margins significantly.

Another creative method to overload current expenses is to book a large "restructuring expense." This is a common trick used by companies during difficult times. By booking a large restructuring expense today, companies can release the excessive amount into net income through a reduction of operating expenses. Again, let's demonstrate with the use of debits and credits. Assuming company R decides to fire 100 workers and need to pay $10,000 to each worker as a severance expense, which will paid in a future period. The proper method to account for the transaction is shown below.

(1) Current period to recognize the expense:
Restructuring Expense (Wages)

            Wage Payable


(2) When Severance is paid at a later period:
Wage Payable



However, because the $10,000 per worker is a "soft expense" estimated by management, there is a strong incentive to overestimate, such as using $20,000 per worker.

(1) Current period to recognize the expense:
Restructuring Expense (Wages)

            Wage Payable


(2) When Severance is paid at a later period and only $1,000,000 is paid:
Wage Payable


            Wage Expense


By booking an extra $1,000,000 of restructuring expense in the current period, the company can reduce wage expense by $1,000,000 in a future period when the restructuring liability is extinguished. This is a creative method but fails to conform to the basic matching rule under GAAP.

Despite real world accounting is more complicated than what you learned in Ms. Hopwood-Jones's class, I believe everyone has the necessary tools to detect accounting frauds. As stated many times in this article, the key is to read the footnotes carefully so that you can detect aggressive accounting assumptions, whether it is related to revenue, expenses or one-time items.

[1] The word "earnings" is often used in place of "net income" when discussion financials of public traded companies (ones that trade on a public exchange such as the TSX or NYSE).
[2] When an accounting textbook uses the word "GAAP", it is referring to the old Canadian GAAP rules. IFRS, the international standard, replaced Canadian GAAP in 2011. Nonetheless, IFRS is quite different and US GAAP is closer to the old Canadian GAAP.
[3] Recall that a gain/loss is recorded from the sale of a fixed asset when the sale price is higher/lower than the net book value (historical cost - accumulated depreciation)
[4] When you read financial statements of public companies, the income statement is commonly called the "statement of operations" or "statement of earnings."
[5] Stocks valuation can be explained by the P/E ratio which is market price of stock divided by its earnings. Usually investors would use operating earnings (income) as the denominator as those earnings are continuous in nature. Therefore, IBM's action of moving a gain from sale of an asset above the operating income line inflates operating income and increase the "E" in the P/E ratio, result in a higher stock price.
[6] The net book value is credited for the sake of simplicity. In reality, the asset account (historical cost) is credited while the accumulated depreciation is debited.
[7] "Shareholder Equity" is the equivalent of "Owner's Equity" and it is used for the equity account of a public traded company
[8] Assuming no dividends (Owner's withdrawals) or share issuance (Owner's deposit)
[9] Salvage value is ignored because it usually a negligible amount