I think matter that Camden55 so clinically exposed to view has been thrashed to death by now, so this might be the last salvo, and it covers quality-measurement fictions for valuing listed stocks that masquerade as truths (the thrust of Camden55's first-class post), but more importantly, the non-highlighting of inconvenient truths.
I cannot bring to mind a word in common use that means to tell the truth in order to hide the truth – for example, you might brag to your pals that you slept with the desirable Lulu, while remaining silent on the fact that this happened when you and Lulu were toddlers at the same child-care facility, and a late-morning sleep was part of the regimen. There are arcane terms used in ethics such as “evasion”, “equivocation” and “mental reservation”, and in politics “prevarication” is used, but these words have shades of meaning that do not cover what I have in mind. For now I'll use the term “selective veracity”. “Selective silence” is the obverse of the same coin.
A common form of selective veracity is to report statutory accounting metrics, and to only resort to “normalisation” when it supports a story that management wishes to convey. I covered this in recent posts on SGH, where much was made of so-called “abnormals”, and “normalised” metrics were proffered in the reports for FY2012, which was a poor year for SGH. However, a year later the favourable FY2013-comapred-to-FY2012 metrics were allowed to speak for themselves, shout even, and no mention was made of normalised metrics for FY2012 as a basis of comparison, which would have hinted at a more modest growth trajectory. I baled out at $2.65 on a higher-than-my-fair-value basis, but Mr Market ran the SP up to $2.80 soon afterwards – only to bring it back below $2.65 after a cold shower had reduced his ardour.
The usual practice of comparing results to the previous comparable period (pcp) can give the wrong impression, especially in mid-year reporting. If a business is non-cyclical, and its half-year compares unfavourably to the immediately preceding six months, then that should be the relevant comparison that investors should make – not the pcp comparison. Most mining services stocks had good 1H2013-to-1H2012 comparisons, but but poor 1H2013-to-2H2012 comparisons, which signalled a turning point in the sector's performance – a matter that was rarely highlighted.
One could go on and on about the fanfare made of certain metrics (revenue, EBIT, NPAT, EBITDA etc), when the EPS is declining, and worse yet, cashflow is in trouble. These things are why investing companies with honest management is important – honest and competent would be fantastic. We all are guilty of selective veracity, so one has to live with a measure of it, and one should develop a nose for sniffing it out. Warren Buffet's reference to EBITDA in the following extract is interesting, because this can be extended to other areas of potentially mendacious investment argot:
“We’ll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them."
In certain cultures lying is so common that when functioning within their own cultural milieu, the liars do little harm because nobody expects the truth to be told. Much the same no-harm outcome can be achieved in our selective-veracity stock market milieu, where crass lies are rare – you have to develop the instinct to know that some things have not been highlighted, and extract the relevant facts yourself.
As for the views of analysts, brokers, stock-market commentators, fund managers and financial advisers – be suspicious of their intentions and/or their ability. On the matter of ability, the more unquestioning they are of their own opinions, the more incorrect they are likely to be – it's called Dunning-Kruger effect, which you can Google, but someone summed it up as “The dumb get confident, while the intelligent get doubtful” – not that I like using the word dumb to mean anything other than lacking the ability to speak.
Current opinions about stocks often sound sensible (so-called lullaby logic), so it is instructive to read what was written in earlier times. Reading dated investment magazines is almost worthwhile for the sheer mirth of reading the pompous but incorrect calls made a few years ago. For instance, in 2006 somebody wrote: “In the 2004-2005 financial year ABC Learning earned profits of over $50 million. This financial success has been reflected in a share price that increased more than 300 per cent in the 5 years since the company first floated on the Australian Stock Exchange in 2001. In April 2006, ABC Learning’s market capitalisation stood at $2.6 billion.” Words of this ilk would have tempted many an unwary investor to buy ABC shares, particularly as aggregating child care centres and horning in on the government subsidy would intuitively make sense, and still does, but Eddy Groves was the wrong person to trust with your money. Never entrust your money to a guy who drives a Lamborghini and flaunts a trophy mistress.
When I first jumped into the stock market circa 2007, I bought into Perth-based CXG, Coote Engineering. The macro environment looked good – providing diesel engineering services to the booming mining industry and getting into the railway rolling stock game to service the same customers. Soon afterwards an annual report was published, and this furiously massaged my stock-picking ego – sales were up, revenue was up, the metrics looked good, including a seemingly healthy balance sheet with a large current asset called debtors, and to top it all, the SP shot up to give me a paper profit. However, I later noticed an inconspicuous note to the effect that Michael Coote had a familial nexus with the entity that had purchased a swag of rolling stock that CXG had refurbished, and the rolling stock had been leased back to CXG. This struck me as odd, so I attempted to locate the buyer, Greentrains, but without success. I rang CXG to ask them for Greentrain's contact details, and I was never put through to the company secretary – some Indian bloke who could never take my call, and who never rang back, and who I later read had returned to India. I checked the website where ABNs are registered, and I learned that Greentrains had been registered as a business in early June, and from elsewhere I learned that this huge rolling-stock deal (from memory it was something like $160 million – it could have been less, but still huge) was transacted about two weeks after the Greentrains ABN was registered, and only days prior to CXG's 30 June EOY, which explained the good accounting numbers. To cut a long story short, it transpired that Greentrains had no money to pay off the debt, and in time the equity in CXG effectively vanished. CXG's SP was over $1.00 circa 2007-2008, and now the rebranded EGN shares are worth 18 cents, but from memory each 10 shares of the erstwhile CXG were converted to 1 share, so the comparable SP is 1.8 cents. The moral of the story is that good earnings and profitability metrics, a bullish annual report and good press can all mask the reality of the situation. In those days I would not have looked at cashflow, and the warning was probably skulking there. The spurt of takeovers in 2007 should also have been a warning (five in seven months). By 2008 CXG was in trouble. You can hear how bullish Mike Coote was in August 2007 at:
The maxim “caveat emptor” can aptly be changed to “caveat investor”. There is another Latin saying, “Luna mendax est”, which translates to “the moon is a liar” (because in the northern hemisphere the crescent moon is D shaped, and the decrescent moon is C shaped). This saying could be altered to apply to accounting treatment and management's selective veracity, or selective silence.
