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Diamonds In The Dust

What To Buy: Accounting Quality

The key points that we will discuss in this chapter are: 


  • Why evaluating account quality should be a central part of investment research and analysis?
  • How to identify the key traits of fraudulent companies/management? 
  • What is Marcellus’s forensic framework for avoiding dubious companies?

First, let us discuss why evaluating accounting quality is central to investing? 


1. Financial statements form the foundation of the Investor’s efforts to evaluate and value companies

Financial statements provide the critical window to understanding and evaluating the company's operating performance, competitive strengths, and health. Financial statements also form the basis for making future company projections and valuing them. Hence, if the financial statements themselves are inaccurate, the whole edifice of the analysis can come crumbling down. Therefore, building confidence in the sanctity of the financial statements and the broader corporate governance of the company should be the starting point for any stock analysis.


2. The majority of listed companies in India give a raw deal to the minority shareholders

Given that greed is a common human trait, financial misreporting has been occurring in companies worldwide for decades. However, given the high proportion of Indian companies manipulating their financial statements, evaluating accounting quality is the single most important component of researching Indian stocks. This is amply demonstrated in the quantum of churn in the BSE500 Index—a premier index representing the top 500 companies by market capitalization in India.


Between June 2003 and June 2020, the annual churn in the BSE500 was close to 12%, which means, on average, nearly sixty companies exited the index every year. The high churn ratio implies that most incumbents cannot sustain their place in the index, making way for more deserving candidates.


A closer analysis of the stocks exiting the BSE500 over the last five to ten years indicates that most of these exits had little to do with business downturns but were mainly on corporate governance/accounting lapses and capital misallocation at these firms. If one were to look at the BSE500 as it stood in end-December 2009, of the 500 member stocks, only 267 remained in the index by end-December 2019. Nearly 40% of the stocks have exited the index over the last ten calendar years for reasons other than corporate action (delisting, acquisition, etc.). Most of these stocks saw significant erosion in their shareholders' wealth on their way out. On average, the companies which exited the index in 2019 had lost 30% of their December 2009 market capitalization.


While the number of companies that have generated enormous wealth for their shareholders is bound to be a handful, the number of companies that have destroyed shareholder wealth is perturbingly high in India. For example, only 18% of the December 2009 BSE constituents generated compounded annual returns in excess of 15% over December 2010–to December 2019. On the other hand, 51% of the constituents generated negative returns for the same period. Hence, an investor's ability to avoid dubious names is equally important as her ability to discover a great company.


3. Corporate frauds often leave the investor with little time to react and to exit the stock without material financial loss

As discussed earlier, when a fraud starts unravelling, the stock in question sees significant erosion in price. While the absolute destruction in the market cap is enormous, the pace of destruction is equally devastating in most cases. 


When the fraud gets unearthed, the share prices decline sharply in most cases. However, a similar or even more painful scenario is when the complete picture of the fraud is not yet out in the open. Still, the accounting quality and practices of the company appear to be questionable. A typical feature of such stocks is that they seem to be significantly cheaper than their historical valuation multiples and relative to their peers. Gullible investors who cannot recognize that such stocks are value traps keep buying the stock every fall. However, the share price slide never stopped, and what was perceived to be value hunting turned out to be a falling knife.


Key traits of a fraudulent company/management 

To build a practical fraud detection framework, the investor must understand the modus operandi of fraudulent companies. Based on the collective experience of analyzing the financial statements of thousands of companies over the last twelve years, the author and his team at Marcellus believe that the following are the most common traits of companies/managements engaging in accounting malpractices:


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