How to Protect Your Portfolio From Earnings Surprises

Team Hoodie brings in revenue from a customer base that has the attention span of a New York cab driver focused on his next fare amid a sea of pedestrians. For Facebook, weekly earnings data might be best.

Under these circumstances, there’s immense pressure from inside and outside the company to “hit” the numbers, avoid debt covenant violations and influence shareholder, lender, and supplier expectations — all of which are carefully orchestrated to boost share prices over time.

These pressures are so great the gamesmanship uncovered by the study isn’t surprising at all.

It’s unpleasant. It’s unethical. And it’s disheartening.  But it’s not shocking.

How to Spot Earnings Gamesmanship

So how do you know if a company you own is cooking the books, and what do you do about it?

It’s not easy, but here are six things to watch for:

1. Cash flow, cash flow, cash flow. Nobody ever went broke on accrual accounting and cash truly is king, especially now. That’s why I am especially interested in a company’s free cash flow. It’s tougher to fake. A quick and dirty method to calculate this is simply to subtract capital expenditures from operating cash flow.
2. Big changes in accruals. These can come in many forms. Examples include capitalized expenditures, reserves, and accrued liabilities. Sometimes there’s an explanation, like pending litigation or a product recall, but CFOs don’t build these up for no reason.
3. Big one time charges. Lately these are de rigeur and examples include write-downs, write-ups, trading losses, unusual transactions and, my personal favorite since the financial crisis began, gains or losses on asset sales, particularly toxic debt.
4. Unrealistically smooth earnings. Business cycles vary tremendously, so it’s logical that earnings should too, perhaps not wildly, but they should show some variability under normal circumstances. Any business that doesn’t is immediately suspect in my book because either a) there are hidden accounting games being played or b) the company might really be run well in which case it’s worth an even closer look.
5. Wide variations from their peer group. Not all companies are the same so don’t expect cookie cutter analysis to work. But if a company is way outside similar figures reported by its peers, chances are something’s “up.”
6. The people. Admittedly, this is more art than science. It’s where you’ve either got to hone your instincts or study interpersonal behavior. I’ve actually had formal training on how to spot individuals who may not be entirely honest. So I listen carefully during analyst calls for voice tremors and watch televised interviews much more closely for physical tells than other people might. You may not be in the same boat, so I encourage you to use what I call the bar test…as in would you turn your back to this executive/politician/leader during a bar fight? If not, have faith in your instincts because chances are you don’t want to trust the person you’re observing.
   

I’ll leave you with one final thought.

Under the circumstances, this kind of information may shake your confidence in the system. I know it does mine. But there’s little we can actually do about it until the regulators, Wall Street, and Congress stop the incestuous relationships they maintain and force a return to more cash-oriented reporting standards.

So concentrate your investments in companies that have long histories of doing the right thing and management that has repeatedly demonstrated integrity.

Focus on companies with strong international cash flow and brands the world needs. Wants are secondary during difficult times like today. Needs are constant.

Finally, place a priority on dividend payers. People forget that dividends are not just about yield. Instead, dividends are an implied promise management has made to you as an investor.

Companies that keep their promises are far less likely to screw around with your returns.