The importance of fundamental oversight of systematic investment processes.

Robert Swift & Robert Medd, 27 November 2018

Quantitative analysis models form a key element of our investment process to aid stock selection.  However, we do not blindly follow the outputs and carry out further analysis to ensure the models are not being fooled by the data inputs.  Improving the strategy success rate from 53 out 100 picks to 54 out of 100 will significantly improve portfolio return on risk.  Since the 1990’s we have combined quantitative and qualitative research in order to harness the best of both methods and thereby reduce the mistakes that either approaches alone tend to make.

In this regard we are aided by similarly experienced independent research analysts who focus on getting ‘behind the numbers’.  Robert Medd founded Bucephalus, https://www.buceph.com/,  in 2016 to provide forensic accounting analysis of some the world’s largest companies and, needless to say, he has uncovered shenanigans which have eluded most of the sell and buy side.

We share his latest output with you below.  Thyssen Krupp was a stock which ranked well on our quantitative model as being cheap.  On further examination through our ASG, or Accounting Strategic and Governance, assessment we decided to avoid.  Robert’s work highlights some of what was uncovered.
 
Reality overwhelms creative accounting, Bombardier has recently fallen 38%, thyssenkrupp 18% and Celltrion 30%.  In each case, the market was surprised when management admitted that they could not deliver on targets. This need not have been the case. For months, we have been warning that they have been using creative accounting to hide their business reality.

It seems that many observers simply accepted management’s word, rather than closely examining the accounts. This failure to understand the methods used to disguise weak performance, a lack of cashflow and real leverage exposed their clients to unnecessary accounting, fiduciary and reputational risk. The worst in not over. All three still have problems and are likely to need further capital, yet the traditional sell side remains positive.
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These are just some of the stocks using creative accounting to attract investors.  Common factors include diverse operations, complex balance sheets, aggressive M&A, working capital manipulation and the use of “adjusted” EBITDA to justify negative cashflow.  Our revised Governance, Accounting and Performance scores include several new anti-creative accounting measures and have been re-run for the largest listed companies, generating several new names to be investigated.

​The presentation deck below details the price movement, analyst coverage and our concerns with the respective companies.

reality_overwhelms_creative_accounting.pdf
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