HOWMUCHMONEYISACOMPANYREALLYMAKING

earningsqualitysignals
thefundamentalsofhowacompanyoperates

intensiveresearchandvaluationiskey

howtointelligentlyreadandusealldocumentsthatacompanyfiles

prospectus

genuineknowledgematterslittleintheshortrunespeciallywheneverybodyisbeing
emotional

mostinvestorsandanalystshavenoclearconceptionofhowcorporationscanreport
earningsthatarepartiallyillusory

nobodyfocusesonqualityofearningsbecausesuchresearchoftenleadstonegative
conclusions

theproswanttherealitywhichoften(thankfully)consistsofbadnews

alwaysassumetheworstofmanagement
whataretheytryingtodocosmeticallytomakethemselveslookbetter

aprospectusshouldbereaddiligentlyfromcovertocover

investmenttaxcredits

LEONARDSPACEK

mostpeoplepreferillusiontorealityifitconformstoaviewtowhichtheyarecommited

ABRAHAMJBIRLOFF
hecritiquedthetypeofaccountingassociatedwithconglomeratesinmakingtheirnumerous
acquisitions.heopenedmyeyestothewaythatpoolingofinterestsaccountingmade
earningscomparisonsglowunrealistically
distortionsarisingfrompoolingofinterestsaccounting

THEQUALITYOFEARNINGSREPORT


1)DONTTRUSTYOURANALYST
analystbrokerclient(you)
whatandwhentobuyisdecidedbyfears,hopes,rumors,hunchesandsolidinformation
everybodyoverestimatestheimportanceofthesolidinformationtheythinktheyhave

allofthisinfocomesfrompeoplewhoareincentivizedtoconvinceusthattheyareright

youmightaswellgetgoodatthisonyourown.nobodyelsecanreallybetrusted.

simpletechniques+methodsofinterpretingdata

celebrityapersonwhoisfamousforbeingfamous

sametvshows
samenewspaperstories
avuncular,wellcoiffed
theyareexperts,youthink,whoseadviceshouldbetaken.butdontthinkthat.remember,
theyarecelebrities.famousforbeingfamous.

briefanswers.themedialovesshortandwittyanswers

manyofthoseinterviewedtendfortheextremes

thereisavestedinteresttoissuebuyreccos.thereiscommisioninthisanditsthewhole
raisondetre

thepriceveryoften(exceptwhenitisapublicshort)doesnotreflectallavailableinformation.
itreflectstheoptimisticbuyers.
pessimistscannotaffectastockpricesoinsteadofitbeingtheaverageoftheconsensus
(5.50)itwillhoveraround7

whatarethispersonsinventives
analystbrokercustomer

sellsidevsbuyside

mgmtcontacts+requiredreports

theproblemisthattheanalystisworkingforthefirmthatgiveshimthatfatpaycheckandnot
youandthatcreatescomplicationsandconflicts

theanalystknowsaboutcomingIPOs,M&Aandfinancingneeds


theinvestmentbankingbusiness,inconclusion,ismorelucrativethanthefinancialanalysis
business

analystsmustearntheirkeepbybeingongoodtermswiththefirmstheycoverandthat
usuallymeansincentivesforgoodcommentaries

DAVIDKATZEN
RICHARDHOFFMAN
RJHOFFMAN&CO

goingfroma+toacommentaryiscareersuicide

analystrelationshipwithagivencompanytendstobemutuallybeneficialtobothparties.
thereisvirtuallynoincentivetorocktheboat

everybodyisusingtheexactsamenumbers.thiscouldexplainsubparresults.

consistencyiskey.eveniftheyarewrong,youcanjustdotheoppositeofwhattheysuggest.

juststudytheinfotheyhavetogivetotheSEC
dontvisitacompanythatyoufeelbullishonifthereisanychancethattheymaymakeyou
excessivelyoptimistic

...foreignloans[were]questionableandaccountingproceduresdeceiving.iftheyestablished
justa10%lossreservefortheselowqualityloans,theirearningswoulddropbycloseto
90%

loweringourintermediatetermrating
thestockisnotlikelytooutperformthemarket
thisstockisforpatientinvestors
deferaction
weakhold

allinvestmentadviceiscaveatemptor(buyerbeware)

17)THECOSTOFCREDIBILITYAUDITSBYCPAs

2)ANDDONTTRUSTYOURAUDITOR
auditorclient(bigcompany)
checktheauditorsopinionfirst.readthetracysection!!

cleanunqualifiedacceptancepresentedintwoshortparagraphs

subjecttotheauditoracceptsthefinancialswhicharesubjecttopervasive
uncertaintythatcannotbeadequatelymeasuredsuchasrelatingtothevalueof
inventories,reserveforlosses,orothermatterssubjecttojudgement

exceptfortheauditorwasunabletoauditcertainareasofthecompanys
managementorotherconditionsbeyondhiscontrol.SECwillnotletpubliccompanies
getawaywiththis.

disclaimerofopinionastatementfromtheauditordisclaiminganyopinionregarding
thecompanysfinancialcondition

nonsequitur

theauditorrecklesslyallowedSaxontolimitthescopeofitsauditsin1979and1980by
delayingthecommencementoftheonsiteaudituntilmidtolateMarchwhenFoxknewthat
SaxonsconsolidatedfinancialstatementsweredueonMarch31ofeveryyear
//notenoughtimetodoitproperly

asauditsbecomecommoditized,accountingfirmsneedtobeingoodstandingwiththeir
clients.priceslashinghasbecomecommonintheaccountingindustry.

theauditistheopeningwedgefortheBigEighttoperformothermorelucrativeserviceslike
generalconsulting,taxes,governmentwork,actuarialstudied

anytimefeesfromnonaccounting,auditing,taxengagementsbecomeverysubstantial,and
thiscanbelessthan50%ofthetotal,thefirmmaynolongerdeserveitsprofessional
standing

loanlosses
collateralvalues

youcannottrustonanybodytodoyourhwforyou

3)PERSONTOPERSON:ASHAREHOLDERLETTER

financialhighlights
stockholdersletter

readasmany10K,10Qandproxystatementsasyoucan

startattheannualreport.ittypicallycomesinthespring

withallthosepages,onecanalwayslearnsomethingaboutthefirm,sincethelongerthe
report,thegreaterthechancethatmanagementwillinadvertentlyslipinsomethingwhichcan
bedissectedbyastutereaders

atleast5andpreferably10yearsworthofannualsandquarterliesforanygivencompanyin
ordertomakesenseofthe10Kandthe10Qyoureadforthisyear

readHOWTOREADABOOK.applythoseprinciplestoreadingtheannualreport

whatisinanannualreport

ifthefinancialsarenotdisplayedprominently,bepreparedfortrouble

doesthefirmmentionproblems?aresolutionsdiscussed?
bewareoffirmsthatdismissproblemsbyblithelysaying,weareconfidentwecanovercome
thesituation

lookatthegraphics.whatdoesthefirmwanttodrawyourattentionto?
lookathowthegraphicsovertimehavechanged.whatarethetrendsinthechanges?

lookatFINANCIALHIGHLIGHTS

thefirstreallysubstantivepartistheLETTERTOSHAREHOLDERS.
here,managementdiscussessuccessfulandfailedstrategies

theletterscanindicatecoverupsandblunderswhichcanbemaskedbyfiddlingwiththe
numbers
youhavetoreadthemslowly,carefullyandwithacriticaleyeespeciallythosepartsofthe
letterwhichcanbeverifiedbyreferencetothestatisticsreferencedelsewhereinthereportor
inearliermessages

areoldletterscontradictoryoroverlyoptimistic
comparethereportstoseeifthereweremanychartsandgraphsduringgoodyearsand
noneorfewinbadyears.ifthatisthecase,theyarephonies

1980InternationalHarvesterLetter
[29,30,31]

iftheyaredoingbetternow,howmuchworseoffweretheyinthepast?

ANDREWCORP
[32]

asuddenshiftingearsisusuallyindicativeofasituationthatwillnotturnaroundnearlyas
fastasthecompanywantsshareholderstobelieve

ifsomebodyallegedlyimportanttothecompanyisremovedfromthestaffphoto,theyarenot
longerthatimportant

biginventoryisoneofthesurestsignsoftroubleahead

redflags:
auditorputsoutaqualifiedopinion
auditorresignstheaccount

afrankdiscussionofproblems,alongwiththoughtsofpropersolutions,isthemarkof
managementwhichcanbetrusted

thisisakeychapter.itmeritsarereading

4)DIFFERENTIALDISCLOSURE

differentialdisclosurewhatthecompanysaysinonedocumentismarkedlydifferentthan
whatthecompanysaysinanotherdocument

theremaybemorecompleteinformationonaparticulartopic

annualsandquarterliesvs10Kand10Q

stockholdersletterrevealstherationalebehindmgmtactionsanddecisions

howareoperatingearningsdefined?
whereistheAnalysisandDiscussionsection?(inwhichreport)

payattentiontotheannualreportbutmaymoreattentiontotheanalysisanddiscussion
section


ifearningsdropforthefirsttimeinalongtime,theanalysisanddiscussionwillhelpyou
understandthecauseandifthatcauseisboundtobepermanent

challengealmostinvariablymeanstrouble