It must be February. Twice a year – usually February and August for most companies – we enter ‘earnings season’.
Financial analysts and business journalists cancel holidays and settle in for long hours, attending numerous results presentations and digesting a steady stream of press releases while trying to see what new information can be gleaned from company managers and directors.
Many CEOs (and their PR teams) treat it as a cat and mouse game – eager to present the company’s best side to investors with the aim of convincing them that the results are good, and the business is on track for a bright future.
You can’t do much about outright fraud in financial statements – though some of the most egregious lies are easier to spot – but you can arm yourself with a keen eye and a healthy scepticism as you wade into earnings season.
Here are some things to look out for:
Companies love telling you the good stuff. They also do their best to avoid talking about the not-so-good. Accordingly, beware of the company that tells you all about its wonderful sales growth, but hides the profit decline on the second or third page of the press release.
Healthzone Limited (ASX: HZL) gave a copybook performance in its final reporting effort before entering administration. It trumpeted a higher gross profit and net tangible asset growth (of all things) at the top of its press release. You had to get to the table at the bottom of page 1 before you noticed that sales were down 17 per cent, and profit had fallen by almost a third.
It’s standard practice in financial reporting to compare the most recent results against the last corresponding period. Easy done for whole years – you simply compare the results to last year. For quarters or halves, however, the best comparison is to the same period in the previous year. That way, whatever ‘seasonality’ exists (more soft drinks sold in summer, more jackets in winter) won’t distort the numbers by comparing a summer season with a winter season, for example, when trying to see if the company is growing.
So when a company starts comparing sequential periods (summer versus the recent winter), you should tread carefully – it’s likely that management have chosen a comparison which shows their performance in the best light.
Salmat (ASX: SLM) performed just this feat in their results released yesterday. The company will argue that sequential halves are more relevant due to the loss of a Telstra (ASX: TLS) contract – and they may be right – but investors should always be vigilant.
One of the perennial management favourites is to exclude so-called ‘one-off’ factors from company results.
Restructuring, IT system replacements, new premises and product recalls are often the main culprits here. There is actually some validity to this approach – used wisely, it allows investors to compare the underlying business performance, free of one time benefits or costs. However, like all numbers, this metric is open to abuse.
Firstly, when did you last see management highlight a one-off benefit? Yes, it does happen, but the ratio of good to bad one-off factors is squarely in favour of the latter. Management teams who only isolate the bad news are trying to have their cake and eat it too – claiming the good news as the fruits of business as usual, but seeking to explain away the negatives.
The other watch-out for one-offs is when they’re not one-off at all. Some companies report one-off factors so frequently, you’d swear they were in the restructuring business.
Billabong International (ASX: BBG) has been guilty of the latter, with asset write-downs in 2009, followed by restructuring charges in 2010 and 2011. Again, there may be good reasons why there are sequential one-off factors, but investing caution should be the result.
Some companies are very diligent about being up-front with investors. Berkshire Hathaway (NYSE: BRK-A, BRK-B) and our own WH Soul Pattinson (ASX: SOL) are two companies who are scrupulously open and honest about both the good times and the bad – and don’t try to spin their way into your portfolio.
This reporting season, make sure you are on the lookout for PR shenanigans. There’s nothing necessarily improper or irregular about using some of the practices outlined above, but if management is trying to bury bad news, you have to ask yourself whether you want to buy shares in that company with your scarce investment funds.
Instead, do your own research. Read past the headlines and glossy pictures, and let the numbers do the talking. Check out the company’s products or speak to their customers and suppliers (if you can) and have a look at previous reports, to see if the emphasis of the management commentary has changed. Above all, make sure you employ the ‘sniff test’ – does this seem like a company trying to inform its shareholders, or a company trying to spin its way through the bad news? I know which business I’d rather invest in.
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Scott Phillips Is The Motley Fool’s feature columnist. Scott owns shares in Telstra, Berkshire Hathaway and WH Soul Pattinson. You can follow him on Twitter @TMFGilla. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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