What's Behind the Numbers? Reading The Fine Print

In the investment world, we often focus on what to look for in great companies. However, not as much attention is paid to the flipside of the coin – what to watch out for. Throughout this post, I’ll be paraphrasing an excellent book on the subject, “What’s Behind The Numbers” by John Del Vecchio and Tom Jacobs. As we know, avoiding big blunders is what matters in the long-run.

DSO & Aggressive Revenue Recognition

No matter your investing style, strategy or experience, you will consider buying companies which say that their business is growing so much that of course it’s taking longer to collect from customers – a nonsensical explanation for rising days sales outstanding (Del Vecchio & Jacobs, 2013). Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment for a sale. You’ll find the number from the financial statements and the calculation is as follows:

Quarterly DSO = 91.25 * (Accounts Receivable / Quarterly Revenue).

Annual DSO = 365 * (Accounts Receivable / Annual Revenue).

What you want to do is track the DSO of the past 6-8 quarters. Changes in DSO tell us a lot about whether the payment terms have shifted. Of course changes in DSO can come from economic slowdowns, poor collection, and so on, but the practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is.

The only information that matters comes from the company’s filings with the SEC.

On a quarterly earnings call, management might have a host of explanations for higher DSO. They may say that customers are of high quality, with good credit, so there is no risk to collection. In truth, higher DSO has nothing to do with collection but everything to do with revenue recognition. Looser payment terms allows a firm to pull revenue forward into the current quarter. If payment terms would have been stricter, the company would book less revenue; something Wall Street analysts don’t like. On a year-over-year basis, even just a few days increase in DSO can signal poor earnings quality and potential trouble ahead (Del Vecchio, 2013).

Questionable Inventory Buildup

Most companies have some form of inventory on their balance sheets. If inventory rises along with sales, it’s not a case for alarm on its own. Again, what we want do is track trends from past years and quarters. A definite red flag is if inventories are rising, while sales are not. The nature of inventory (and its shelf-life) depends on the industry. As long as we are religiously operating within our circle of competence, we shouldn’t have too much trouble in understanding the nature of a company’s inventory.

The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.

For so-called “tech” companies that make physical products, the longer their inventory collects dust, the sooner the company or competitors incorporate advances so that aging inventory becomes obsolete and unsellable. Or, it has to be disposed at such low prices that profit margins quickly evaporate. This is a win for consumers, but not to investors.

The Debt Debate

There will always be a debate on the use of debt. Wherever you stand on this question doesn’t matter. Yes, debt always represents risk. But not all debt is made equal. The most important thing when investing in leveraged companies is to know the debt intimately. As an investor, you will encounter at least several credit crises in an investing lifetime. Here are some guidelines when considering companies with debt:

Avoid all companies whose business models depends on securitizations or consistent access to credit markets.
Only buy companies with large debt to assets where you can model interest coverage, maturity dates, and other terms. Make sure the companies regular cash flows can cover a significant downturn in business. If you really want to be on the safe side, prefer companies that can pay all interest bearing debt in less than two years with operating cash flow.
Debt used to fund dividends and/or stock buybacks is usually a recipe for disaster.

There is a large class of income-hungry investors who choose dividend-paying stocks as a rule.

A company with a history of dividends eventually attracts a long-term shareholder base because of that dependability, and a history of rising dividends only locks in the shareholders more tightly. A dividend-paying company’s management therefore will sell its firstborn rather than cut – let alone eliminate – its dividend. Income-loving investors would sell en masse and destroy the stock price. Therefore, a company may build up debt to pay dividends and put off the day of dividend-cut reckoning. Eventually, in almost every case, debt used for dividends is completely unsustainable.

There are countless quotes on debt. Personally, I’d like my companies to operate under one from Adam Smith:

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”

Conclusion: Look for Opportunistic Value

Industries and companies go in and out of investing favor all the time. “Opportunistic Value” is simply a way of saying buy a business you know well when it goes on sale. Why many, many people who buy goods on sale but overpay for stocks will remain a mystery. Experience and research suggests that if you buy a steady-state business – a decent business with reasonably recurring cash flows and stable margins – at a multiple of 10 or fewer times market cap to free cash flow, it’s pretty tough to lose money. You buy optionality – future growth, reversion to the mean, whatever – for low or no cost.