Glancing at the rear view mirror does help

Published on January 12, 2013 by Chanakya Dissanayake

 

How often do we hear that the historical financial statements of companies represent the “past”, and portfolio managers should rather focus on the “future”, given the fact that companies are valued based on future earnings potential? You don’t drive by looking at the rear view mirror, do you?

Once in a while, we get clients who like to do the opposite! They get our team to keep glancing at the rear view mirror, while their own team peers straight into the future. One such team at our office delivered a spectacular result a few days back. It took a year for this to play out, but when it did, it was worth the wait to get the client’s rave reviews of our analysts.

Recently, an IT giant (let us call them ‘A’) realized too late that it had overpaid for an acquisition (let us call it ‘B’) since B had been manipulating its financial statements through aggressive revenue recognition. Eventually, A had to write-down a substantial part of the goodwill recognized on this investment.

Our client, which had exposure to company A, exited the investment about a year back based on our team’s forensic analysis of its business and investments. Needless to say, it takes time for such things to come out in the open, which is when the stock price tanks. Two weeks ago, when the matter became public, our team and senior managers got congratulatory calls and emails from the client for saving them a few tens of millions of dollars.

How did our team accomplish this task? Firstly, this particular team was focused only on identifying potential issues with accounting and corporate governance. This way, the analysts were not influenced by other aspects of the investment decision-making process, which often cloud the issue. The team followed a two-step process. The first step was to do a sanity check. The second was to see if the suspicion had a basis other than a genuine business rationale. Company B had been able to manipulate revenues by recognizing software sales ahead of time, instead of doing so over the respective contact periods. A look at sales growth, particularly when compared to operating cash flow growth, raised suspicions. A closer look at the company’s business history and practices made us strongly recommend the issue to the client.

Sometimes, we struggle to convince clients to allocate a budget for research support, even though using our team costs a fraction of onshore teams. And then there are other times like these, when events justify the cost of the service many times over.

(My acknowledgement goes to Zo and his team for producing this success story.)

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