By Larry Cao, CFA
When I was a new analyst following technology stocks for a predominantly US equity fund, one thing I noticed in doing competitor analysis was the low multiples of some Asian companies, even after taking into account the more pronounced differences in accounting systems in those days. Did low-multiple stocks necessarily present good values? Were there any systematic reasons behind the low valuation?
Later I was also given, among other things, the added responsibility of managing a quantitative international equity fund. Finding systematic patterns in company financials that were good indicators of future stock performance became even more challenging.
Still eager to find answers to these questions, I recently read Asian Financial Statement Analysis: Detecting Financial Irregularities and was completely intrigued.
First, this is not your father's accounting textbook. The authors, ChinHwee Tan, CFA, founding partner of Apollo Global Management in Asia, and Thomas R. Robinson, CFA, managing director of the Americas at CFA Institute, are trained accountants and seasoned analysts, which gives the book a very practical bent. All the examples are actual cases of accounting irregularities identified in Asia. Some are high-profile cases, such as Satyam Computer Services; some are less well-known but not any less revealing.
Second, the authors explain the issues at hand in almost painstaking detail and in a very structured way. As the saying goes, the devil is in the details. This is true for accounting. It is even more so for forensic accounting. For example, rookie analysts tend to lose sight of the relationships between different financial statements (I know because I was one!); they home in on items in the income statements, such as earnings and revenue growth, without paying sufficient attention to balance sheets or cash flow statements. Identifying discrepancies in the trends shown across statements can be very powerful in finding red flags in a company's financials. The authors discuss in detail the key issues that may point to "red flags" in a company's financials. Through their disciplined and structured approach, the authors provide investors in Asian securities with a very powerful toolkit.
Third, better governance pays. No one wants poor governance, but investors have often found it challenging to decide on the right trade-off between lapses in corporate governance and, at least seemingly, strong business performance. The book has an entire chapter on corporate governance and related-party issues. In addition to highlighting the common governance issues, the authors provide a few cases in which investors lost substantial amounts because they ignored poor governance practices. There is a feel-good factor to buying companies with good governance practices, but not only that, it also helps investors make more money.
As for answers to my questions, yes, I found quite a few related discussions. On the low valuation of stocks in some Asian markets, the authors find a similar pattern. The differentials between some fast-growing economies' GDP and stock market performance are striking. One explanation, they suggest, could be the lack of confidence in the markets because of the prevalence of financial scandals. And patterns that analysts/quants can use to build models? There are plenty. I don't want to ruin your reading pleasure, so I'll just share one that's more widely used, namely the cash conversion cycle. If a company's earnings have been growing rapidly but operating cash flow has not kept up and receivables have become bloated instead, you should at least be concerned about the slowing conversion. It may also warrant a closer look at other warning signals.
You may never have liked accounting. (Neither have I.) But both novice and mature investors in Asian securities could benefit from this exceptionally practical guide to reading between the lines of Asian financial statements. I am keeping this one on my bookshelf. Will you?
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