Wednesday, August 31, 2016

Are you getting fucked by management?

Hello again! Recently, a company which I invested a lot of money in fired their CEO because he was under investigation for insider trading or some shit like that. The stock of the company in question (Northern Oil & Gas) of course took a significant hit. This incident got me to thinking if Northern Oil & Gas’ management has done anything else to fuck me and other shareholders over. I don’t have any evidence that Northern Oil & Gas are cooking their books. But nevertheless, a falling stock price because the former CEO may or may not have done something shady can make a guy like me very paranoid. So, I did some thinking and some googling to try and find out what are some signs that management aren’t flying straight. Again, I’m not saying that Northern Oil & Gas’ management have done anything wrong as there is no evidence for that. This article simply highlights some of the things investors should look out for when researching companies in general.

Disclosure: The intention of this article is not to influence investors to sell or buy shares in Northern Oil & Gas. Investors should do their own research. I personally do not know what I’m going to do. I might sell my shares in Northern Oil & Gas or add to my position in Northern Oil & Gas in the future. What I may or may not do in the future depends on a variety of factors. I’m also thinking about using options to hedge my position in Northern Oil & Gas so that I can sleep better at night. The problem is that I don’t think I can buy options on U.S. stocks through Malaysian brokers. I would have to find a reputable online broker, and I would also need to make sure that I’m not breaking any Malaysian laws by opening an account with an online broker.

An increase in accounts receivable as a percentage of sales (or days sales outstanding if you prefer)

An increase in the accounts receivable/revenue ratio could indicate that the company might be lowering their revenue recognition standards (which could result in higher sales returns) or booking sales that do not exist. Investors should pay attention to the company’s operating cash flow as it takes into account changes in accounts receivable. Investors should also look into how the company recognizes its revenue to see whether or not the company is loose in booking sales. For example: Recognizing the entire lump sum payment for a multi-year contract as sales in the current period.

One-off items

One-off gains obviously will result in higher accounting earnings. This is easy enough to get around by just excluding one-off gains in your analysis. Investors also exclude one-off losses to get a more accurate representation of a company’ financial performance under normal circumstances. And there’s nothing wrong with that if those expenses are indeed non-recurring. But if a particular non-recurring cost keeps recurring, then maybe investors should factor in that non-recurring item in their valuation model.

An increase in accounts payable as a percentage of sales

A company can improve its operating cash flow by delaying payments to its vendors. I think that vendor financing is overall a good thing as it frees up more cash for the company to reinvest in the business or pay dividends. However, a significant increase in the accounts payable/revenue ratio could indicate that the company is fucking around with its operating cash flow (perhaps to appear in compliance with debt covenants), or worse, having problems paying their vendors.  

Capitalization of expenses

Companies could dress up their earnings by capitalizing costs that should be expensed in the current period. This essentially moves some expenses that should be reflected in operating cash flow to investing cash flow. I get around this problem by calculating free cash flow which accounts for capital expenditure.

Other income

I get nervous as fuck when I see a large other income figure as who knows what kind of shit management has stuffed under other income. I usually exclude other income when valuing companies unless I’m confident that certain items under other income are likely to be sustainable.  

An increase in inventory as a percentage of sales

An increasing inventory/revenue ratio could indicate that the company was too optimistic in its demand projections, and overproduced or over ordered inventory. It could also indicate that management has delayed writing down inventories which could result in a significant writedown somewhere down the road.

Off-balance sheet arrangements

Management might hide liabilities off-balance sheet to make the company’s financial condition look better than it really is. Therefore, it’s important for investors to check whether the company has potentially material off-balance sheet obligations.

A good way of reducing the risk of getting it up the ass from an unethical management team is to invest in companies where management actually owns a lot of stock in the company they run. People are less likely to fuck themselves, not intentionally anyway. Thanks for reading. Take care and stay rational.

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