“In good times, few focus on such ‘mundane’ issues as earnings quality and footnotes. However, this lack of attention to ‘detail’ tends to come back and bite investors during bad times. There are notable exceptions to this generalization. The short sellers tend to be among the most fundamentally driven investors. Indeed, far from being rumour mongers, most short sellers are closer to being the accounting police. To aid investors in assessing the likelihood of accounting shenanigans, I have designed the C-score. When combined with measures of overvaluation, this score is particularly useful at identifying short candidates.”—James Montier
Almost done with my reading of James Montier’s book Value Investing: Tools and Techniques for Intelligent Investment. In chapter 25—Cooking the Books, or, More Sailing Under the Black Flag—James discuss his own C-score metric to be used when identifying short candidates.
Below is an excerpt with this discussion of the C-score and its six inputs. Emphasis added by me.
Who is Cocking the Books? The C-score
“In the previous chapter we explored one method of screening for short candidates.
However, it occurred to me that a more accounting-based screen might also be useful in identifying potential shorts by looking at those who might well be cooking their books, or trying every last trick to ensure that they can beat the analysts’ quarterly forecasts.
To this end I have created the C (for cooking the books or cheating) score to help measure the likelihood that a firm may be trying to pull the wool over investors’ eyes. The score has six inputs, each designed to capture an element of common earnings manipulation:
- A growing difference between net income and cash flow from operations. In general, managements have less flexibility in shaping cash flows than earnings. Earnings contain a large number of highly subjective estimates such as bad debts, pension returns, etc. A growing divergence between net income and cash flows may also indicate more aggressive capitalization of costs.
- Days sales outstanding (DSO) is increasing. This, of course, signifies that accounts receivable are growing faster than sales. This measure is really aimed at picking up channel stuffing (sending inventory to customers).
- Growing days sales of inventory (DSI). Growing inventory is likely to indicate slowing sales, never a good sign.
- Increasing other current assets to revenues. Canny CFOs may know that investors often look at DSO and/or DSI, thus they may use this catch-all line item to help hide things they don’t want investors to focus upon.
- Declines in depreciation relative to gross property plant and equipment. To beat the quarterly earnings target, firms can easily alter the estimate of useful asset life.
- High total asset growth. Some firms become serial acquirers and use their acquisitions to distort their earnings. High asset growth firms receive a flag in this score.
These elements are scored in a simple binary fashion, so if a company has increasing DSI it will receive a score of 1. These are then summed across the elements to give a final C-score bounded from 0 (no evidence of earnings manipulation) to 6 (all the flags are present).”
“The C-score is only a first step in analysing whether a company is or isn’t cooking its books. However, it does seem to work relatively well. Figures 25.2–25.3 show the performance of stocks by C-score across Europe and the USA over the period 1993–2007 (portfolios are formed in June and held for one year).
In the USA, stocks with high C-scores underperform the market by around 8% p.a., generating a return of a mere 1.8% p.a. In Europe, high C-score stocks underperform the market by around 5% p.a., although they still generate absolute returns of around 8% p.a.
Of course, the C-score is likely to be more effective when it is used in tandem with some measure of valuation. After all, it is often the case that high flying stocks (which are likely to be expensive) will be more tempted to alter their earnings to appear to maintain their high growth status, than value stocks. It is also likely that when these stocks get ‘found out’ the punishment will be considerably worse than that for a cheap stock.
This is borne out by the evidence. When we combine the C-score with a price to sales ratio greater than 2 the returns drop dramatically. In the USA this combination results in a negative absolute return of 4% p.a. (median stock return −6% p.a, and 54% of stocks seeing negative returns). In Europe, the combination of a high C-score and price to sales greater than 2 also generates a negative absolute return of 4% p.a. (median stock return −10% p.a. and 57% of stocks seeing negative absolute returns).”
See here for James Montier’s paper “Mind Matters: Cooking the books, or, More sailing under the black flag.”
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.