Madura, Jeff - What Every Investor Needs to Know About Accounting Fraud

McGraw-Hill, 2004, [Equity Investing] Grade 2

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Reading this book I went from mildly pleased, to incurious and finally downright irritated. The subtitle is “Proven Techniques to Avoid Questionable Stocks”. In reality Jeff Madura, a finance professor at Florida Atlantic University and an author of several finance textbooks, provides nothing of the kind in this book written after the Enron and WorldCom scandals burst in the early 2000s.

The author has divided the text in 5 different parts and the book starts off by displaying a number of ways that companies historically have used to look more profitable - by increasing sales alternatively decreasing costs - or look more financially stable than they actually were and Madura clarifies with some of the then recent examples from the bust after the TMT-bubble. It is fairly basic but illuminating and written in good spirit. It’s an okay introduction to the subject of financial deception.

In the next chapter Madura tries to explain why so few have the ability but more importantly the incentive to uncover the shenanigans. The short answer is that they are all on the payroll of the corporations who cheat. Auditors are paid by the companies and apart from doing audits earn money on doing extra corporate consulting. The firms that Wall-Street analysts work for earn the big bucks from corporate finance services for the companies and the analysts are dependent on the goodwill of the companies for their flow of information. Credit rating agencies depend on the audited accounts prepared by the auditors who are on the take. This was prior to the debacles of the rating agencies in the GFC so the fact that companies pay for the rating agencies’ ratings as well isn’t discussed. Still the bottom line is that no one wants to bite the hand that feeds them.

Then follows two sections on how board practices should serve the owners of the companies and governmental regulatory initiatives and bodies related to financial supervision. These sections are fairly basic (SEC should get more resources), they have a kind of academic ivory tower touch to them (FASB should be allowed to write really detailed accounting rules), also they are a bit dull and don’t really speak to the investor who wants to understand how to protect himself from investing in the wrong kind of stocks.

The last part is called “How Investors Can Cope With Deceptive Accounting” and at last we should presumably in the six chapters that follow learn how to “protect your investing portfolio from accounting fraud”. I expected some discussion on how to use financial tools like cash conversion, change in accruals, change in Days Sales Outstanding, Days Sales in Inventory or other less frequently used metrics perhaps in combination with other more subtle signs of ethical collapse in companies.

One of the chapters can be summed up with that the reader shouldn’t trust anyone. This is a rather superfluous message since it has to a large extent been the overall message so far. However, Madura now also adds that the reader shouldn’t even trust his own ability to uncover financial tricksters. Consequently the advice in three of the other chapters is “give up”! Invest in mutual funds, ETFs, T-bills and bonds instead of individual stocks. Talk about a let down! Yes, by investing in bonds the investor clearly “avoids questionable stocks” but that was probably not quite the type of advice that people expected to get and what got them interested in purchasing the book.

In all honesty there are two other chapters that look into investing in stocks. The author advices the reader to look for corporate management teams that run their companies for the long term and to do detailed fundamental research on all aspects of the company’s business operations, sector and management and then make common sense judgments on the corporate quality. This is fair advice, but it’s hardly very specific.

Buy Howard Schilit’s Financial Shenanigans or Thornton O’glove’s Quality of Earnings instead.

Mats Larsson, March 25, 2017

Damodaran, Aswath - Narrative and Numbers

Columbia Business School, 2017, [Equity Investing] Grade 4

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The procedure of valuing a stock through is rather simple once it has been learnt. And when looking in retrospect on why old valuations turn out to be incorrect it is rarely due to getting the mechanics of the valuation tool wrong. Instead it is almost always because the sales or profits turned out very differently from what was forecasted since the company, its strategy or business environment developed in an unanticipated way – the narrative was wrong. This is a book on how to combine the numbers of the valuation tools with a narrative that brings life, understanding and, by this, increased precision into the valuation made. The author is a well-known finance professor at NYU who has written a large number of finance books.

As I understand it the book started with the author posting and updating the narratives and subsequent valuations for a number of stocks like Uber, Amazon, Apple, Alibaba etc. online. They now feature as case studies throughout the book. Taking a step back, Narrative and Numbers is also a personal journey for Damodaran as he over time has developed from a pure number cruncher to taking a more holistic approach. I find that when a reader is invited to share an author’s personal development the result is often very likable. This book is no exception and it is evident that the author has enjoyed writing it.

The structure of the text is very, well… structured. Damodaran tells you that he will combine narratives and numbers, he describes the basics of one of those, then he describes the basics of the other one, he merges them and finally discusses the consequences. The author who describes himself as a “teacher first” gives us short but thorough accounts of the two components before merging them into a greater whole. And to clarify, the narrative referred to in this book is the fundamental story of long-term value creation drivers for the company, not the flimsy, often biased and constantly shifting stories that always surround listed companies on the stock exchange. All the way through the book we get to follow the described process through the case studies and there are further several illuminating pictures giving good oversights of the reasoning.

The advocated valuation process is to:

1.      develop a narrative for the business,

2.      test the narrative to see if it is possible, plausible and probable,

3.      convert the narrative into drivers of value,

4.      connect the drivers of value to a valuation and

5.      keep the feedback loop open.

Interestingly the author calculates one value of the company as a going concern and one liquidation value and then estimates the probabilities of each life-or-death scenario. I very much appreciate the 3P test in stage 2 and the openness for change in stage 5 importantly tries to ensure that the narratives are reasonable and don’t becomes stale and outdated in the light of changes. Damodaran’s arguing for the importance of having enough humility to alter ones opinion brings to mind similar arguments from George Soros.

My main caveat is that the process doesn’t explicitly enough ensure a combination of an inside view and an outside view when developing the story. When forming a narrative it is very easy to focus on the uniqueness and thrill of the situation at hand and extrapolate from the recent history. Often this leads to too high expectations and bottom-up sell side analyst estimates are partly due to this almost always too optimistic. The outside view treats the situation statistically and takes into account the outcome of many similar historical situations. In business where success is governed by both skill and luck both viewpoints have merit.

To make good forecasts narratives must meet numbers. Without the verbal structuring of the fundamental business story of a company it isn’t even possible to understand the numbers to start with. Damodaran shows that good decisions benefit from several points of view such as the numerical and the verbal and I fully agree.

Mats Larsson, March 03, 2017

Miller, Jeremy - Warren Buffett's Ground Rules

Profile Books, 2016, [Equity Investing] Grade 4

I like this book. It’s got a genuine and honest feeling. There are several dozens of books on Warren Buffett. What makes this one special or needed? All other texts on Buffett’s methodology are based on how he has conducted his business at Berkshire Hathaway. However, before this... Further reading... Link to Amazon...

Ashworth-Lord, Keith - Invest in the Best

Harriman House, 2016, [Equity Investing] Grade 4

The author of this text on stock selection is touted as the Warren Buffett of the UK. This is a bit unfair since, to me, Keith Ashworth-Lord displays a distinct investment personality of his own. He’s not simply a Buffett clone. The author has more than 30 years’ experience from sell-side... Further reading... Link to Amazon...

Chancellor, Edward (ed) - Capital Returns

Palgrave, 2016, [Equity Investing] Grade 5

This is the even more brilliant sequel to the already superb 2004 book Capital Account. Edward Chancellor, the author of the classic Devil Takes the Hindmost, picks and chooses among the 2002 to 2015 Global Investment Reviews written by money manager Marathon Asset Management... Further reading... Link to Amazon...

Chancellor, Edward (ed) - Capital Account

TEXERE, 2004, [Equity Investing] Grade 5

There lies a danger in rereading books after a long time – it’s not always they age gracefully. The subtitle of Capital Account is A Money Manager’s Reports on a Turbulent Decade, 1993-2002. The time period corresponds roughly to the first half of my time in the equity market so far and I... Further reading... Link to Amazon...

Neely, J. Lukas - Value Investing: A Value Investor's Journey Through the Unknown, 2015, [Equity Investing] Grade 4

In Value Investing the author, an investment advisor and former hedge fund manager, shares his framework for investing in stocks. The stated aim is to provide a process for investment success. The emphasis is on process as investors without one are prone to let psychology determine... Further reading... Link to Amazon...

Crosby, Dr. Daniel - The Laws of Wealth

Harriman House, 2016, [Equity Investing] Grade 4

This is something as unusual as a practical book on behavioral finance. Where the discipline for too long has focused on disproving the so-called Modern Portfolio Theory and listing psychological quirks among investors, Daniel Crosby takes things one well needed step further... Further reading... Link to Amazon...

Ervolini, Michael A. - Managing Equity Portfolios

MIT Press, 2014, [Equity Investing] Grade 4

When someone writes a book on a subject and at the same time runs a company offering a software solution to the issues discussed this generally throws up warning flags. In the case of Managing Equity Portfolios this is unjustified. The author is clearly passionate about solving the... Further reading... Link to Amazon...

Cunningham, Lawrence A. (ed) - The Buffett Essays Symposium

The Cunningham Group & Harriman House, 2016, [Equity Investing] Grade 4

If you’ve ever watched Warren Buffett and Charlie Munger answering questions at a Berkshire Hathaway AGM, one thing that is striking is the combination of breadth and depth. That is, the breadth in the number of topics covered and the depth of the insight. The George Washington... Further reading... Link to Amazon...

Montgomery, Roger -

My Cents Worth Publishing, 2010, [Equity Investing] Grade 4

A few years ago I attended a class at Columbia Business School and seated next to me was this very nice Australian. When I at one point asked about his favorite investment book he pointed to by Roger Montgomery. Later on when I read the book my expectations were perhaps... Further reading... Link to Amazon...

Griffin, Trent - Charlie Munger: The Complete Investor

Columbia University Press, 2015 [Equity Investing] Grade 4

This might very well be the best over-hyped book I have ever read. Already a year before actual publication rumors began to swirl around the book - fully understandable given the intriguing combo of our time’s most mythical investor and a hugely successful writer with an ardent... Further reading... Link to Amazon...

Kirz, Jarred J. - Fisher Investments on Financials

John Wiley & Sons, 2012, [Equity Investing] Grade 3

With this book the author provides the basis of an understanding of how to invest in the finance sector. The author is an analyst at Fisher Investments covering the financial sector and macro strategy and with this book Ken Fisher’s investment firm completed the book series going... Further reading... Link to Amazon...

Bares, Brian T. - The Small-Cap Advantage

John Wiley & Sons, 2011, [Equity Investing] Grade 3

This is a book with the dual purpose of on the one hand teaching aspiring small-cap portfolio managers how to set up shop and on the other hand giving institutional investors a better feel of what to look for when performing due diligence of small-cap managers. In respect to this aim... Further reading... Link to Amazon...

Ware, Jim - The Psychology of Money

Wiley Finance, 2000, [Equity Investing] Grade 4

The starting point for this Jim Ware’s first out of currently three books is the observation that very few portfolio managers continuously manage to beat their benchmarks and that the standard solution to this problem is to do “more of the same”, only with more energy. The... Further reading... Link to Amazon...

Gray, Wesley R; Fogel, Jack R. & Foulke, David P. - DIY Financial Advisor

Wiley&Sons, 2015 [Equity Investing], Grade 4

Trying to elbow oneself into the latest unicorn-celebration in Silicon Valley is a mean feat. But it pales in comparison to the task at hand for the authors of DYI Financial Advisor – achieving tenure in the Advice For The Individual Investor-section of the bookstore. However, we believe... Further reading... Link to Amazon...

Freeman-Shor, Lee - The Art of Execution

Harriman House, 2015, [Equity Investing] Grade 5

I’m a terrible snob when it comes to investment literature. Books written for private investors rarely interest me. This is different. This might be the most important book on investments that a private investor can read – if he can gather the discipline to follow the advice. It might actually... Further reading... Link to Amazon...

Del Vecchio, John & Jacobs, Tom - What's Behind the Numbers?

McGraw Hill, 2013, [Equity Investing] Grade 4

If your portfolio looses 50 percent of its value it needs to recover 100 percent to reach the same spot. If you can avoid a fair number of the worst performers in the stock market you will have a good chance to outperform. One way to avoid some of the holdings that kill performance is to... Further reading... Link to Amazon...

Greenblatt, Joel - The Little Book That Beats the Market

John Wiley & Sons, 2006, [Equity Investing] Grade 4

During the summer InvestingByTheBooks will review some older books that we never got around to writing about although we think they are important. Joel Greenblatt’s The Little Book That Beats the Market had an immediate and vast impact when it was published in 2006. Greenblatt is through his hedge fund Gotham Capital and later ventures clearly one of the most successful... Further reading... Link to Amazon...

Easterling, Ed - Unexpected Returns

Cypress House, 2005, [Equity Investing] Grade 4

During the summer InvestingByTheBooks will review some older books that we never got around to writing about although we think they are important. Ed Easterling shows that by taking a step back and getting a better overview the investor gains an understanding of secular market... Further reading... Link to Amazon...