The importance of accounting cannot be overstated in the eyes of the Montaka research team. Accounting is the lens through which the underlying economics of a business are viewed. If this lens is distorted, the perception of a business’ health will be somewhat distorted too.
One of the four characteristics we look for in an attractive short candidate is called “misperceptions”. Opportunities along this dimension stem primarily from misleading accounting techniques. Misleading accounting can create distorted perceptions of a business’ quality in the eyes of investors, and this can create an opportunity in the market to profit from a potential mispricing.
Chief Financial Officers have at their disposal a large number of techniques – all legal – to shape their publicly-disclosed financial accounts in ways that can create an inflated perception of quality. Whether through acquisitions to create the perception of growth; or the capitalization of expenses to boost the perception of profitability – these are just two tricks that are often employed.
Another is the creation of new (and more favourable) profitability metrics to draw investor’s attention away from standard definitions. These are known as non-GAAP financial measures, meaning they are not part of the Generally Accepted Accounting Principles (GAAP) under which companies are required to prepare their accounts.
One of the more farcical examples of a non-GAAP profitability metric that we can recall was the “Adjusted Consolidated Segment Operating Income (CSOI)” defined in the IPO prospectus of Groupon (NASDAQ: GRPN), the online coupon-shopping website, back in 2011.
It is worth reading the legally-required disclosure with respect to this metric the company was touting. Essentially, this “profitability metric” told investors very little about the business’ actual profitability.
More recently, many have been observing an increase in the use of such non-GAAP profitability measures. As illustrated in the chart compiled by BAML (below), the percentage of companies reporting non-GAAP adjusted EBITDA metrics has accelerated in recent years to nearly 90%.
Furthermore, the Wall Street Journal recently observed a growing divergence between GAAP earnings per share (EPS); and reported non-GAAP EPS measures. Of course companies will aim to draw investors’ attention to the better looking non-GAAP metrics – while the true economics of these businesses are looking increasingly different.
It is encouraging, therefore, to see the Securities and Exchange Commission (SEC) starting to take note of this situation. As the Wall Street Journal reported, SEC Chairwoman, Mary Jo White, told guests at a US Chamber of Commerce conference that regulators were considering restricting the use of such non-GAAP financial metrics.
“Your investor relations folks, your CFO, they love the non-GAAP measures because they tell a better story… We have urged for some time that companies take a very hard look at what you are doing with your non-GAAP measures… We have a lot of concern in that space.” – Mary Jo White
While we certainly encourage the SEC to rein in such use of accounting gimmicks, we are not optimistic that games will cease to continue. Since the dawn of time, humans have become highly proficient at positioning the truth in advantageous ways. We do not see this changing any time soon.