When performance strength is a worry

864_MW_P12_strategy_main — Elizabeth Holmes: from hero to zero

One major risk to anyone investing in individual stocks (rather than an index fund, say) is that one of your carefully picked shares turns out to be in a much worse financial state than you thought. We looked at how to avoid such stocks in a recent issue of MoneyWeek. Now a group of academics think they have uncovered another key indicator of a company that's set to go bad a strong track record of beating expectations.

The title of the paper (by researchers at the universities of Cambridge, Southern California, Hong Kong and Houston) says it all: "A reputation for beating analysts' expectations and the slippery slope to earnings manipulation". The team looked at US-listed stocks that had been sanctioned by the regulator (the SEC) for manipulating earnings between 1985 and 2010. "These firms are both more likely to consistently beat analysts' quarterly earnings forecasts during the manipulation period, as well as in the three years prior," notes the study.

In short, companies start by beating the market honestly. But as expectations and valuations rise, it becomes ever harder to maintain that record. So companies turn to "aggressive accounting" (perfectly legal figure fudging) and "ultimately, earnings manipulation", as the authors put it. The more concentrated that power is within these companies ie, the less accountable the CEO the more likely it is that the company will succumb. When the subterfuge surfaces, unwary investors are in for a nasty shock.

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We've seen variations on this before when a CEO makes the cover of a magazine, it's often a sign that the market is over-excited about a stock, and that the CEO, the company, or both, are about to fall off their perches. Take the downfall of blood-testing group Theranos (not listed, but a great example of the phenomenon). Theranos promised a revolutionary new blood test, and photogenic CEO Elizabeth Holmes was plastered across US business magazines throughout autumn 2015 even as a few journalists and sceptical scientists were about to reveal the company as a massive triumph of hype over reality. Forbes, which had listed Holmes' net worth as $4.5bn in 2015, cut it to zero last year.

So here's what to bear in mind. If a company is enjoying a strong, smooth run of growth and that's being priced into valuations then trawl its accounts with a particularly fine-tooth comb. Look for changes to accounting policies; "one-off" items that seem to be anything but; and rising profits not being reflected in rising cash flows. And if it is led by a charismatic, media-friendly CEO, then double-check all the data before you even think of investing.