How to spot a dodgy company – never trust a high achiever

Businessman dressed as superman © Getty Images
You don’t want your CEO to be a superhero

One of the biggest risks to anyone investing in individual companies – rather than a fund, say – is that one of your carefully chosen shares turns out to be dodgy.

Everyone invests in duds, even the smartest fund managers. Sir John Templeton – certainly one of the single best investors of all time – owned a big chunk of Polly Peck, one of the most celebrated corporate disasters of the 1980s, for example.

Now a group of academics have uncovered one of the key indicators of a company that’s set to go bad.

The upshot? Never trust an over-achiever…

The downside of high expectations

A Reputation for Beating Analysts’ Expectations and the Slippery Slope to Earnings Manipulation is a new paper from researchers at the universities of Cambridge, Southern California, Hong Kong and Houston.

As John Authers highlights in the FT, the researchers looked at US listed companies between 1985 and 2010. More specifically, they looked at companies that ended up being pulled up by the regulator (the SEC) for manipulating their earnings.

In short, “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”. So companies start fiddling the figures after they’ve had a good run of beating the market, and expectations are high.

And 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 to manipulating its earnings.

This is one of those beautiful academic papers that gives some respectable statistical proof to a concept that should be blindingly obvious to anyone who understands how humans work, rather than how we all pretend they should work.

Companies do well. They get used to the market’s good opinion. They don’t want to lose it. So they delve into the dark arts to keep up appearances. And it all ends in tears.

You are the CEO

What’s most interesting to me about this study is that it’s a great demonstration of the single most important factor in financial markets (and pretty much everything else for that matter) – the power of incentives.

Picture it. You’re a successful chief executive. You’re being lauded by shareholders. Other companies want you. Other CEOs want to be you. Magazines want to put you on their covers. Everything you touch turns to shareholder value. You don’t make mistakes. You never put a foot wrong. When you ignore the “expert advice” of your underlings, you always turn out to be right.

Then one day, you’re approaching the end of the quarter, and… it’s not great. It’s OK. By the standard of lesser CEOs, it’s good. It’ll meet market expectations.

But you didn’t get where you are today by meeting expectations. You beat them.

And the annoying thing about markets is that if you keep delivering, then they start to expect results that beat their expectations. If they expect you to beat their expectations, and you only meet them, then they get disappointed and send your share price (and the value of all those lovely options you’ve been hanging onto) lower.

So to meet their expectations, you really have to beat their expectations. So much for efficient markets. If you think about it too much, it makes your head ache a little. So you don’t.

Then the accountants tell you that if you just shift a little from this column and slide a little into that column and capitalise this and ignore that and downplay this and up-play that… well, they can put a bit more sparkle on the figures.

It’s all entirely legal, by the way. Other companies do it all the time. In fact, in a way, you’ve been short-selling yourself (and the company, of course) by not taking full advantage of the flexibility of the accounting regime. It’s practically your duty to your shareholders to do it.

And it’s only one quarter. You’ll make it up next quarter.

Do you take the pain? Or do you fudge the figures?

Take a wild guess. And when next quarter doesn’t quite meet expectations, you fudge again. And because you’re increasingly worried about how the figures look, you start making mistakes. Your panic turns into pressure in all the wrong parts of the organisation. You listen to ‘yes’ men while second-guessing and undermining your most competent people, who leave. And because you’re a golden CEO, no one contradicts you.

It’s not that long before everyone in the place is fudging their figures and turning a blind eye to genuine problems, because that’s what you’ve incentivised them to do. The gap between the numbers and reality grows to the point where it can no longer be covered over. At that point the market gets a nasty wake-up call, or you cross the line into outright fraud.

That’s a dramatised schematic of a CEO’s road to hell, but I think it’s pretty close to the truth.

Follow the path of least resistance

One useful guide when analysing markets – which are all about human beings, of course – is that human beings, like electric current, will always follow the path of least resistance.

Don’t get me wrong. It’s not always easy to say what the path of least resistance is. Put two different people into the same situation, and you might find that they each have a different path of least resistance. Someone who avoids what the average person would perceive as the path of least resistance has “character”.

But markets are about playing the odds. And on average, everyone is average. So betting on the “easy” option is almost always the best bet.

Anyway, in the next issue of MoneyWeek (out on Friday), regular contributor Phil Oakley will be looking at ways to spot companies at risk of hugely disappointing their shareholders – and I’d advise you to read it, it could save you a lot of money and heartache in the long run (if you’re not already a subscriber, sign up here).

But the main takeaway from this study is that, if a company is enjoying an unusually strong and smooth run higher, then you should trawl its accounts with a particularly fine-tooth comb before you buy it. If that’s beyond your skillset, then either acquire the skills you need, or stick with index funds for your pension fund and do the stock picking with your “fun” money.