The Central Role Of Accounting Quality In Investment DecisionsBloombergQuintOpinion
Accounting quality is the most underestimated investment risk in India. Nearly half the stocks which were in the BSE 500 ten years ago, have exited the index since. The primary driver of these exits is shoddy corporate governance and poor capital allocation (the two are linked). In contrast, the number of companies which have significantly enriched their shareholders are a handful. At Marcellus, we use 12 powerful forensic ratios to evaluate the accounting qualities of Indian companies. This framework has proved to be an effective predictive tool with strong correlation between its accounting quality results and investment returns.
“It has been far safer to steal large sums with a pen than small sums with a gun” – Warren Buffett
1. Avoiding Dubious Companies Is As Important As Identifying Great Companies
Analysis of the stocks exiting the BSE 500 over the last 5-10 years indicates that most exits had little to do with business downturns, but were mainly due to corporate governance or accounting lapses and capital misallocations at these firms.
If one were to look at BSE 500 as it stood in December 2009, of the total 500 member stocks then, only 274 stocks remain in the index.
In other words, nearly 45 percent of the stocks have exited the index over the last ten years.
On their way out, most of these stocks saw significant erosion in their shareholders’ wealth. On average, the companies which exited the index have lost 40 percent of their December 2009 market cap. Hence, for every Bajaj Finance and Eicher Motors which have significantly enriched their investors, there has been an Educomp and Lanco Infratech which left their minority shareholders high and dry.
2. Evaluating Accounting Quality Becomes All The More Important For Small Caps
While the reward is enormous for picking the right small cap stocks, the associated risks and rigour required are manifold, as compared to that in the large cap and even mid cap space for that matter. In particular, the risks and hardships of investing in a small cap stock are due to the following factors:
- Inordinate bet on the promoter’s integrity: There is relatively high dependence on promoter(s), as generally the level of institutionalisation is relatively low in the company given the stage of evolution. Hence the business acumen and integrity of the promoter(s) would play a defining role in the success or failure of these smaller companies.
- Inadequate coverage by brokerage analysts necessitates deeper diligence: The low level of analyst coverage creates a ‘valuation gap’ in small cap stocks and thus creates an opportunity for non-linear share price returns from successful small-caps. At the same time, lack of analyst scrutiny puts the onus of deep due diligence and research on the investors.
3. Quality Rules In The Long Run
A look at longer-term stock returns in India suggests a direct relationship between better accounting quality and superior stock performance. In the shorter run, however, markets do have a tendency to test investors’ patience even if the investor is using the most time tested and rational investment methods. Hence during this period of irrational exuberance and abundant liquidity, where there is a pressure to chase near-term returns, quality does take a backseat. Take the instance of the bull market of calendar year 2017 which saw speculative excesses being created in lower quality stocks.
However, things changed with the onset of 2018. As the cost of capital rose, liquidity started drying up and equity markets turned volatile. This, in turn, made investors more selective. Recurring news flow on auditor resignations further spooked investors through 2018. All of this, in turn, brought the focus back on accounting quality. This has resulted in good quality companies outperforming their poor-quality counterparts by a considerable margin in 2018 and continuing to do so in 2019.
4. Marcellus’ Forensic Framework To Evaluate Accounting Quality
Given the points discussed in the earlier sections of this column, evaluating accounting quality of a company needs to be a cornerstone of our investment process. We at Marcellus have developed a set of 12 ratios that helps to grade companies on accounting quality. The selection of these ratios has been inspired by Howard Schilit’s legendary book on forensic accounting called ‘Financial Shenanigans’. The book was first published in 1993 and the fourth edition was published in 2018. It draws upon case studies of accounting frauds—involving not only well-known frauds like Enron and WorldCom but also numerous lesser known cases of accounting trickery—and draws lessons from these to create techniques for detecting frauds in financial statements.
These 12 forensic accounting ratios cover checks around key financial statement categories like income statement (revenue/earnings manipulation), balance sheet (correct representation of assets/liabilities), cash pilferage and audit quality checks. Some of these key ratios and rationale are shown in the table below. We look at the historical consolidated financial statements for the universe of firms. We first rank stocks on each of the twelve ratios and give a final decile-based pecking order on accounting quality for stocks – with:
- D1 being the best on accounting quality and D10 being the worst.
- The top 5 deciles i.e. D1 to D5 are generally indicative of a company with good accounting quality/practices – we call D1 to D5 the ‘Zone of Quality’.
- Whereas the bottom 30 percent, i.e. D8 to D10 generally represent companies with questionable accounting practices – we call this the ‘Zone of Thuggery’.
5. Our Forensic Framework Has Proven To Be An Effective Predictive Tool
Over the longer term, there has been a strong correlation between the accounting quality as suggested by our forensic model and shareholder returns. For instance, the ‘Zone of Quality’ has outperformed the ‘Zone of Thuggery’ by a whopping 9 percent per annum, over 2016 to 2019.
There is another way to understand the effectiveness of this forensic model – there are around 53 companies (out of the BSE 500) which constantly featured in the bottom three deciles in our accounting model for the years FY15 to FY18.
Over CY16-19, these companies have on an average delivered negative CAGR of 13 percent compared to benchmark BSE 500’s 10 percent – an under performance of nearly 23 percent per annum.
As investors in India once again start getting excited about small caps, they would be well served by devising a forensic accounting model which can help them screen out the numerous mischief merchants in the Indian stock market.
Saurabh Mukherjea is Founder and Ashvin Shetty is Portfolio Counsellor at Marcellus Investment Managers.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.