Qualitative Factors

By Aaron Nematnejat

In this article we describe other potential hazards in stocks which cannot be gauged using the quantitative metric system I have outlines in the “Profitable Equity Investment Strategy” article. In this article we describe how one has to step into the qualitative aspects of the company and evaluate whether the details manifested will impact the stock price.

1. Auditors statement

Every company must have their year end financial statement audited by a certified public accountant that is also “independent” to the company. The year end report for a public company is called the 10-K report. In the report one can see the balance sheet and income statement as well as other important details which management felt necessary to include.

             The annual report has a “going concern” section where it describes the auditor’s opinion of the financial statements. Important details include the companies financial statements are “described fairly” and “in conformity with GAAP”.

2. Law Suits

Next check the financial statement including details in the footnote of any impending lawsuits. A lawsuit could damage a company quite badly in terms of the publicity it generates as well as the potential financial damage it creates if the companies will loose the court case. Assess any legal cases which appear and if you do not understand them then keep well clear of the stock.

3. Earnings Restatements

Caution should be placed with companies which restate earnings. Questions need to be asked like: - Why did they restate earnings? What are the consequences of the restatements?

 Famous financial disasters like Enron, WorldCom and Dynegy all had earnings restatements before they went bankrupt. It is important therefore to make sure that the company that one chooses to invest in hasn’t restated earnings in the past few years. Research has been done to show that companies that have independent audit committees are least likely to restate earnings

4. Evaluating Management

The direction, strategy and day to day processes are all pretty much directed by management. As much as quality of employees is important in the success of a company, of vital importance is the management because they have the ultimate final decision as well as the responsibility of shaping the employees to yield their maximum productivity. I will split this section up into 2 subcategories 1. The CEO and  2. Other stakeholders such as the board of directors, auditors and employees.

D1.  In terms of management responsibility the CEO in most companies is the top of the chain of commands. So analyzing the details of how the CEO conducts himself can unravel some important hindsight into the details of the company management and strategy.

             Read the CEO’s annual letter to stockholders in the annual report (or 10-K). Get a feel for what the CEO thinks in terms of the direction of the company and check his tone. Make sure that the “Management Discussion and Analysis” section is carefully read. Here a lot of the details of the balance sheet and income statement are elaborated.

In terms of the overall result of the report what is the CEO’s account for recent performance? What does he say or respond to if the company hasn’t done well. What went wrong? What went right? How can the company improve and learn from mistakes or enforce previous successes? Does he take ownership of responsibility or does she just brush them off with excuses.  Does the CEO discuss how much money the company has made and does he mask problems by using different measures of profit? Check to see if the CEO switches between net income to EBITDA and operating profit. Analyze previous statements to see if past predictions produce actual performance.  Are enthusiastic initiatives put to practice in forthcoming years?

             Listen to conference calls on the highs and lows of the past 90 days. Beware of defensive and aggressive behavior. It is also useful to see how successful the CEO was in his previous job. Check to see if the CEO is also the chairman of the board of directors. This is a big conflict of interest as the board of directors have the role of hiring the CEO and if the CEO is in control of them they would most often be reluctant to speak against him. Just a side note, if the CEO or other top executives own actual shares rather than simply own stock options, this could be a good indicator that management’s interests are in line with the companies.

D2. The board of directors are responsible for enhancing value to the company. It is important therefore to check how many of the directors are also employees of the company. This could be a conflict of interest in terms of employees having the incentives to maximize their own efficiencies. If available check also to see how many of the directors are related to each other.  Another potential problem could be interlocking of directors. If the chairman of let’s take for example Apple Motor’s is also one of the directors of Henry’s Auto Parts (a supplier of Apple Motor) and vice versa, potential conflicts arise. This is because suppliers are chosen based on outside interests rather than minimizing costs and efficiency.

             Other potential conflict of interest issues can come up in related part transactions. If management owns shares in companies which are suppliers to the company they are managing then there is room to argue that suppliers are chosen because of their own interest rather than what is best for the company. This has been a major problem in the East Asian relationship based business structures like the keiretzus and chaebols which had a strong emphasis on cross shareholdings.

             Check to see how independent the “independent auditors” really are. Coming from one of the top 5 accountancy firms doesn’t guarantee this. Check to see if the auditors have a long history of also being consultants. If that is the case the auditors can potentially be hesitant to questions the company’s finances for fear of weakening the relationship.

             Another useful concept to measure is the company’s morale. This is off course is a lot harder because there is no easy way to gauge this from the annual report. There are indirect ways of measuring this however. One should analyze how many layoffs the company has made recently. This could worry employees and instead of them focusing on the job they might be more involved in their personal anxiety of who the “next person” will be. One can check morale by searching through bulleting boards and reading comments. Vault.com has a specific section with chat boards.

             Does the company have any powerful unions? Hyundai Motor for example had a huge strike in 1998 after 3000 workers protested rising layoffs. If unions have a powerful bargaining position with the company then management cannot structure employees to maximize efficiency.