enough on its own. Without regulatory oversight in microcaps, you need to know whether you can even trust that what the company is reporting on its financial statements is reality. Because of that, for every microcap company we analyze, we don’t just do Uniform Accounting. We go an extra layer deeper... We look at metrics like a company’s working capital trends relative to revenue and allowances for write-downs to signal a company that might be understating expenses or overstating revenue trends. Looking at metrics like this allowed us to identify and avoid nut company Diamond Foods (DMND) before management announced in 2014 it had been defrauding its walnut growers. The stock quickly cratered from $90 to $17. We use this same framework to review each company we might recommend. But we don’t only check for potential accounting anomalies. We check for potential auditor and We’re looking at where management has previously worked, whether they have anything questionable in their background, and any other red flags. We want to make sure they don’t have a legacy of selling snake oil.
management anomalies and use a framework we call “Fundamental Forensics.” We use tools like the Public Company Accounting Oversight Board (“PCAOB”) report on a company’s auditor to understand if an auditor has systematic issues for specific audit areas. The PCAOB is the auditor of auditors and reviews them every three years. The PCAOB highlights key areas where auditors are deficient in its reports – like revenue recognition, review of internal controls, or transfer pricing – as well as areas of risk for anyone analyzing financial statements. We can use these reports to identify if a company has a high-risk auditor, a reliable sign that the company is seeking out low- quality controls to management’s decision- making and reporting. We track these auditors over time, too, which gives us a list of problematic auditors to immediately tip us off whether to avoid a company or not. By starting at the auditor, we can determine whether we can even trust the financials to start to perform our Uniform Accounting analysis. And we don’t just stop with reviewing the auditors and the financials. We also always want to make sure companies have management teams that are focused on the right things for the business, are properly aligned, and have a strong history. We’re looking at where management has previously worked, whether they have anything questionable in their background, and any other red flags. We want to make sure they don’t have a legacy of selling snake oil.
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May 2020
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