(Illustration by Serge Bloch)
It’s been 14 years since Enron Corp. released its last annual report, but Laura Rittenhouse can still recall the queasy feeling she experienced when reading it. In its shareholder letter, the company boasted that its 2000 net income reached a record US$1.3 billion. Rittenhouse tried to verify that number on Enron’s income statement, but was left scratching her head.
“I couldn’t find it,” she says. “I saw US$979 million, but that’s not even a rounding error. I had to search into the footnotes to find something that added up.” She knew something was fishy and, sure enough, within a year, Enron’s stock price had fallen from US$60 to 60 cents, and the end was near.
As the Enron case proved, simply having a credible multi-national auditor is no guarantee of accounting rectitude. And while few publicly traded companies engage in such outright fraud, investors would be wise to pay attention to earnings calls, quarterly reports and media interviews with CEOs for subtle hints that the picture they paint is misleading, says Rittenhouse, the author of Investing Between the Lines. She’s also CEO of Rittenhouse Rankings, a New York consultancy that helps executives of listed companies build trust with shareholders. She’s been able to tell whether a company is covering for something just by reading reports and listening to executives speak.
It happens more often than you might think. According to John Graham, a professor of finance at Duke University in North Carolina, 20% of firms are misrepresenting their economic performance at any given time. They do this because of the pressure from public markets. “It’s almost always the case that if you miss earnings, you’re going to get punished by the market,” he says. It’s not entirely logical—companies go through ups and downs—but when you add earnings-based executive compensation into the mix, the temptation to at the very least fudge some numbers is great.
Uncovering deception requires careful attention to how executives communicate with shareholders. Incomprehensible language and hard-to-find numbers are red flags, says Rittenhouse. Some companies refer to adjusted earnings per share or adjusted net income numbers on calls. She often has trouble finding those numbers on income statements. “Occasionally a CEO will explain what the difference is [between adjusted earnings and just earnings], but some don’t,” she says. That lack of clarity could indicate shoddy accounting.
She’s also bothered by convoluted language and generalities unsupported by specific numbers or facts (such as, “employees are our greatest assets”). For example, CEO Robert Card’s shareholder letter in SNC-Lavalin’s 2013 annual report placed 99th out of 100 such missives (only Citigroup’s ranked lower) in Rittenhouse’s Candor Survey for its overuse of jargon, platitudes, clichés like “SNC-Lavalin’s best years lie ahead” and the royal “we.” The Montreal-based engineering giant (TSX: SNC) was trying to bounce back from corruption-related charges, but its stock has instead declined another 20% in the year since.
Peter Romary is a partner at QVerity, a behavioural analysis firm that was started by ex-CIA interrogators. Executives’ statements comprise a large part of what he and his colleagues are paid to analyze. He says there are five types of deceptive behaviour that raise concerns. You don’t want to see a CEO avoiding questions, answering questions with oblique “convincing statements” (such as, “everything’s great!”) or attacking an interviewer. It’s worrisome too, when executives repeat a question or attempt to buy time by giving a non-answer, such as, “That’s a good question.” Certain non-verbal cues, such as putting their hands on their faces or repeatedly clearing their throats, can also indicate deception.
Enron was a textbook study in deception. In April 2001, an analyst famously told then-CEO Jeff Skilling, “You are the only financial institution that can’t produce a balance sheet or cash flow statement with their earnings.” His response? “Thank you very much. We appreciate that…asshole.” When Romary hears something like that, warning bells ring. “That’s straight on the attack,” he says. “I know the financial world is tough and there’s bad language, but when it’s directed at someone, that’s concerning.”
Investors should only be satisfied with straightforward answers to questions. If they’re not getting that, there’s a problem, says Romary. In one case he was working, a CEO was asked how sales were doing. He responded by saying domestic sales were fantastic, which was true. But he failed to mention that they accounted for only 10% of total sales and that the company’s international sales were underperforming. “It always goes back to the golden rule,” Romary says. “Did they answer the question I asked?”
When examining financial statements, check to see that earnings correlate with cash flow from operations, Graham suggests. If earnings look attractive but cash flows look weak, then he’s concerned. He’s also wary of companies that consistently meet or beat earnings targets. Every company goes through good times and bad. If your holding never has a down quarter, something’s amiss.
It’s important not to take any one sign in isolation, notes Romary. He needs to see at least two deceptive indicators before he’ll be prompted to investigate. He also looks for those tics to show up five seconds after a question is asked or, if it’s written, in a cluster of deceptive indicators.
Even with all of these warning signs, it’s hard to catch a CEO in an all-out lie. The idea is to identify suspicious patterns and either investigate or avoid taking a chance on that company. “There’s no such thing as a human lie-detector,” says Romary. “What you’re doing is burrowing down to see if what you have is gold or a copper penny.”
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