Value Investing: Tools and Techniques for Intelligent Investment

Chapter 25. Cooking the Books, or, More Sailing Under the Black Flag^[25]

In good times, few focus on such 'mundane' issues as earnings quality and footnotes. However, this lack of attention to 'detail' tends to come back and bite investors during bad times. There are notable exceptions to this generalization. The short sellers tend to be among the most fundamentally driven investors. Indeed, far from being rumour mongers, most short sellers are closer to being the accounting police. To aid investors in assessing the likelihood of accounting shenanigans, I have designed the C-score. When combined with measures of overvaluation, this score is particularly useful at identifying short candidates.

• Contrary to the silly populist backlash which sees short sellers as rumour mongers and conspirators, they are actually among the most fundamentally driven of all the investors I interact with. Rather than being some malignant force within the markets, in my experience short sellers are closer to the accounting police (something the SEC once purported to do!).

• While companies often accuse short sellers of lying and conspiracy, it turns out that the accusers are often the guilty party. Owen Lamont from Chicago University has examined the battles between corporates and short sellers in the USA between 1977 and 2002. He found that ultimately it was the shorts that were right; the stocks underperformed the market by a cumulative 42% over three years after the start of the battle.

• Inspired by the shorts' ...