Premier Miton UK Income Funds
What is forensic accounting?
Forensic accounting involves in-depth analysis of financial statements in order to gauge the quality and sustainability of a company’s revenue, profits and cash flow, and to identify balance sheet risks being overlooked by analysts and investors. It involves performing tests and ratio analysis on figures and other data found in companies’ accounts to detect signs of aggressive revenue recognition, one-off unsustainable boosts to earnings and cash flows and uncover hidden liabilities. Some of the worst performing stocks over the last few years have spectacularly imploded due to underappreciated accounting issues including Wirecard, NMC Health, Carillion and a host of other contracting companies.
Why is forensic accounting important to us?
Forensic accounting is a meaningful beacon in our eyes to assess the quality of the companies we invest in, with the objective of avoiding problematic companies before they run into problems. In turn, this enables us to manage downside risk in our portfolio in a way in which we believe many other fund managers may not.
Before moving into investment management, I trained as an auditor at two top tier accounting firms over a period of 10 years and a specialist forensic accounting research firm. Since joining Emma Mogford as part of the investment team for the Premier Miton Monthly Income Fund, Premier Miton Income Fund and Premier Miton Optimum Income Fund in 2021, we have enhanced our analysis of accounts using the techniques developed over my career.
We place a high bar on accounting quality for new portfolio opportunities. Existing holdings are also reviewed for a deterioration in the accounts which can lead us to exit from a position if we believe future profits are at risk. A good example of this was Vodafone, which we exited in Q3 last year on the back of our review of its accounting quality, which highlighted several red flags.
Accounting analysis is also helpful with forecasting, despite the fact that financial reports are based on historical events and transactions. We believe annual reports contain a wealth of quantitative as well as qualitative information which provide meaningful insights as to how a company might perform in future.
Forensic accounting also helps us to gain a deeper understanding of a business’ operating model, and why its performance and rating might differ from peers. There are certain financial reporting disclosures that are determined by how a company chooses to present certain data within financial statements rather than prescriptive accounting rules. For example, a manufacturer (company “A”) may choose to present depreciation charges within cost of sales, whereas its peer (“B”) opts to disclose depreciation within admin expenses. This may explain why A generates a lower gross margin than B, and has nothing whatsoever to do with the fundamental earnings power of the two businesses. Yet we may find that the market unjustly places a lower earnings multiple on company A due to its superficially lower gross margin.
In which areas do we see risks now?
At this stage in the cycle, highly rated companies with underappreciated accounting issues and poorly designed management incentive schemes are likely to be at greater risk of disappointing investors. Several of these can be found within the tech sector as well as recent IPOs. DAX listed Teamviewer is a good example of a company where a combination of overoptimistic guidance, accounting red flags, and a management team incentivised to hit short term share price targets eventually resulted in a c.62%* share price decline from its 2019 IPO. We believe that value traps and distressed companies in imminent need of capital injections should also be avoided. There are certain UK listed companies falling into these categories which spring to mind. One of these, a premium car manufacturer, had to recently raise equity for the third time since its 2018 IPO, having already been bankrupt 7 times in its 109 year history. Some basic analysis on the company’s IPO prospectus should have raised alarm bells for investors.
Accounting has a place in the process, just don’t over or under estimate its importance
Being long-only, long term investors, the key challenge for us is correctly counterbalancing accounting quality with the qualitative characteristics of a business such as the strength and sustainability of its economic moat, market positioning and quality of management. A disparity between these two perspectives may occasionally arise and so it’s important to view accounting issues in the context of the broader investment case. Partly for this reason, accounting quality forms only one out of ten points in our investment checklist, albeit an important one. Our ten point checklist covers quality, risk, culture, valuation and investment rational summary. It helps to ensure we don’t miss key things, that investments are treated equally and we have a checklist to refer back to in the future to learn from our successes and mistakes.
Some of the key things we consider upon finding accounting issues in our review of companies include the following:
- Does the accounting issue impact short or long term performance? Long term issues will obviously have more of an impact on intrinsic value and lead to a reassessment of our original investment theses. Such issues may entail, for example, a discretionary change in accounting policy whereby revenue is booked more aggressively than in previous years, or aggressive capitalisation of costs. We are less concerned by accounting issues which may potentially suggest a miss in short term earnings – indeed if we saw this coming then we would view any resultant share price weakness as an opportunity to top up our holding in a great company. This approach illustrates our high conviction and long term style of investing.
- The magnitude of the problem. After an accounting issue is identified we try to quantify its potential impact on revenue, earnings, cash flow or balance sheet risk, depending on the nature of the issue. If the impact is likely to be insignificant then it is easier to overlook, however if the issue bears a more significant impact then this may warrant action on our part with regards to the portfolio position or its size. We are particularly wary of acquisition accounting shenanigans in relation to poorly performing businesses, as these sorts of situations typically increase balance sheet risk for the acquirer and also create opportunities for earnings manipulation further down the line.
- How an accounting issue triangulates with other qualitative data points or evidence and feeds into our general intuition about a stock.
Having considered the above, it might be the case that accounting red flags identified are just too big to ignore, no matter how attractive the other aspects of the investment case may be. For example Aveva, once a stock market darling, has been struck by a series of earnings disappointments since 2020. The company pulled forward revenue on multi-year contracts as a result of a change in accounting rules, which consensus failed to reflect in forecasts. However one could argue that signs of trouble were apparent on Aveva’s balance sheet well before its revenue downgrades, in the form of rising net contract assets relative to revenue growth.
To sum up, forensic accounting analysis is an important tool in the management of our funds, and we believe this is one of the features of our investment strategy that sets us apart from our peers. Over time we have honed the art of finely balancing accounting considerations with other more qualitative aspects of an investment case, and we rely on the framework within our ten point checklist to maintain a wider perspective. Our approach to forensic accounting analysis has been tailored to fit with our long term, high conviction investment style, and although we may not always get it right, we can be counted upon for analytical rigour and making what we believe are sensible investment decisions based on detailed analysis.