I read What’s Behind the Numbers: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio (McGraw-Hill, 2013) by John Del Vecchio and Tom Jacobs on a power-less Thursday and Friday post-Sandy. But I can assure you that, even I had been able to get back to my computer and had worked assiduously all weekend, I still wouldn’t have been able, as the authors suggest, to use their book (profitably) on Monday morning. Their long-short portfolio is tough to construct. It’s not for the instant gratification crowd.
About two-thirds of the book is directed at investors who would like to improve their portfolio’s performance by unearthing accounting tricks that make corporate earnings look better than they are and—even more important—better than they are going to be. Or, put differently, it is for those who are willing to analyze earnings quality so as either to short stocks with a margin of safety or to avoid ones likely to implode. It “does not advocate … shorting or selling based on overvaluation, fads, frauds, or poor business models, even though these make up the overwhelming majority of stocks sold short. Surprisingly, very bright fundamental investors—those who do bottom-up research on companies and their industries—will only short on these bases, even though they are willing to go long on stock with specific catalysts. It’s as if investors with enormous skill at ferreting out value where no one else can find it suddenly have memory loss on the short side.” (p. 19)
In analyzing earnings quality the investor should be on the lookout for aggressive revenue recognition, aggressive inventory management, assorted unsustainable boosts to earnings, and cash flow warnings. Each of these red flags gets its own chapter, with telling examples.
Let’s say you have done a lot of careful research and have built up your short portfolio. The next challenge is to find a long strategy to complement it. The book’s recommendation is to seek out sound small cap value stocks.
The authors’ actual portfolio results are impressive, at least for the years 2007-2009. Whereas the S&P 500 lost 17.6% over that time (including dividends), a 100% long/30% short portfolio would have returned 6.4%, a 120% long/80% short portfolio would have done the best at 65.9%, and a 50% long/50% short portfolio would have gained 43.7%.
The authors also address the controversial topic of market timing and add a dash of technical analysis to their fundamental mix.
The Stock Trader’s Almanac named What’s Behind the Numbers? the best investment book of the year (although claiming that it’s the best investment book of 2013 is a tad premature). The book is very good indeed. It steers the investor in the right direction by emphasizing risk management, and it introduces him to a basic hedge fund strategy with a twist. The writing style is sometimes a little too cute for my taste, but admittedly I can be schoolmarmish; I assume most readers will enjoy its lightheartedness.