on February 9, 2013
In the opening lines of What's Behind the Numbers?, co-authors John Del Vecchio and Tom Jacobs offer to "help you find where the investing bodies are buried so you don't join them." These are appropriate words to begin a book on the detective work of finding financial chicanery.
Numbers covers the art of short selling--a lonely endeavor that requires thick skin. By definition, you aim to win when others lose. This means that when you're right, you're hated; and when you're wrong, you are shown no sympathy. In Del Veccio and Jacobs' words, short selling is considered "un-American at best and criminally manipulative at worst."
Moreover, shorting stocks requires taking an unsentimental approach to investing and--perhaps most importantly--keeping the ego in check. Very few investors have the disposition to be successful short sellers; John Del Vecchio is one of them.
Del Vecchio is the co-manager of the Active Bear ETF and the creator of the Del Vecchio Earnings Quality Index that drives the Forensic Accounting ETF. Tom Jacobs is the portfolio manager of Motley Fool Special Ops and a specialist in small-cap value opportunities. In Numbers, Del Vecchio and Jacobs reveal some of the tricks of their trade and expose some of the myths that tend to get novice short sellers in trouble.
To start, overvaluation is not a sufficient reason to initiate a short position. A stock that is irrationally expensive can always get more expensive. Likewise, while it is tempting to short a fad stock--think of Crocs, the maker of colorful rubber clog shoes--fad stocks can stay trendy for longer than you think. The same is true of questionable business models--think Netflix.
And what about the stocks of companies engaging in fraud? Well, maybe. But good luck finding them ahead of time. Remember, if management is engaged in something illegal, they're not likely to mention it in the footnotes of their financial statements.
What is missing in each of these cases is the catalyst. What is the sign that the jig is up--and that the stock is due for a tumble?
Some traders rely on contrarian indicators, gauges of investor sentiment towards a stock, or simply the feeling in their gut. But Del Vecchio and Jacobs take a more rigorous approach.
The key is aggressive accounting and specifically aggressive revenue recognition and inventory management: "The time to sell or short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance."
And how might you know when this is the case? Del Vecchio and Jacobs spend most of the book telling you, but I'll give two examples that I found to be particularly insightful.
The first is a metric called Days Sales Outstanding (DSO), which measures accounts receivable in proportion to sales. An unusual increase in DSO can mean that future sales and being pulled forward by looser payment terms or special financing.
This hurts future profitability in two ways. The most obvious is that sales that might have happened in the following quarter have now already happened. But worse, those sales might have come with more favorable pricing had the company not been in such a hurry to book revenues. In order to keep Wall Street happy for another quarter, management makes the eventual day of reckoning worse.
A second, similar metric is Days Sales in Inventory (DSI), which measures inventory build-up. You don't need to be a CPA to see why this metric is important. Inventory build-up suggests that the company's products are not selling as briskly as forecast. It also means that discounts will probably be needed move the merchandise, which will lower profit margins.
All inventory is not equal, of course. A build-up of raw materials inventory may mean that demand is stronger than ever. It is the build-up of finished goods that should be a major red flag.
What's Behind the Numbers? is full of little tricks like these, explained in simple terms that non-CPAs can understand. Before you attempt to short another stock, read and re-read this book, particularly the chapters on aggressive revenue recognition and aggressive inventory management.
I'll leave you with two final nuggets of wisdom from Del Vecchio and Jacobs.
First, don't be too eager to jump into a short position. As the authors point out, "You make as much money shorting a stock that falls from $70 to $5 (93 percent) as one that falls from $100 to $5 (95 percent)." Getting into a trade too early will turn a would-be profitable short into a frustrating loss.
Second, watch out for crowded trades. Don't short a stock if the short interest is too high as a percentage of the float. This puts you at risk of being short-squeezed as your fellow sellers all scramble to buy at the same time and send the share price to the moon.
If you are a serious investor, pick up a copy of What's Behind the Numbers? and keep it close at hand. More than anything else, it will help you to win by not losing.
on February 15, 2013
I bought this book after reading the 5* reviews here on Amazon and after reading the first (introduction) chapter of the book. There are not that many books out there on using fundamental anaylysis to base your trades on. There are the classical works from Benjamin Graham and some more popular works like Phil Town's book. This book doesn't reach the quality of those two books. The parts on fundamental analysis are not that elaborated, and these authors go look in places I wouldn't use immediatly to base my trading decisions on.
Some parts are kind of good, like using the DSO and DSI numbers and monitoring their change. What I didn't like though on these chapters are the links to a stock graph. Several times the autors point out a fundamental change in the inventories or the cashflow and two pages later you'll see a stock immediatly rising or declining as if it was a direct consequence of the change these autors write about. They can't possibly know if the stock movement was due to the fundamentals or just random noise or some macro economic event.
For the chapters on fundamentals I could still give a 3*, but the later chapters on technical analysis and stock charts are way to basic. It they'd just let these chapters out the book would have been better. It's just a series of stock charts (from investors.com and CANSLIM related websites) with basic TA stuff (determine the trend by looking at the chart, 50 day moving averages, ...).
Two stars is my total score for this book.
on May 26, 2014
This is an ambitious book. It tries to draw together financial statement analysis, value investing, short-selling, technical analysis, market timing, and portfolio management into one slim book of 254 pages.
It spends the most time on financial statement analysis, going over revenue recognition, inventories, and all of the squishier areas of accounting that most industrial companies face. It will not help you much with financial companies, they are far more complex, and deserve a book all their own.
I was surprised that the book did not suggest common summary measures of accounting quality, such as Normalized Operating Accruals. It did feature Cash Flow from Operations less Net Income, which is almost as good.
The book focuses on the short side -- how do you make money from failure? The long side suggests maxing out on small cap value stocks, and idea which I like, but can get overfished at times.
Think of it this way: do you want to run a portfolio that is systematically short company size, long value, short liquidity, long quality, etc? I helped do that for 4.5 years at a hedge fund, and boy that ride was bumpy. The market can remain insane longer than you can remain solvent.
But, to the book's credit, it understands position sizing for short positions, which is momentum following. Short more of things that fall. Do not add to shorts when the prices rise. This is a key insight of the book, and it is a reason why value managers often don't do well in a long-short context.
My last complaint is that the book does not explain even in broad terms how they balance the various portfolio management ideas. If you buy this book, you are on your own. You do not have a full roadmap to guide you. If you were going to use this as a main strategy, you would have to fill in a lot of holes.
Now, I'm often critical of turn-the-crank books -- follow my rules, and you will make money. But I am more critical of almost turn-the-crank books -- follow my rules, and you still won't know exactly what to do.
Is this a good book? Yes. Read it and you will learn a lot. Will it help you analyze stocks? Also yes. You can make a lot more money by avoiding stocks with a high probability of losing money. Will it tell you exactly what to do? No. That is a strength and a weakness -- I'm not sure any book on investing that offers a formula can be exact, and be good. Investing is an art, not a science. Then again, science is an art, not a science, but that's another topic -- all the great discoveries come from not following the scientific method.
So if you want to learn, this is a good book. If you want a foolproof way to make money, sorry, this won't do it for you, and the same for almost every other investment book.
There are far better books on all of the topics that they cover, and most of them have been reviewed at my blog. Far better to read books that specialize on a single topic, than one that is a hodgepodge.
This is a good book, but average investors should not buy it as a formula, because they can’t implement it. Average investors could benefit from the book, because it gives them a taste of a wide number of investing topics. Just be aware that you aren't getting a full dose of anything.
on August 8, 2013
Well, what to say about this...
The book is based on assuming the EMH is false. Nothing really wrong with that, it is a very debatable topic. And it is predicated on the small value premium existing. Again, nothing wrong with that. It provides a number of tools for evaluating stocks to include in a value portfolio and explains the role of eliminating stocks with signs of questionable accounting from your portfolio and potentially shorting said stocks as well. Probably OK so far all things considered.
So why the one star? Well, as a whole the presentation is somewhere between grossly misleading and downright fraudulent. This became less surprising when I read the jacket cover and saw both authors are associated with Motley Fool - the same group of people that brought you the back-test tuned "Foolish Four" portfolio that lost individual investors millions and was shown to under perform random portfolios.
As just one example consider the section on the "death cross" which is a technical market timing indicator based on crossing moving averages. This indicator has been evaluated over the historic data many times and the result is that it isn't an indicator at all. It doesn't work, no flavor or variation of it is predictive. Nevertheless the authors not only advocate it but first only run it back to about 2000 and then fine tune the averaging intervals to show it returned a huge positive return compared to buy-and-hold. This is back test tuning at its worst and only the most intellectually dishonest and reprehensible authors would do such a thing.
A careful reader will also note some of their other portfolio examples are run only over four years! They are already selecting for value stocks that have huge variation (SD's of like 25% or more). A four year analysis is completely meaningless, all you are looking at is noise and by tuning the portfolio parameters you can reach any conclusion you want. Even if you don't tune any random portfolio selection will show as much difference as they demonstrate through random variation alone over such a short period. As they have already demonstrated complete intellectual dishonesty in the back test tuning of the "death cross" one can only assume they've done even worse in these examples.
Yes, the book might include some interesting and even valid fundamental analysis techniques. Unfortunately the authors are clearly charlatans based on their writing and back testing - no reader would be well served by trusting what they write. It just isn't clear to me who this book is for. A savvy investor who can see through the authors' misleading statements already knows the fundamental analysis techniques outlined rather thinly in the book. A new investor will be mislead without the experience to be able to recognize and dismiss them.
A sad effort, and amazing it is reaping five star reviews. Proof again I guess that you can fool most of the people some of the time.
Look elsewhere. New investors - this book is packed with misleading data and you don't have the experience to tell right from wrong. Experienced investors - there are better texts on fundamental analysis than this not saddled with dishonest back testing. Experienced investors might find some humor in just how ridiculously bad the portfolio analysis examples are but I'm not sure that's worth your time or money. There are plenty of free examples just as bad on the internet, no need to buy the book to peruse their particularly egregious examples.
I'd like to give this more stars since it does include some nice presentations, but when a book has got "numbers" in its title and then the authors go out of their way to be insultingly dishonest with the numbers in their back testing I can only say I wish there was a negative star rating.
on October 13, 2012
If you are passionate about investing, this book is a must-read. John and Tom explore many important -- yet frequently overlooked or misunderstood -- topics such as earnings quality, deep value investing, short-selling, long/short portfolio construction, and technical analysis. These are not topics commonly found in today's investing books and they're certainly not all discussed in one place, so this is a book to keep alongside your other favorite investing books as you'll likely reference it often.
This is not beginner material and requires the reader to have a basic understanding of investing and financial statement analysis, but John and Tom are both excellent writers who thoroughly explain these higher-level topics in a down-to-earth and easy-to-understand fashion.
Whether or not you fully adopt John and Tom's approach to investing, you'll put down the book a more complete investor. A long-only buy-and-hold investor, for example, will still appreciate the earnings quality sections that can help detect aggressive accounting practices that distort "true" earnings and signal trouble ahead. The chapters on reading charts and market timing -- topics that fundamentals-focused investors often scoff at -- are compelling and may convince even the staunchest buy-and-hold investor to consider the use of moving averages and relative-strength indicators to help make better entry point decisions.
Such well-written yet challenging investing books like this don't come around often. Do yourself a favor and add this one to your collection.
(In full disclosure, John and Tom are former colleagues.)
on October 16, 2012
What's Behind the Numbers is distinctly different from all other investment books that I have ever read. That's not an overstatement. Few practitioners are willing to discuss the subject of earnings quality and short-selling which is why this book should be considered one of the most significant investment-related books written within the last five years. In my experience, most books try to explain what to buy. What I think makes this book unique, is it teaches the reader in easy-to-follow examples what to avoid which is usually ignored by authors, but to me, is equally important. To date, this is the most complete book on earnings quality and short-selling.
on February 12, 2013
As a book on earnings quality, this book dives into some good methods of detecting quality of earnings, particularly with revenue, inventory management, and cash flow. The issues regarding aggressive revenue recognition have been covered in both "Quality of Earnings" and "Financial Shenanigans." However, the authors handle the inventory inspection aspect of the book very well, detailing positive and negative inventory convergence, and how to interpret the inventories. Definitely worth reading just for their take on inventory, as they go into more details than both "Quality of Earnings" and "Financial Shenanigans." The section on cashflow was also informative, particularly the part on comparing EBITDA margin to OCF margin, and when EBITDA should and shouldn't be used.
However, the book is not without its drawbacks. The portion of working capital management isn't very clear, and the charts accompanying that section provide little insight into what the authors are referring to regarding "proper" and "improper" working capital management (although they do point out that using the cash conversion cycle is a good indicator of working capital efficiency). The section on cash and accruals is amazingly short for a book about quality of earnings, no mention of how to measure accruals relative to cashflow or assets besides "Cash EPS should exceed or equal net income," and then lists what accruals are, without any further discussion. My biggest issue is that the authors rarely give absolute values of what to look for (What would you suggest is a high percentage of goodwill and intangibles to total assets? Of depreciation and amortization to fixed assets? How much of a percent change in DSO/DSI/etc. would be a red flag? What is too high an amount of inventories as a percentage of revenues from one quarter to the next?), but rather simply states to watch for trends and increasing/decreasing percentages, without any further clarification.
Perhaps the biggest flaw of the book was chapters 7 and 8, which deal with technical analysis and market timing. Both chapters were not only out of place for a piece on earnings quality, but offered only an introduction of sorts to both investing techniques. In my own experience I rarely ever use technical analysis (so maybe I'm biased here), but market timing should only be used by those that have a thorough understanding of the political macroeconomy, there's simply not much of value within the 20 pages or so of each topic. Given how much the authors talked about compiling a long/short portfolio, these chapters would've been better used to discuss how to identify potential short candidates, rather than discussing 50-day moving averages and whatnot. Totally out of place in a book that for the first 6 chapters focused solely on the fundamentals.
Overall, the sections on inventory management and cashflow analysis are certainly worth the purchase, but the fact that 15% of the book is spent discussing topics that have no real relation to earnings quality, on top of their rather vague guidelines on what to look for are ultimately what holds this book back. I would read this in tandem with "Quality of Earnings" and "Financial Shenanigans" for a more complete picture on "quality of earnings."
on November 19, 2012
The first thing I want to tell readers is that I really enjoyed the material in this book. It's well written and it's a book that both "professional" investors and those who do their own investment work will find insightful.
I'm always interested in learning more about forensic accounting techniques and when I saw this book on Amazon I was immediately interested. I recognized one of authors of the book right away as I had followed Mr. Jacobs career for many years dating back to his Motley Fool days. I was also intrigued when I read that Mr. Vecchio had worked for David Tice AND Dr. Howard Schilit, both legends in the forensic accounting field.
For those that haven't read the book yet it certainly covers forensic accounting, and does so using real examples in an easy to understand format, but it also contains much more. So just what is the thesis of the book? They explain it on page 19:
"With the tools in this book, investors will increase their chances of achieving high real returns by weeding out or avoiding the stocks that perform so poorly that they will ruin overall returns and possibly destroy capital permanently."
To reach this goal they advocate using an investment approach that combines a small-cap value strategy (while also participating in select special situations) with a short component.
I found their short thinking quite interesting as they state not to short companies "...based on overvaluation, fads, frauds, or poor business models" which is what I would have considered to be perfect short candidates. They instead advocate waiting until the aggressive accounting methods discussed in the book are used by companies, i.e. "wait until there are negative catalysts for profits in the near future - a year or two at most, the rough time period that the value-with-catalyst investor seeks."
To summarize I found the book filled with great forensic accounting information while also detailing an effective investing methodology. As they mention in the book even if you don't short stocks yourself "...the short-selling expert's tools - and the shorting mindset - can lead to successful investing, simply by avoiding the statistical basement revealed by the data."
on November 26, 2012
This book does a great job of exposing very subtle methods that companies employ to manipulate the earnings, inventory, cash flow and revenue numbers. What struck me most was how many inventive ways companies have concocted to keep up appearances, particularly surrounding revenue. The authors very effectively dispel the myth that top line is hardest to fudge. They also do a nice job of keeping the material balanced, so you don't need to be a CPA to comprehend it, nor does it get so trivial to render the information useless ; a common complaint I've had with other stock market investing books. Further, the technical analysis section provides an unemotional look at market trends, and gives some extremely simple indicators to assist in the decision to exit stocks and head for cash or bonds. Again, the authors don't overdo it , they've achieved a happy medium of keeping the material useful, uncomplicated, yet interesting. In conclusion, I'd recommend this book for those who have the inclination to spend a little time understanding what they own and when to own it, as I believe adopters of the book's philosophies will reap large benefits over a lifetime of investing.
on October 17, 2012
Long-only investors will benefit greatly from the book's insights and especially how to get out of their losers quickly by following a few simple fundamentals on the balance sheet and income statement. In my opinion, this is a must-read for investors who have trouble letting go of failed investments and who have come to understand the hard way that "time does NOT heal all wounds." Cisco investors holla!
The authors spend their days more like forensic accountants looking for the chicanery (that is a lot more prevalent that you may care to believe). I found the authors' research head-shaking in that regard. There are far too many accounting tricks that publicly traded companies use in order to make their quarterly numbers. And sooner or later that catches up with them.
One company he writes about has recently offered big discounts to generate revenue for the near quarter, but that's 'robbing Peter to pay Paul' according to the authors. As they state, "eventually there will be an earnings shortfall, like there always is with companies like this, and the stock will tank."
By understanding the tactics, you the investor will have side-stepped such a debacle and you will have done the first thing you need to do in any investment process: preserve your equity.