The following is a meaty Q&A with the authors of the recent book What’s Behind the Numbers?, Tom Jacobs and SumZero member John Del Vecchio.
John Del Vecchio is a member of SumZero and is the cofounder and co-manager of The Active Bear ETF, a fund dedicated to shorting individual stocks with fundamental red flags. Previously, he managed a hedge fund for Ranger Alternative Management, L.P. In addition, he worked for well-known short seller David Tice and famed forensic accountant Dr. Howard Schilit.
Tom Jacobs, Portfolio Manager of MF Special Ops, applies this book’s earnings quality tests to his value and special situations long side to form a long-short portfolio. He is managing partner of Complete Growth Investor, LLC, principal of The Marfa Group, Inc., and a real estate investor.
Nicholas Kapur, SumZero: Guys, thanks for joining us for this Q&A. You have been working together for nearly a decade now, employing a mixed long-short strategy that you describe in your book, What’s Behind the Numbers?, with some significant success. And essentially you’re ready to reveal the secret sauce. Why don’t you start by telling us more about that strategy?
Tom Jacobs: From the moment John introduced me in 2001 to the classic works on earnings quality, I applied them to weed out any longs for small cap value-with-catalyst long investing. I mostly use the findings of Tweedy Browne’s seminal What Works in Investing, tweaked for today, mixed with special situations you will find in Joel Greenblatt’s work and elsewhere. We don’t believe in a short-only approach.
We knew none of the earnings quality books out there—about four before ours--showed both how to avoid, sell or short stocks with poor earnings quality predictors and what long strategy to pair it with in a practical way to manage a portfolio. Nor did they use real-time examples. We use actual reports John wrote for clients over years in all markets to show concepts in action. We wanted to marry the two to give people a practical, full portfolio risk management. Neither an academic text on all negative predictors—no matter how important—nor one without a way to buy stocks long, too.
Nicholas Kapur: John, you’re the short specialist as I understand it. What do you most look for in potential shorts? What are the most important earnings quality predictors of poor stock performance ahead?
John Del Vecchio: It all starts from the top line, revenues, and both revenues and the close number two, inventory, both of which cross all financial statements. Management will do anything to keep the stock price up, and Wall Street is obsessively focused on revenue growth. So naturally execs look to aggressive revenue recognition and aggressive inventory management to keep the Street happy with its other obsession, EPS. But they are the top items from which all flow and make everything else suspect, from EPS to cash flow to book value and more. But the aggressive accounting techniques are unsustainable, the quarter comes when the numbers hit the wall and the stock collapses with cement overshoes. Investors wake up that day and rub their eyes. Over and over, the growth or hypergrowth stock of the day blows up and people get burned.
To help them, there are other top predictors such as cash flow warnings and serial acquisitions, but they too involve revenue and working capital games. Other red flags including accounting changes, which can appear conservative but often create opportunities for chicanery later, and where adding back stock-based comp makes operating and free cash flow look better than they are.
Nicholas Kapur: Can you provide a few timely examples of offending securities?
John: My best short idea right now is Fossil (Nasdaq: FOSL). Its relative strength has declined dramatically, though its stock has climbed slowly back from its prior fall. Europe has been a part of its growth story, and it dropped 8.3% in the most recent versus 30% growth a year ago. North American growth dropped from 15.8% a year ago to 5.3% in the most recent quarter. The only bright spot was strong Asian growth at 24%, and anything there would eliminate the only good news for the company. One of the strong earnings quality predictors of poor performance is where cash flow lags net income, and it has at Fossil for five quarters year over year. Plus, for 10 quarters days sales in inventory have grown year over year, leading eventually to likely heavy discounting and crashing earnings. It’s hard to see anyone wanting the stock, and especially after the high probability all the numbers will hit the wall.
Nicholas Kapur: Tom, what do you see on the long side today? Do you have a favorite idea?
Tom: Among my favorite small caps with catalysts, one stands out, provided any of us can conquer the tendency to anchor. Sprott Resource, listed on the Toronto exchange (SCP) and with unsponsored ADRs in the U.S. (SCPZF), is an investment company primarily in natural resources. CEO Kevin Bambrough has fought the analysts’ misperception that it ought to be priced as a closed-end fund, at a discount to NAV. So while Sprott’s cash flows support his high-return investing they have allowed him substantial buybacks at a large discount to NAV to boost shareholder value towards NAV.
Then, just a few weeks ago he announced a monthly dividend that will be 0.833% of book value. That still leaves plenty of cash to invest. The gap between the stock price and NAV closed a lot on that announcement, as you would expect, but still has room to go. At today’s $4.30, the dividend is 10%-11%. Even at a $6.00 share price and NAV, the latter my current calculation, we’re talking a 7.6% dividend, not to mention continued compounding from Sprott’s investments we think will raise book value—his historical record has been 28% annualized.
Our view is that you get management absolutely committed to shareholder value, strong value investors in hard natural resources assets—you get paid in so many ways. It’s important not to anchor to the pre-dividend announcement stock price of $3.60, because of the significant upside to NAV and future catalysts through value investing in energy, producing agricultural land, and mining. Also, while not a gold bug, Bambrough has Sprott hold gold bullion bought at $1,019 not because he is a gold bug but because he pounds the table on worldwide sovereign debt—and of course there are already nice gains on that. Gold and hard assets offer inflation protection and capital gains.
Nicholas Kapur: As an investor, who influences you?
John: Well, both of us grew up in grey, wet and cold upstate New York—I in Syracuse and Tom in Rochester—so that certainly makes us see the darker side. But I picked up Ken Fischer’s Super Stocks in college and then interned for James O’Shaughnessy, author of What Works on Wall Street, which popularized the price-to-sales ratio on the view that management couldn’t fake sales. But in the dot.com boom and the working for Howard Shilit and David Tice, I saw that didn’t work. With dot.com managers compensated with massive option grants, and investors boosting the stocks and the value of those options sky high, I saw in stark reality all the ways management aggressively recognized revenues and played other games that couldn’t go on.
I put this into practice for three years at a fund successfully and then started Ranger Bear ETF (HDGE), which targets earnings quality shorts and does not use leverage—the devil of every crash. And now my Forensic Accounting ETF (FLAG), expected to launch January 29, will cull the worst earnings quality large caps from the greater large cap universe.
Tom: Apart from our shared history in the snow belt, I am the youngest child of parents who were of working age at the time of the Great Crash of 1929 and ensuing Depression. I grew up with stories of my mother’s descent from comfortable merchant class prosperity to destitution--her mother’s broker told her in July 1929 not to sell--and my father’s of relative stability because his father kept his job throughout. They communicated both with words and in actions the fear that at any moment it could all come back again. Yet despite hearing this practically out of the womb, I still fell for much of the dot.com stories, particularly in telecom and biotech.
Meeting John and implementing earnings quality analysis and value changed everything for me. I was fortunate to recover all losses and outperformed beyond that. And with years now of studying market history, especially the once-a-decade devastations and banking crises of the 1800s through the Crash, I have a healthy fear of that other shoe dropping at any time. Deep value and catalysts, mixed with patience because they can underperform during conditions such as today’s monetary policy, they’re my knitting, and I stick to it.
Nicholas Kapur: Thanks for taking the time, gentlemen. Really enjoyed the book and our discussion today. Happy to recommend it to the SumZero community.
Please check out What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio (McGraw-Hill, 2012), available in hardcover and ebook formats.