Dividend Reference senior analyst Michael Johnston recently interviewed David Trainer, CEO of New Constructs. New Constructs is an investment research provider with a patented system for analyzing publicly available financial information to determine the true profitability of a company. The interview was completed over email, in June of this year.
Michael Johnston: Your firm is based around the idea that reported earnings don’t tell the whole story of a company’s profitability. I don’t think that statement would shock most investors, but I would also guess that most investors assume reported financials are “close enough” to use in their evaluation. I’m guessing you’d disagree with them?
David Trainer: True. One of the biggest myths on Wall Street is that analysts models and reports reflect the disconnect between accounting and cash flows. They do not. Ever since the tech bubble, doing proper diligence on cash flows has not been a priority in research — they’ve been too busy making money on deals to take time to do real research. And as long as markets remain buoyant, no one seems to know any better.
Michael Johnston: Why not just use reported cash flow to evaluate a company? I understand that earnings can be manipulated, but cash is hard to fake.
David Trainer: Cash flows from operations or reported cash flows have many flaws as well. For starters, they ignore most of the changes in the balance sheet, which are often quite large. They ignore certain types of compensation, which can be rather large expenses. Be careful with the “cash flow” numbers the companies provide as well. Trust me. They doctor those numbers to be sure they reflect the business in the best possible light. We’ve done a couple case studies on how reported cash flows are misleading for Amazon and Salesforce.com.
Michael Johnston: My guess is that you find the standard P/E ratio to be lacking. What metrics to you believe are most useful for evaluating a potential investment?
New Constructs CEO David Trainer
David Trainer: P/Es can be very misleading. As we’ve been discussing, the “E” or the denominator is not a complete reflection of the cash flows of the business. In addition, the P/E does not capture risk or the time value of money. The best approach to valuation is discounting future cash flows (DCF). The problem with this approach is that it is complex and time-consuming. The appeal of the P/E is that it is simple and quick. We do the DCF heavy lifting for our clients. We’ve developed technology that makes DCF analysis as simple and quick as a P/E – so our clients have the best of both worlds for our reports and models on 10,000+ securities.
Michael Johnston: Have these loopholes been around for awhile? Or is it a byproduct of more recent developments on Wall Street? Have the numerous new regulations that have gone into effect in recent years done anything to improve transparency?
David Trainer: Accounting loopholes have been around forever and have evolved over time. Having done forensic accounting for two decades, I’ve seen companies constantly change the way they report and the methodologies they use. Keeping up with accounting rules is a full time job in itself. As a member of the Investor Advisor Committee, I advise FASB on how to close loopholes and prevent new ones. We are working hard to ensure accounting rules are developed with the investors’ perspective in mind.
Forensic accounting has only gotten tougher in the last several years. The regulations focus on the symptoms not the causes of accounting complexities. Annual reports are over 200 pages long on average. The amount of work to analyze just one company is enormous. Over the past decade, I’ve developed technology to address the ever-growing workload. The technology allows us to scale our accounting and finance expertise and provide best-in-market earnings quality analysis on 10,000+ securities.
Michael Johnston: Can you give us an example of a company that your methodology would qualify as “Dangerous”? What exactly causes a red flag?
Twitter (TWTR) and Groupon (GRPN) are recent members of what we call the Danger Zone, our weekly warning on a particular stock, ETF or mutual fund. Both of these companies have misleading earnings due to hidden unusual gains or expenses buried in their income statement. One would never know about these unusual items without analyzing the footnotes. They also have extremely high valuations. For example, to justify its stock price ($37/share), the company must grow cash flows at over 30 percent per year for about two decades. At current margins, the company needs to reach 82 billion (with a “b”) customers to generate such cash flows. When you look at valuation thru this objective lens, its hard to justify taking the risk of owning TWTR. (Editor’s note: the full article discussing Twitter is available here.)
Michael Johnston: You’re a member of the FASB Investor Advisory Committee. What is the focus of that organization now?
David Trainer: Being a member of the FASB Investor Advisory Committee has been a great experience. Most people don’t enjoy accounting, but I love it. And I love being really good at understanding how one must use accounting to understand the true economic cash flows of a business. The FASB has made huge progress toward better aligning the goals of accounting rules with the best interests of investors. Part of that process is improving transparency for investors by providing more disclosures and doing more diligence before issuing new rules/standards (e.g. modeling and reviewing impact of potential new rules in real-world scenarios). I think the FASB is headed in the right direction.
This article, Interview with David Trainer, CEO of New Constructs, first appeared on Dividend Reference.