Tuesday 21 August 2007

Earnings manipulation as source of short ideas

One of the wonderful things about a change of jobs is that it provides a good opportunity to clear out your old stuff. Whilst I was doing this the other day I came across a note I wrote at the end of October 2003, which I called Earnings Junkies. I scanned the note and came across a list of stocks that I had put together which had poor M scores.

The M score was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimised to detect earnings manipulation rather than bankruptcy. The orginal full paper can be found here www.bauer.uh.edu/~swhisenant/beneish%20earnings%20mgmt%20score.pdf

Beneish used all the companies in the Compustat database between 1982-1992. The M score is based on a combination of the following eight different indices:

DSRI = days' sales in receivables index (measured as the ratio of days' sales in receivables in year t to year t-1). A large increase in DSR could be indicative of revenue inflation.

GMI = gross margin index (measured as the ratio of gross margin in year t-1 to gross margin in year t). Gross margin has deteriorated when this index is above 1. A firm with poorer prospects is more likely to manipulate earnings.

AQI = asset quality index (asset quality is measured as the ratio of noncurrent asses other than plant, property and equipment to total assets). AQI is the ratio of asset quality in year to year t-1.

SGI = sales growth index (ratio of sales in year t to sales in year t-1). Sales growth is not itself a measure of manipulation. However, growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances.

DEPI = depreciation index (measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t). A DEPI>1 indicates that assets are being depreciated at a slower rate. This suggests that the firm might be revising useful asset life assumptions upwards, or adopting a new method that is income friendly.

SGAI = sales, general and administrative expenses index (the ratio of SGA expenses in year t relative to year t -1).

LVGI = leverage index (the ratio of total debt to total assets in year t relative to yeat t-1). An LVGI >1 indicates an increase in leverage

TATA - total accruals to total assets (total accruals calculated as the change in working capital accounts other than cash less depreciation).

These eight variables are then weighted together according to the following:

M = -4.84+0.92*DSRI+0.528*GMI+0.404*AQI+0.892*SGI+0.115*DEPI-0.172*SGAI+4.679*TATA-0.327*LVGI

A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator. In his out of sample tests, Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.

When I ran M score on the non-financial companies in the S&P500 at the end of October 2003, some 57 stocks showed a M score greater than this critical threshold. I have recently updated their performance. Since October 2003, the S&P500 is up some 38%. An equally weighted basket of the stocks identified as potential manipulators is up only 21%, a 16% underperformance.

The median return on the identified stocks is just 12% (a 26% underpeformance of the S&P500). Some 73% of the stocks uncovered as potential manipulators had returns below the market, 20% had negative absolute returns!

As I was thinking about this issue a new paper by Prof. Beneish landed in my inbox (
In this new paper Beneish explores the use of the M score as a stock selection technique. Beneish examines portfolio deciles based around his M score over the period 1993-2003 with annual rebalancing done four months after the financial year end.

The results are impressive. When using market and size adjusted returns the M score strategy generates a hedged return of nearly 14% p.a. Using the Fama and French 3 factor model (market, size and style adjusted) , the stocks with the worst M scores show a -12% return, whilst the stocks with the best M scores show a 4% return, generating a long/short return of 16% (of course).

In the last year I have had many conversations with traditional long only fund managers who were setting up internal hedge funds or 130/30 style products. They were often surprised when I suggested that the shorts were not just the opposite of their longs. Shorting requires a different discipline. Perhaps using the M score might offer up a short list of potential candidates.

With earnings at a cyclical peak, finding out who has been fudging their numbers could be a particularly useful pursuit. Sadly, I don't have the data to run this screen from here, but perhaps a call to your favourite quant analyst might be in order (if that happens to be Andy Lapthorne, then you are out of luck as I know he, like me, is enjoying his garden at the moment).


Steven said...

It would be very interesting to see how the stocks with high M scores did in the year (or years) preceding their attainment of that score. In other words, is there any outperformance associated with the earnings manipulation while it is going on, or is it all for nought? Is the subsequent underperformance that the paper identifies simply those companies "giving back" their ill-gotten outperformance? Is there a net outperformance over some multi-year period (crime pays) or underperformance (crime doesn't pay)?

Unknown said...

They were often surprised when I suggested that the shorts were not just the opposite of their longs. Shorting requires a different discipline.

If you have a minute, James, would you mind filling out this point a bit.

Publius said...

The interesting thing about using earnings manipulation as a short thesis is the sheer hell one often experiences in the interim while waiting for the market to catch on - those stocks can fly while the world remains oblivious to what seems like glaring abnormalities in the financials.

Howard Schilit's "Financial Shenanigans" is a good read, but I think inadvertently quite illustrative of these risks - often the stock of a company that CFRA raised the red flag on rose for years after their initial warning. Even when the world caught up to the financial chicanery, those stocks often broke down to levels not drastically lower than the prices at which they traded prior to CFRA's first report.

Shorting, as much as anything else, clearly requires one's appreciation of Keynes' observation that "The market can remain irrational longer than you can remain solvent." Can you withstand the collateral calls as a brilliant short thesis gets taken to the woodshed in the interim?

returntomean said...

At last a blog worth reading, I am quoting your articles everywhere.

Anonymous said...

In my opinion using only earnings manipulation as an indicator for selecting stocks is not robust enough. There are several other factors affecting the trend of a particular stock.

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Ed Croft said...

Not sure you are reading this blog anymore James but we are now publishing M-Scores for the UK market and soon for all of Europe at Stockopedia. As a result we managed to drum up quite a lot of publicity about it from the FT and other publications, but still it remains little known or understood.

As a short selling screen the M-Score is proving exceedingly effective. We've also modelled some of the short screens from your book Value Investing - each of which are proving effective this year too. Including the 'C-Score'.

Would be good to speak to you about some of this stuff if you are in London.



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Unknown said...

I want to know the basis of multiplication factors (like -4.840, 0.920, 0.528, etc,) for all the variables. How these are derived?

Unknown said...

Please can you show me where in Beneish Paper where the benchmark of -2.22 was stated. Thanks