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Earnings Red Flags

Nadia Papagiannis, CFA

Nadia Papagiannis: So a lot of your return has come from stock picking. So, can you discuss some of your long investment ideas at the moment?

Jonathan Lamensdorf: Sure. An investment theme that we are invested in and think has some legs is the auto parts suppliers and the actual OEM car manufacturers themselves. Through the downturn, there were some major changes within the industry, lot of restructuring through bankruptcies, lot of cost reduction, as well as about 30% of capacity was taken out of the industry during the downturn.

So what that set up for is, even though we had a weak year in car sales last year in 2010, the companies were still able to be profitable. If you go back to the downturns in the early '80s recession or early '90s, the companies lost billions of dollars during the downturns. So we think the troughs aren't going to be as deep as they were previously and that the companies will be revalued at a higher multiple as people realize that the downturns aren't going to be as severe as they were.

On the demand side, you clearly have an improving economy and that helps. You also have the fact that used car prices have ratcheted up to a point where it's more compelling almost to buy a new car. And then, because of the extended amount of people who haven't bought cars in the last couple of years, the average age of the cars on the road has gotten very old. So there is a lot of pent-up demand to buy new cars.

So, you have all those demand drivers, as well as the fact that – we have the fact that profitability is much higher now. 11.5 million is about how many cars were sold last year. At that same rate in the '90s recession, '80s recession, they were losing money, and then over the next couple of years, they moved up to where they were selling 15 million, 16 million cars.

A lot of people are skeptical about that at this point and we think that that would happen again because there are deep recessions like the one we just had. When we get there and get to that 14 million, 15 million, 16 million run rate, these companies are going to be much more profitable than people realize. So, now we get a higher multiple, but there will be higher profits on the whole sector.

Papagiannis: What do you look for on the short side?

Lamensdorf: On the short side, there is a couple of different buckets we look for. One is companies where we think fundamentals are deteriorating more than the Street currently anticipates or where we think expectations are too high and the company will not meet those high expectations.

Then another big bucket are companies that are showing quality of earnings issues. By that I mean companies where their earnings might look okay on the surface, when you delve deeper into their cash flows, their cash flows are not suggesting the same thing. Either they are going negative or not growing nearly as fast as you are seeing on the earnings statement themselves.

That could be from a variety of reasons, receivables going up, inventories going up, capitalizing expenses, there's a number of reasons behind that. A lot of companies that end up having big earnings misses tend to have these characteristics in their income statement and balance sheet before they have those earnings misses.

Papagiannis: Can you give us some examples?

Lamensdorf: Sure. One company we are short is a clothing retailer. All clothing manufacturers as well as retailers are going to see a higher cost of goods as we move into this year, mainly from China, the appreciation of their currency, we know the currency is going to appreciate here over the next year as well.

The fact that their incomes are growing, the amount they're having to pay for labor is going up, as well as with energy prices higher, the amount to cost to ship it over to the U.S. is also going up. So a lot of those companies are going to see their profit margins cramped and we don't believe that they will be able to pass on all those added costs to the consumer.

Secondly, this company, in particular, has started to ratchet up their new store growth. So they are growing more quickly. What that does in the medium term is it actually adds some expenses as in preopening expenses to the income statement. So people have expected this company to always beat their earnings and raise their earnings, but as they get more and more openings and they have more and more expenses, it gets harder for them to beat those earnings. We think that there will be some disappointments even if they come in line with the Street and we think it's going to be harder and harder for them to beat the Street.

On the quality of earnings side, for instance, for a short an industrial company where their EBITDA margins and their operating cash flow margins have diverged in quite a big way in the last couple of quarters and years. And so, the next thing is to say, why is that important? Well, EBITDA is a measure of cash flow, but it's based on accounting. Operating cash flow is operating cash flow.

So, again, we delve deeper why is that occurring? You start to see that there is receivables building on their balance sheet and inventory starting to build on their balance sheet. What that points to potentially when your receivables are building is that you are extending favorable terms to customers. So maybe somebody that wouldn't buy it this quarter buys at this quarter because you say, "Hey, don't pay me for two years." So you're bringing forward sales and it's a form of discounting, but on your income statement there is no show of that. It's just normal sales and earnings.

Another thing that's going on with this company is they've changed their revenue recognition policy. So some of their revenues are actually being – hit their income statement today, whereas in the past they've been deferred and not seen until six or nine months later. So that's bringing forward some sales. It doesn't make it comparable.

They've also been a serial acquirer. They've added about 10 companies in the last 18 months, which masks the true organic growth rate of the company. So it's hard to see exactly how fast this company is growing.

So when you see these type of characteristics in companies, and we search out these type of companies, it's a good leg underneath the stool to say, "Hey, they're starting to show these characteristics, there could be potential problems down the road."

Now, not all companies that have their characteristics end up having big earnings misses. Either they grow through it or there is a real reason behind it. But when we find companies that have these characteristics and do our fundamental legwork behind it, it adds to our conviction that this company is going to have troubles here over the medium term.

Papagiannis: We look forward to seeing these opportunities play out. Thanks for joining us.

Lamensdorf: Thank you very much.