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The Science of Hitting
The Science of Hitting
Articles (570) 

Spotting Hidden 'Cockroaches' In Investing

May 18, 2015 | About:

“There’s seldom just one cockroach in the kitchen. You turn on the light and all those others start scurrying around. I couldn’t find the light switch, but I’d seen one.”

That’s what Warren Buffett (Trades, Portfolio) told the Federal Crisis Inquiry Commission when they asked about his decision to begin liquidating his stake in Freddie Mac in the late 1990’s. Warren has warned about cockroaches many times over the years, and it’s something that I’ve taken to heart. As an investor, I feel that I have very few meaningful chances to judge the character of the managers that are entrusted to run the companies I invest in. As a result, I try to operate under the philosophy that red flags should not be overlooked.

Over time, I’ve refined my process; I now have a couple of areas that I consciously search for cockroaches. You might find it interesting that searching in these areas doesn’t necessarily require any thorough analysis, or even a deep understanding of financial statements. As long as you can read and are willing to put in the leg work, even a beginner should be able to spot these red flags.

I thought it might be helpful to share my experience with fellow readers. As always, please comment if you have other approaches that have been helpful in your experience. So with that, here are a few places were I’ve learned to look for red flags:

(1) Footnotes / Disclosures – The first place I’ve found fruitful are the footnotes and disclosures in SEC filings (primarily the 10-K). As an example, I was researching Exelon Corporation (EXC) a few years ago when I came across the following language in the annual filing:

“Generation also enters into certain energy-related derivatives for proprietary trading purposes. Proprietary trading includes all contracts entered into with the intent of benefiting from shifts or changes in market prices as opposed to those entered into with the intent of hedging or managing risk. Proprietary trading activities are subject to limits established by Exelon’s RMC. The proprietary trading portfolio is subject to a risk management policy that includes stringent risk management limits, including volume, stop loss and Value-at-Risk (VaR) limits to manage exposure to market risk.”

That’s not what I was expecting; as I recognized at the time, that’s an activity I know nothing about. That paragraph alone was enough for me to disregard EXC as a potential investment.

(2) Earnings Release Presentation – Another red flag is when a company changes, without explanation, how they present KPI’s in their earnings announcement; I’m also quite skeptical of companies that have difficultly supplying basic financial statements to shareholders.

A classic example from financial history is Enron. You probably remember that Jeff Skilling, the former CEO of Enron, famously called an analyst an “asshole” on a conference call in 2001. The comment that had Skilling so riled up should’ve caught the attention of investors:

“You’re the only financial institution that cannot produce a balance sheet or cash flow statement with their earnings.”

Here’s a more recent example: When I opened Weight Watchers (WTW) earnings announcement for the most recent quarter, the first thing I noticed was that management failed to include their customary consolidated balance sheet in the release; if management had failed to explain the rationale for this temporary change on the conference call, I likely would’ve sold my shares.

Another way that this surfaces is in annual reports; I’m talking about the section that includes graphs and colorful pictures before the 10-K filing. With the internet, investors can easily pull up 10+ years of old annual reports, allowing them to review what metrics management views as noteworthy – and how that has changed over time. As you complete this exercise, you will often walk away with the feeling that management has become more selective or open with their disclosures over time; in my experience, you should think carefully about the significance of these changes.

(3) Shareholder Letters – These are found in the colorful portion of the annual report as well; in this scenario, I’m usually tracking two separate items: first, what management is focused on in their letters, and second, how that changes over time. The beauty of old shareholder letters is the benefit of hindsight; in addition, a period like the financial crisis gives you a chance to see how management communicates with the owners of the business under stressful scenarios. In my experience, old shareholder letters have been the most useful tool I’ve found in assessing the integrity and rationality of a CEO.

One of my favorite examples, which I mentioned recently in the comment section of Tom Macpherson’s great article “Investor Friendly Management” (here), is from the former CEO of BNY Mellon (BK). In the company’s 2009 shareholder letter, the former CEO spent more time discussing employee donations to Haiti following the January 2010 earthquake (a total of $900,000) than he did on the $1.6 billion in securities write-downs the company took in the prior year under his leadership. For scale, the securities write-down is nearly 1800x larger than the dollar value of the employee donations to Haiti. In my mind, this is simply inexcusable; little things like that are worth remembering. After this gentleman eventually “resigned” in 2011, subsequent reporting showed that this was a cockroach investors shouldn’t have overlooked – and that there were plenty of others in the kitchen.

It’s worth noting that this exercise isn’t always negative. In some cases, it reflects quite favorably on the management team / CEO. As an example, I’d highly suggest that you take the time to review the shareholder letters from Progressive Corp. (PGR) CEO Glenn Renwick; I walked away from that exercise with the belief that Mr. Renwick is entirely transparent with the owners of the business, and that he does not shy away from important discussions even when the company has struggled (like improving customer retention). That’s a big positive in my book.

Conclusion

As a small investor, I literally have thousands of potential investment opportunities in front of me at any given time; I don’t have size or style restrictions that many professional managers are confined by. The beauty of this is that I can simply discard those that make me uneasy. To use my earlier example, there’s probably a near zero chance that Exelon will have any issues with their proprietary trading in the next few years (as noted in the filing, they have a risk management team that’s paid to ensure that’s the case); for me, the simple fact that this risk existed – no matter how small it actually might have been – was enough to pass on EXC.

This may seem too conservative, but that’s a price I’m willing to pay. Personally, I think constantly monitoring questionable activity is likely to be time consuming, and most likely unsuccessful. A skillful executive can hide potential disasters outside the purview of the investing public; if (when) their actions come to light, it will already be too late to get out.

When you spot cockroaches, it’s worthwhile to focus your time on finding a new place to live.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Great article Science. It is mind boggling to see actions like those at BNY. It would be great to see someone create a program for CEOs that includes Allocation of Capital, Honest Communication, What a CEO Does, etc. that could guide future leaders. I'd make this article part of the mandatory reading. Best. - Tom

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Tom - I must admit that I was quite surprised when I read that in the BNY letter; mind boggling indeed. As always, thanks for the kind words!

batbeer2
Batbeer2 premium member - 4 years ago

Thanks for an interesting article.

A thought:

In life, where would you go hunting for a cockroach?

Now invert. Where would you go if you wanted to avoid running into a cockroach?

I think in business, a manager who's crooked and not dumb (that's the worst kind) will be drawn to those places where you have mountains of company cash that's required for the routine operation of the business: banks, insurance, gambling....

Conversely, you are less likely to find that kind of manager at a plain old operating/manufacturing businesses that also hapens to require very little capital. So if you find a business like that, managed by someone who is not dumb, then you don't have to worry as much. I'd say CHRW, LNN, PCP and PMD fit the bill.

In other words, businesses that require very little capital to begin with (asset light) come with the added advantage that they don't normally attract managers with an unhealthy appetite for other people's money.

Just another reason to seek out boring companies with very high returns on capital.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Batbeer2 - Interesting thinking, and no complaints here - boring businesses with high returns on capital sound great to me! Thanks for the comment!

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

I would only add that as a CEO myself I've never found a pattern to what industries are most susceptible to the Cockroach Theory. It seems bad eggs are spread across all business from utilities to software companies. Unfortuntely I think its a bottom up problem. At Nintai we generally start with the assumption SOMETHING has to be wrong with management - we just want to avoid the ones that can permanently impair investors' capital. To reach that level of comfort we have to see great communication, crystal clear financials, and great management measurable skills such as allocation of capital, return on equity, and free cash flow management. I dn't think there's any perfect formula, but you simply have to make enough hurdles it makes ir awfully hard for mamagement to slip through in th long term.

tonybuffett
Tonybuffett - 4 years ago    Report SPAM

I agree with Thomas also, there are bad apples even in the best orchards!

batbeer2
Batbeer2 premium member - 4 years ago

>> I agree with Thomas also, there are bad apples even in the best orchards!

Perhaps.

But at a company like Citigroup with two trillion worth of assets, you can bet your bottom dollar there are 20 hidden cockroaches for each one you see. At a company like Coca-cola you may spot a couple but for sure there are fewer places to hide.

My theory is of course hard to prove simply because it is difficult to count the cocroaches you can't see.

But it is fair to say history has shown critical problems at places like Citigroup, Salomon Brothers, AIG, and GE etc. show up long after they have become too big to handle. All these companies use(d) huge ammounts of capital to generate their earnings (they have/had low returns on capital).

Take Enron. That was a pretty simple busines untill someone grew the balance sheet to ridiculous proportions. Many problems where swept under that rug. When the problems finally became apparent, it was too late.

A big balance sheet adds a layer of obscurity that makes it easier for management to hide problems and/or investors to spot them.

At places like Coca-cola, C. H. Robinson and Precision Castparts there can be problems too but they show up long before they are big enough to destroy the company. Just name me one example of a company with high returns on capital that had an accounting scandal that brough down the house.

Best example I can think of is Polaroid and that one took decades to come to its knees. I don't think it was an accounting scandal that finally did them in.

Again, just another reason to prefer simple businesses with high returns on capital.

Cogito
Cogito - 4 years ago    Report SPAM

@SoH: great article, thank you!

@Batbeer2: I like your idea that their may be certain industries where it's more likely to find issues - and I also believe that fincance, esp. investment banking, is a risky place for investors. But - at least in the finance industry - I don't think that the amount of cash involved is the main reason causing the cockroaches. Imho, wrong incentives combined with too high a business complexity is the main reason financials may attract cockroaches.

Let me explain: To understand the economic situation of a bank, you have to calculate the value of its financial contracts (a large bank may have several millions of fincial contracts), using mathematical models. The mathematical models for the types of credit derivatives that caused the crisis were highly complex (indeed, most executive boards were unable to understand them) and at the same time too simplistic to adequately represent the risks involved.

As the risks of the credit derivative contracts were not properly represented, traders made high profits with these contracts at seemingly low risk - hence, they had high incentives to buy more and more of these risky deals. Incentives for traders were typically based on short time-horizons (usually the current year, up-to-date). Hence even if the traders understood the true risks involved (not all of them did), they may simply have bought more and more, nonethelesss - because if they made a loss in a later year, the bonusses earned in the previous years had already been earned.

So, if you take banks as anectodic evidence, I would think that it is the complexity of the business (which attracts highly intelligent players and makes it difficult to adequately represent the economic situation) combined with wrong incentives and obscenely high bonuses (which lowered the ethical standards). Regulation has tightened, and a lot of these issues have been addressed, but the main problem - complexity - is inherent to banking, and hence getting the incentives right is very difficult.

I am not certain whether one can generalize this to other industries. Incentives are key everywhere, but I don't think there are other industries with a similar level of complexity and opaqueness as banking.

batbeer2
Batbeer2 premium member - 4 years ago

>> Regulation has tightened, and a lot of these issues have been addressed, but the main problem - complexity - is inherent to banking, and hence getting the incentives right is very difficult.

Is it bad behavior/culture that creates the complexity or is it inherrent operational complexity that makes it hard to detect bad behavior? I would argue that banking (along with retail) is as simple as it gets. And yet at the banks you'll find endless layers of complexity.

I've heard a number of banking CEO's complain that it is neccessary because their competitors do it too. That is interesting because it implies they are knowingly doing dumb things.... people don't ascribe their most brilliant decisions to peer pressure do they?

GE created a captive bank to smooth earnings. Management didn't even make a secret of it. So that is at least one case where we find management deliberately adding layers of complexity/capital to the balance sheet so their earnings statement less accurately reflected recent operational results. That was precisely what Enron did too.

Incidentally, I'm glad to see GE is now simplifying its balance sheet.

It does not matter why it is opaque, the fact that it is, means problems go undetected. There are lots of analysts discussing how many contracts Verizon added (or lost), how many jet engines Rolls-Royce sold and how many new stores Costco opened but I challenge you to find a single analyst who can say anything meaningful about the operations at Citigroup last quarter.

Especially if you operate under the assumption that there are always cockroaches then you should assume there are many more where the sun don't shine.

AlbertaSunwapta
AlbertaSunwapta - 4 years ago    Report SPAM

I have a theory (possibly pretty flaky) that people in many fields are there because an intrinsic interest and passion for that field. Earning a lot of money is secondary for many, many people.

Then there's those working with money. There my theory is that among those people choosing to work with money, for the accountants, it's more due to capitalizing on a skill with numbers and transactions and not necessarily any passion to run, or own, or build a business. It's more about the transactions. (More like people that go to casinos to play cards because they like the action more so than winning and making money.) Then there those that go for MBAs. They want to make money but tend to lack a passion for any particular field. They just want to make a lot of money doing whatever it takes. So,basically, the cockroaches follow the money for lack of any kind of intrinsic passion in their lives.

rrurban
Rrurban - 2 years ago    Report SPAM

On that note, Wells Fargo showed us the first cockroach in early September.

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