Book Review: Financial Statement Analysis by Martin Fridson & Fernando Alvarez

Any book that reaches its 4th edition (updated to 2011) should be good. That's true in spades for Financial Statement Analysis. Fridson and Alvarez have written a classic. It should be required reading and a constant reference source on the bookshelf of any investor intending to buy individual company stocks or bonds. It is a book for those who intend to follow Warren Buffett and increase the security of their investments not by diversification but by depth of knowledge and confidence in the companies whose securities they hold.

The book is not primarily an accounting text in the sense of indicating the mechanics or the theory of accounting. It assumes basic familiarity with balance sheets, income statements and cash flow statements. What the book does thoroughly and brilliantly is to explain how to analyze and interpret the numbers to enable an investor to figure out what is really going on in a company.

The authors take account of and put heavy emphasis on the motivations of company management for their own personal ends - everything from presenting results in the best light at the legal end to outright fraud at the illegal end. Through many simple examples they show where and how to look for signs of manipulation of accounts. They admit the limitations of even the most expert analysis. They note, explain and give examples of the necessity to be wary of auditors, regulators and boards of directors. Frank and severe commentary abounds but the book is not a diatribe and the reader is not left with a sour or negative view. It is entirely practical and realistic. The book moves the investor from the textbook into the real world.

Though not to the same depth, the book also explains how industry conditions need to be taken into account in interpreting financial ratios. It explains how factors like seasonality, cyclicality, capital intensiveness, size of company, maturity of the company or the industry all can impinge on the safety/danger of debt or equity and the relative over-/under-valuation of securities. Want to know the hows and whys of leveraged buyouts, mergers, serial acquirers, stock buybacks, reserves and write-offs? This book will tell you.

The viewpoint is that of an investor arming him or herself with defensive detective tools. Its motto could be the modification of the adage "trust but check" to "check, and keep checking".

One of the surprising, given the subject matter, and delightful features of this book is that it is highly readable and accessible. The writing style is engaging with enjoyable turns of phrase, the sentences are understandable and never confusing, the examples are simple enough but not too simple, the organization of topics within chapters flows naturally. The authors have mastered the art of providing just enough detail - sometimes only a little, sometimes a lot - to make their point.

My Highlights:

• The walk through the dividend discount model is the most intuitive and insightful version I've come across.
• The five pages on Nortel weave together the methods (mostly abuse of accruals) and motivations (management bonuses) of the company's death spiral into a succinct morality tale.
• My strongest takeaway is a sense that the integrity of management is a critical element to judge since there are so many ways for manipulation to be done and it can be very difficult if not impossible to detect till it is too late.
  

Caveats:

• Page 232 reflects a small lapse in updating the new edition as the dates in a table do not match the text and the table on page 234 does match the text, though one can still understand what is going on. Perfection is hard to achieve!
• The reader can only gain understanding through this book. Being able to apply the knowledge would require a person to work through examples to fully absorb it as a practitioner. Presto! The authors have written a companion Workbook.
  

Rating: A gem, 5 out of 5 stars.

Tech Stock Accounting Foresight in Hindsight

Those interested in tech stock investing, or indeed in buying shares of any individual company, should run through this column on devious tech accounting methods, written at the beginning of the tech bubble in 1999 by tech commentator/blogger Robert X. Cringely. It foresaw and forecast the coming accounting fiascoes with tech and Internet companies such as the one where I worked for a while, Canada's darling Nortel (mea culpa, I drank John Roth's cool-aid too). It reminds me of something I read years ago to the effect that the real financial analysts read annual reports backwards - starting with the footnotes at the end, where the financial dirt is hidden.

Cringely is always a good read for anyone who likes technology. That he has been around for ten years on the Internet as a columnist is an impressive achievement,, which I can better admire having blogged for several months now. The quality and value of his writing is consistently high. I take him as a role model to emulate in that way - to write original, well-researched, topical and forward-looking material.

Anyone have a financial columnist/blogger to suggest as their hero?

Deemed Disposition and Probate

Some years ago when I had to perform the tasks of executor for my wife's will, I was caught in a very unusual unusual situation. Since the the tax rules specify that all of a deceased taxpayer's assets are deemed to be sold as of the date of death, capital gains are liable to be paid on that deemed disposition. That's exactly what happened with Nortel at the time, which only begun its slide by the time of death at the end of September 2000.

By the time the will was probated in December 2000, the stock price had dropped by close to 40%. The capital gains tax payable almost exceeded the value of the stock holding. By the time the estate was ready to be distributed some months later, it did by a good margin. The only way to avoid a huge tax hit was to avail myself of a provision that allows a spouse, and only a spouse, who is to inherit some or all of an estate, to receive his/her share at the original cost of the deceased taxpayer and to avoid deemed disposition of those specific assets. At least the executor, unless the will states otherwise, is at liberty to decide who will receive which specific assets.

This incident revealed to me some interesting characteristics of having a will probated. Financial institutions seemingly will generally (except for things like funeral expenses) refuse to accept instructions of the executor (e.g. liquidating assets) until the will is probated unless the amounts are quite small. This appears to be a matter of the financial institution showing proper care to avoid getting sued later by disgruntled inheritors. Same goes for the executor. There does not seem to be any law that requires a will to have received probate from a court before it can be carried out.

However, even when a will has been probated, if another later will is found and can be shown to be valid then the original probated will does not stand and the executor would have to start all over again. What does all the money paid for probate actually give one then? It can cost a lot of money ($5 per thousand on the first $50k of assets and $15 per thousand on the excess in Ontario). Certainly it doesn't happen very quickly - a matter of months at best.
Does the court check for existence of other wills - no! how could it in practical terms? Does the court even check the accuracy of assets listed in the estate - again, no, unless some lawyers out there can correct me ... some dishonest people might be tempted to understate the total assets, n'est-ce pas? The bottom line is that the probate fee is not a fee for a service, it is a tax on wealth. Why not a flat fee of $150 or some such amount that reflects the actual work involved by the court?