Continuing on my quest to fill in the missing chapters listed on Poor Man’s Mosaic, I recently finished reading “Chapter 15: On Avoiding Enron-itis!” In this chapter of Mosaic, Mohnish Pabrai discusses six red flags that might indicate a company has “Enron-itis.” These six red flags are as follows:
- Obtuse financial statements
- Consistency of business performance
- “Restructuring” charges
- Earnings guidance
- Related party transactions, compensation and stock options
- The nature of management
Consistency of Business Performances: In order to maximize stock price, some executives resort to manipulating accounting to show consistent earnings. If earnings are going up in a highly consistent manner over several years, this may be a red flag except for subscription type businesses with recurring revenues.
“Restructuring” Charges: Beware of companies that routinely report onetime, non-recurring charges. Also, be extremely skeptical of large “restructuring” charges that “clean house” every few years.
Earnings Guidance: From Warren Buffett’s 2000 Letter to Shareholders of Berkshire Hathaway:
“Over the years, Charlie and I have observed many instances in which CEOs engage in uneconomic maneuvers so that they could meet earnings targets they had previously announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. More money, it must be noted, has been stolen at the point of a pen than at the point of a gun.”
Related Party Transactions, Compensation and Stock Options: Be sure to examine the “Related Party Transactions” of 10-Ks and 10-Qs. Related party transactions of any kind are often a problem and indicate low ethics standards at a company. When studying compensation, consider option grants, bonuses and base salaries in relation to business and management performance.
The Nature of Management: The business description of a company in its 10-K should be understandable. Then move on to listening to the latest conference call to determine if you feel good about “partnering” with the management team.
Mohnish Pabrai did a great job with this chapter on identifying red flags that might indicate problems with management. Are there any items you would add to his list?