What a week it’s been on the ASX, and especially for WiseTech Global Ltd (ASX: WTC) shareholders.
Here’s how the last 10 days have looked for WiseTech shareholders:
Short report.
Trading halt.
Company response.
Short report.
Trading halt.
Company response.
Seemingly bizarre interview.
Shares trading 20% lower than a month ago.
How We Check The Accounts
I reckon one of the most important things any savvy DIY investor/analyst needs to do before buying shares in a company is this:
Read the accounting notes — otherwise known as the ‘notes to the accounting statements’.
Financial Statements (Balance Sheet, Cashflow Statement, etc.) are the language of business. It’s important to understand them.
However, if you ask me, it is the ‘notes’ where most investors get caught out.
For example, this past week we saw market darling WiseTech get caught up in an ugly clash with a short seller.
As Corporate Travel Management (ASX: CTM), Blue Sky, Quintis and others can attest, when you’re caught between a short seller and the company, it can be scary and it’s very hard to know who’s telling the truth.
But here’s the thing…
Even if you understand accounting (which is hard enough) and you’ve read the notes (e.g. going back five years), you still might not understand who is telling porkies.
Why?
Companies can — and often do — tell you what they want to tell you.
There are accounting standards, of course. They’re called IFRS, AASB, GAAP, etc. But these are just standards. And companies know the rules as well as anyone.
Moreover, they have an incentive to keep the financials looking good and the share price propped up. What’s more, only the companies have all the facts.
Investors and analysts can only rely on what they’re told by the company and what they can piece together from information available in the public domain.
The discretion in presenting financial statements is just one of the reasons why short sellers can point to aggressive accounting treatment but can’t definitively prove who’s right and wrong.
Even the auditors — the smart cookies employed by big-shot accounting firms — won’t tell you, the investor, for certain what’s going on behind the scenes.
1 Tip For Identifying Accounting Tricks
I’m not certain WiseTech’s accounting is as bad as the short seller says it is, but I’m also not convinced it’s squeaky clean.
I’d say every single company on the ASX uses its discretion to present their financials in the best light possible. Why wouldn’t they?
Fortunately, for investors like you and me, there are many ways to avoid getting caught out by the really bad apples.
The first trick is reading the notes to the accounting statements. In particular, the revenue recognition policy. That’s a no-brainer for any long-term shareholder…
… take it from me, you want to know who you’re getting into bed with before you wake up.
After the notes, probably the easiest way you can avoid disaster is to ask yourself a very simple question.
It’s a question that we ask for our Rask Invest portfolio companies every. single. time. we release a new share idea to our members.
This question is part of the extensive valuation model we’ll be sharing with our Workshop attendees:
“Has the company made any poor acquisitions, played funny games with accounting or is profit ‘hard to see’?”
I bolded the last part because that’s all you really need to consider.
Is profit hard to see?
By that, we mean:
- Have there been lots of acquisitions? This makes accounting murky.
- Is there lots of untested goodwill? It may come back to bite.
- Is the revenue recognition policy aggressive? Cash is the most important metric.
- Is there a significant or widening disconnect between profit and cash flow?
- Are there regular and lumpy working capital items?
- Does the company use an auditor which is not one of the Big Four?
Of course, these questions require some accounting knowledge and skill.
However, this rule can be applied by anyone: the harder it is to comprehend what’s going on, the less conviction you should have in the company.
For example, what’s the organic growth rate achieved by WiseTech’s core business over the past three years?
What Happens Next?
Regardless of whatever happens next with WiseTech, it’s important to remind ourselves that we invest in the presence of uncertainty, not in its absence.
Meaning, no-one knows for certain what the future holds (unless you have a time machine). Risk/uncertainty is part and parcel of investing.
Indeed, using a mosaic theory of proper investing research, we can try to piece together a very good picture of what the future will hold (that’s what our members pay us for). But, no-one ever truly knows what lies around the corner.
For me, there was no smoking gun in the WiseTech report. But, I also don’t own shares in the company…
If you like the idea of learning more while you’re investing, you know where to go. Click here to join Rask Invest.
Cheers to accounting standards!
Owen Raszkiewicz
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Disclosure: at the time of writing, Owen Raszkiewicz does not have a financial interest in any of the companies mentioned.