If you were to look at BSE 500 as it stood 10 years ago, you would find that only 270 of those stocks continue to remain in the index. Most of the 230 stocks which exited the index saw significant erosion in their shareholders' wealth (on an average, the companies which exited the index have lost 40 per cent of their December 2009 market cap). Hence, for every Bajaj Finance and Eicher Motors which significantly enriched their investors, there has been an Educomp and Lanco Infratech which left their minority shareholders high and dry.
Accounting quality rules in the long run
Our number crunching of Indian stock prices suggests a direct relationship between better accounting quality and superior stock performance. In the shorter run, however, markets do have a tendency to test investors' patience even if the investor is using the most time-tested and rational investment methods. Hence, during this period of irrational exuberance and abundant liquidity, where there is a pressure to chase near-terms returns, quality does take a backseat. Take the instance of the bull market of CY17 which saw speculative excesses being created in lower-quality stocks.
However, things changed with the onset of CY18. As the cost of capital rose, liquidity started drying up and equity markets turned volatile. This, in turn, made investors more selective. Recurring news flow on auditor resignations further spooked investors through CY18. All of this, in turn, brought the focus back on accounting quality. This has resulted in good-quality companies outperforming their poor-quality counterparts by a considerable margin since CY18 and continuing to do so in the post-COVID bull market.
Marcellus' forensic framework to evaluate the quality of accounting
Given the points highlighted above, evaluating the accounting quality of a company needs to be a cornerstone of any investment process. We, at Marcellus, have developed a set of 12 ratios that helps to grade companies on their accounting quality. The selection of these ratios has been inspired by Howard M. Schilit's legendary book on forensic accounting called 'Financial Shenanigans'. The book was first published in 1993 and the fourth edition was published in 2018. It draws upon case studies of accounting frauds (involving not only well-known frauds like Enron and WorldCom but also numerous lesser-known cases of accounting trickery) and draws lessons from these to create techniques for detecting frauds in financial statements.
These 12 forensic accounting ratios cover checks around key financial statement categories like income statement (revenue/earnings manipulation), balance sheet (correct representation of assets/liabilities), cash pilferage and audit-quality checks. Some of these key ratios and rationale are shown in the table 'Some of the accounting ratios...'. We look at the historical consolidated financial statements for the universe of firms. We first rank stocks on each of the 12 ratios and give a final decile-based pecking order on accounting quality for stocks, with D1 being the best on accounting quality and D10 being the worst. The top five deciles, i.e., D1 to D5 are generally indicative of a company with good accounting quality/practices. We call D1 to D5 the 'Zone of Quality', whereas the bottom 30 per cent, i.e., D8 to D10 generally represent companies with questionable accounting practices. We call this the 'Zone of Thuggery'.
Forensic accounting scores are a very effective predictive tool
Over the longer term, there has been a strong correlation between the accounting quality as suggested by our forensic model and the shareholders returns. For instance, the 'Zone of Quality' has outperformed the 'Zone of Thuggery' by a whopping 9 per cent p.a. over CY16-19.
There is another way to understand the effectiveness of this forensic model. There are around 53 companies (out of the BSE 500) which constantly featured in the bottom three deciles in our accounting model for the years FY2015-18. Over CY16-19, these companies have on an average delivered negative CAGR of 13 per cent compared to benchmark BSE 500's 10 per cent, i.e., an underperformance of nearly 23 per cent p.a.
As investors in India once again start getting excited about equity investing, they would be well served by a powerful forensic-accounting technique which can help them screen out the numerous mischief merchants in the Indian stock market.
Saurabh Mukherjea is part of the investments team at Marcellus Investment Managers (www.marcellus.in) and is the author of 'Coffee Can Investing: The Low Risk Route to Stupendous Wealth' and 'The Victory Project: Six Steps to Peak Potential'.
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