Tuesday, January 24, 2012

>ACCOUNTING THEMATIC: Accounting quality drives investment returns

Along with everything else, accounting quality in India seems to have stagnated at a low level. Our analysis of the last four years of consolidated accounts of the BSE500 (excl Financials) points to continuing divergence in accounting quality within the stock market. The silver lining is that the relationship between good accounting and positive investment performance seems to be tightening over time.

As one would expect, accounting quality varies by sector (see table on the right) with the usual suspects like Realty, Conglomerates and Construction bringing up the rear. More importantly, the change in a sector’s accounting scores over time seem to have a bearing on investment returns (see exhibit 6 on page 5). Ironically, this puts Realty companies in a nice position as, inspite of being the bottom of the class on a blended basis over FY08-11, Realty is one of the most improved sectors when it comes to change in accounting score across FY08-11. Media companies are also in a similar position.

Similarly, accounting scores vary across market cap buckets (see table below right & Section 3). Whilst the “top 50” stocks have the best blended scores across FY08-11, the improvement in accounting scores over FY08-11 has been the greatest in the midcap bucket (bucket 3: the 100 stocks with mkt cap between $0.2-0.6bn).

Most importantly, from an investors’ perspective accounting scores have a clear impact on stock level returns. Whilst this is not apparent when you look at the BSE500 as a whole, when you drill down to the sector level the relationship is clear (see Exhibits below and Section 5). In fact, if you drill down further into a specific market cap segment in a sector (see Exhibit on the right), the link between good accounting and positive investment performance becomes even clearer.

Whilst our analysis uses on an array of accounting ratios to detect financial manipulation by listed companies, the most powerful ratios are:

  • CFO/EBITDA or the “cash conversion ratio” fluctuates widely across time and across companies. It appears that whenever promoters want to boost profits (and do a QIP), working capital deteriorates and cash conversion suffers.
  • “Other Loans & Advances as a % of Networth” seems to be the most widely favoured route when it comes to pulling cash out of the company (to fund whatever else has caught the promoters’ fancy outside the listed entity).
  • “Provisioning for doubtful debtors as a % of gross debtors” also fluctuates significantly across time and widely across sectors and companies. A low score on this metric combined with poor cash conversion is arguably the defining signature of a dodgy set of accounts.
To read the full report: ACCOUNTING THEMATIC