I started another book recently called The Art of Shortselling. I purchased it after reading a review on Old School Value. The book was published in 1997, so some of the examples in it might not be very familiar to younger people like me, but the examples are great nonetheless, and some are timelessly famous like ZZZZ Best and Crazy Eddie’s. What stuck out to me in the book review was that, despite the title, the book is “focused on hardcore fundamental analysis.” After reading the first couple of chapters, this is definitely the case.
Take for example Jiffy Lube. The author uses Jiffy Lube in part as a case study in the importance of quality of earnings. One sign of low quality of earnings is when the company has a lot of extraordinary items and nonrecurring revenues. For example, in the case of Jiffy Lube, the CEO was one of four members in a partnership which owned a franchising entity called Lone Star. In one earnings quarter, Lone Star bought 24 centers and development rights from Jiffy Lube for $6.5 million. This was a nonrecurring item whose only benefit seemed to be to provide the illusion that earnings were up and therefore the operating business was good.
Most extraordinarily, one of the investment considerations in the 1986 IPO prospectus for Jiffy Lube was low quality of earnings. No kidding, this was actually in the prospectus:
In the past three years the Company has experienced substantial growth in income largely as a result of income from area development fees and items such as gains on the sale of real estate and Company Operated Centers. These sources, which are nonrecurring in nature and have enabled the Company to record a profit in such years, are expected to decline in magnitude….
Whether considering to buy long or sell short, an investor is well-advised to scrutinize the quality of earnings to determine if they are of low or high quality. And at the very least, read the prospectus!
0 Response to “Consider the Quality of Earnings When Buying or Selling”