Hello! As I have mentioned in many articles in the past, beating the market is as much to do with avoiding big losses than it is to do with catching massive winners.
It’s a philosophy that our favourite investors, like Charlie Munger and Howard Marks, swore by. They believed in such similar ideas; Marks believes that in avoiding the losers, the winners will take care of themselves, and Munger believed that if you want to achieve something, find out all the things that will prevent you from achieving it, and avoid those things like hell.
Big losses ruin our prospect of beating the market, so we ought to avoid them like hell too.
These big losses come in many forms, but one of the most perverse is through financial foul play. By the time foul play comes to the spotlight, the stock price will have fallen so far that you won’t be able to find a buyer — especially in the small and micro cap space.
This is why understanding how to spot financial manipulation is absolutely vital. We see companies continuously following unsustainable accounting practices and shareholders suffering the brutal consequences — but there is always a sweet spot where the foul play can be seen in the numbers and has not yet been reflected in the share price.
The reason this sweet spot exists — where foul play is visible but not reflected in the price — is because most investors don’t know how to spot it; they don’t put in the work to read the reports and do the necessary digging.
If we want to sell a bad player before the market catches on to them, we absolutely have to understand how they go about manipulating the figures. And as previously mentioned, most of the investment game is to do with avoiding big losses. They really do kill you. That’s why this article exists, and if you’ve followed this publication for a while, you’ll know I’ve already shared a few articles on similar topics — mostly on how to understand financial statements, and a little bit on sniffing out foul play (Linked below).
So instead of finding a new company today, I highly recommend you take the time to read these articles and ensure that all is well among your own holdings. The risk of being killed by a stock you own today is far more important than the opportunity of finding a winner tomorrow.
With all of that being said, today we’re going to dive into how and why companies manipulate their cash flows and how you can detect such shenanigans. The content of today’s article is primarily drawn from a great book, written by Howard Schilit, called “Financial Shenanigans.” It’s a fantastic read that I’ve mentioned many times before and I highly recommend picking up a copy for yourself. If you don’t have a copy, or you can’t get your hands on one, this is going to be indispensable to you.
Here’s the three cash flow shenanigans we’ll cover in this article:
Shenanigan #1: Shifting Financing Cash Inflows to the Operating Section.
Shenanigan #2: Moving Operating Cash Outflows to Other Sections.
Shenanigan #3: Boosting Operating Cash Flow Using Unsustainable Activities.
You don’t need to be an expert to grasp any of this — it is suitable for most, if not all levels of knowledge. Each part will be explained as it comes.
This article is a summary of almost 50-pages of writing, so if you don’t have access to the book, this is a great time & money saver.
Let’s get into it.
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