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This week saw the launch of Big Short, the Motley Fool's new shorting service. As a guy who's pretty uncomfortable with being "long only" -- i.e., only making money when stocks rise -- I'm excited about this offering.
To date, most of my short bets have been placed on indexes, rather than individual stocks. That allows me to make money if my stocks merely fall less than their sector, or the market overall, in a downturn. Because my largest holding is that of a world-class gold explorer wrapped in penny stock clothing, I have a long put position on the Market Vectors Junior Gold Miners (NYSE: GDXJ ) in place to hedge against a steep correction among the precious metals "juniors."
Big Short is different, because it's looking for individual companies whose shares are poised for a fall. Our team uses forensic accounting techniques that can sniff out aggressive revenue recognition or other accounting shenanigans used to pump up reported profits. The service has a proprietary earnings-quality tool called the EQ Scan, which helps us do just that.
On a whim, I recently fired up the EQ Scan to see how some of the stocks I follow stack up in terms of apparent earnings quality. Chesapeake Energy (NYSE: CHK ) and Nabors Industries (NYSE: NBR ) aced the sniff test, with scores of "A" for excellent earnings quality. Freeport McMoRan Copper & Gold (NYSE: FCX ) and Alcoa (NYSE: AA ) snagged respectable "B" scores, for good earnings quality.
Meanwhile, Graco (NYSE: GGG ) , which I've identified in the past as one of the best industrial companies I've ever seen, totally flunked. What gives? Is this fluid-handling phenom playing fast and loose with its financial figures?
I don't know the secret sauce that goes into generating an EQ Score (and even if I did, I wouldn't want the Big Short guys coming after me), but let's take a look at what factors might have set off the scanner's alarm bells.
Cash flow divergence
This is one of the biggest "tells" indicating accounting chicanery: Net income heads higher, while cash flow fails to follow suit. In Graco's case, I see that in the past two quarters, net income exceeded cash flow. That didn't happen in 2009. However, as I look through more history, I do see a pattern of cash flow undershooting net income in the first half of the year, and then overshooting in the back half. This happened in 2008, 2007, 2006, 2005... you get the picture. This appears to be a normal seasonal pattern, not a recent gimmick to plump up reported income.
Receivables and payables
Ballooning receivables can signal accelerated revenue recognition. At Graco, days sales outstanding have fallen from their elevated levels during the credit crunch, and accounts receivable have fallen as a percentage of revenue. There are no discernable red flags here. Days payables outstanding, meanwhile, have ticked up to their highest level in a few years, so that's something to keep an eye on.
With "days in inventory" falling, no troubling bump in finished goods, and inventory falling as a percentage of revenue, I don't see any warning signs here.
The long and short of it
On balance, Graco's cash conversion cycle -- the time it takes to convert sales into cash flow -- is still elevated relative to historical levels, but it's moving in the right direction (i.e., lower). I'll be watching those days payables now, but I don't see a solid foundation for a short case today.