Global Quality Edge Fund 2Q18 Commentary – 9 Recent Cases Of Aggressive Accounting

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Dear shareholders,

Global Quality Edge Fund’s total return during the second quarter was +1.39% and +5.35%, when measured from the start of 2018. It has now been a year since we embarked on this venture on our own and while it may not be much in terms of time, we look back and feel very satisfied of our achievements so far: the companies we’ve discovered, the return of the fund and, above all, the trust placed in us by our investors that have allowed us to grow and reach almost EUR 5 million of assets under management. By the end of the year, our aim is to reach EUR 10 million, easing our entry to capture and grow further with institutional investors.

In the last 4 quarterly shareholder letters, we focused on explaining Global Quality Edge Fund’s investment strategy and how we go about analysing the companies in our fund from a qualitative perspective; from understanding their business model, their competitive advantage against peers, to assessing the capital management implemented by senior executives. Today, we would like to shift your attention to the likelihood of coming across ‘red flags’ in a company’s finances and how these plays into our stock selection. To start, we define a ‘red flag’ as an accounting risk that may jeopardise a company’s future earnings as well as their expected cash position. There are many types of ‘red flags’ but the key will be in finding those that are most meaningful.

To avoid falling victim to them, it is always best to thoroughly read through annual filings; even though these will not always be easy to grasp and at times will require a certain background in accounting to fully understand them. Mastering them is not always easy. As time goes by, company reports continue to grow in length, new accounting practices are released almost every year which make their interpretation a constant challenge for the reader.

Red flags’ will become more frequent in nature at a time like now, when the economic cycle of the U.S., for example, is coming to an end and companies may struggle to continue growing their earnings at the same rate as they did before. Under this scenario, senior management could find itself ‘motivated’ or ‘incentivised’ to apply more aggressive accounting rules to maintain earnings per share and cash flow. It is then our job to see if we’re facing a potential risk and understand if the underlying figures are cast into doubt by the ‘red flag’.

To do so, we have classified more than 100 different types of ‘red flags’, a list which comes in handy to identify potential accounting risks and understand a company’s management thought process. Our recurring outreach to senior executives is of enormous benefit to later clarify or confirm our initial findings. Let’s now look into a few ‘red flag’ case study’s example.

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