Our research process starts with a screen to narrow down our investable universe to a more manageable number of names. As the screen is reviewed, more names are removed from consideration due to unattractive qualitative factors, such as extreme cyclicality of revenues or earnings. A few names are targeted at a time for a deep qualitative dive, which includes a checklist of characteristics we want the company to demonstrate, such as sustainable margins and shareholder friendly management.
One of the items we check is the auditor. The auditor’s role is to express an opinion regarding whether a filer is presenting a fair report of its financial statements. The reason to scrutinize the auditor is obvious—if the company is lying about its books—it’s probably not worth what the numbers suggest. In the US, most companies are audited by one of the big four accounting firms: Deloitte, PwC, EY or KPMG. If the company uses one of these auditors and isn’t constantly changing, we are generally satisfied. We also like to see financially literate people on the company’s board, especially the audit committee. As Howard Schilit, author of Financial Shenanigans, pointed out, a company with a board full of celebrities may not be taking its obligations to the shareholders very seriously.
A company’s board and auditor tie into the bigger picture about whether a company has a culture of transparency. Companies that report numbers in a clear and consistent manner over time are ideal. Companies that bury important information in financial footnotes or use a stream of acquisitions and the associated “one-time” restructuring charges to manipulate earnings are less than ideal.
For international companies, the choice of auditor varies a little more, although one of the big four are often used. It should be noted that even when used, the big four only license their names overseas to insulate themselves from liability. The structure of an international company is sometimes more complex, in terms of ownership and subsidiaries. This makes the choice of auditor more important.
We recently reviewed a Japanese company, SMC Corporation, which makes industrial automation equipment. The company is well positioned in a growing market with strong fundamentals. We liked the company, but also noticed it does not use one of the big four, but a smaller auditor, Seiyo Audit Corporation. This auditor was selected despite SMC’s complex structure which includes 35 consolidated subsidiaries and another 38 non-consolidated subsidiaries.
We did some further digging and learned SMC is Seiyo’s largest public company client by far and analysts had called into question its accounting in the past. We contacted the company on multiple occasions with questions related to its business and its auditor and did not get a response. Finally, SMC’s audit fees of about $600K were a fraction of the fees paid by a similarly sized Japanese industrial company. Taking all of this information into account, we decided to pass on the company. Even if the chances of any shenanigans were slim, the potential downside was deemed too great.
Investment analysis can be a messy process and there isn’t always a black and white answer, but confirming the quality of a company’s auditor, and thus the accuracy of its financial reporting, is an important step in our research process.