Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors

PART TWO

Margin of Safety—How to Avoid a Permanent Loss of Capital

In Part Two, we describe the first step in our checklist: how to avoid stocks at risk of a permanent loss of capital. The potential for a total loss manifests in three ways: financial statement manipulation, fraud, and financial distress and bankruptcy. All are three different risks, but are closely related and frequently found together. For example, management may manipulate a stock's financial statements to create the illusion of better performance than exists in reality. They may justify it on the basis that these are “white lies” amounting to something less than fraud. Where manipulation exists we can't trust our valuation or management. Where there's financial statement manipulation, it's likely that there are other cockroaches in the kitchen, and it's a short step to outright fraud.

Outright fraud is a high-risk situation for investors. Not only are the financial statements incorrect, but management is stealing from the company. The fraud can go on only for a limited period of time, and the dénouement is often financial distress and bankruptcy for the stock. It's also possible that the cause and effect is reversed, and the financial distress leads a panicked management to manipulate the financial statements to stave off creditors. The end is rarely pretty for the common stockholder, who ranks last in the pecking order behind all other stakeholders.

Firms subject to financial statement manipulation, fraud, ...