How Audit Makes You a Better Investor

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Capital Markets / Investor Relations in Two Minutes or Less
How Audit Makes You a Better Investor or Better Executive
Let us consider two types of companies:
1. The Hall of Fame Management Team: These companies execute well, have buttoned up management, and you want to own the stock forever.
2. Management Out for a Quick Buck: These companies suffer from spotty or poor execution, may not have buttoned up management, and you likely want to avoid the stock.
If you are a Buy-Side / Sell-Side Investor, you may have to own or cover both types.
How Does Audit Help?
The evidence triangulation framework.
The evidence triangulation framework consists of three components:
1. Entity Business States (EBS): Company’s External Environment
2. Management Information Intermediaries (MII): Internal Controls
3. Management Business Representations (MBR): Financial Statements
Evidence Triangulation Applied to Stock Investing
Applying the framework to stocks is simple and value-add.
EBS involves the scuttlebutt an investor collects, company reputation, and where Sell-Side Equity Research comes to life. Think analyzing suppliers, customers, and how the capital markets interact with the company.
MII involves the auditor opinions in given SEC filings like the annual form 10-K. Does the auditor provide a qualified or unqualified opinion. Are there a lot of Critical Audit Matters (CAMs) highlighted?
MBR involves analyzing and understanding the non-GAAP reconciliations for a public company. Do the add-backs flow through the financial statements. Do the add-backs make sense? Does the company actually provide non-GAAP reconciliations?
Analyzing a stock through this framework can give you a sense of accounting scandal risk.
Real Life Examples
$EQIX: Company has a sterling reputation in the data center community, clean auditor opinions in SEC filings, and clean non-GAAP reconciliations.
$DAY: Recently hit with a short attack from Blue Orca. The attack calls out an internal control issue identified by the auditor in the SEC filings around a $500M issue.
$CANO: The company had questionable add-backs to its adjusted EBITDA calculation, a non-GAAP metric.
Applying Evidence Triangulation Tells Us Something Here
$EQIX seems to lack a smoking gun to act as a significant red flag of deeper accounting issues.
$DAY and $CANO both have a smoking gun red flag issue.
Key Learnings
Audit makes you a better investor and better executive.
Applying simple audit frameworks like Evidence Triangulation can significantly improve your investment process and mitigate downside risks associated with Accounting scandals!