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Having scoured financial statements for decades, we’ve identified more accounting red flags than we can count. But the following stand out as perennial portfolio risks.

1. Growth by acquisition

Some companies seem to exist to gobble up others. It can be a smart, and sometimes necessary strategy to grow through acquisition, as when oil and gas companies need to replace production. The approach works when the acquirer can leverage its value in the market to swallow companies priced at lower multiples. The risk comes when the acquisition metrics are not transparent or the accounting is lacking relevant details. What is often easier to understand in the energy space is not necessarily so straightforward in, say, pharmaceuticals (e.g. Valeant).

Suggestion: If you can’t understand where the figures came from, ignore them or heavily discount the amounts, building a margin on safety into what you will pay for the shares.

2. Sensitivity to interest rates

For some companies, nothing derails business like a prolonged downturn in interest rates. Banks and life insurers are most susceptible. Some large Canadian insurers, for instance, have guaranteed products that carry heightened interest-rate risk. In addition to mark-to-market losses from lower interest rates, a prolonged period of low yields can cause these companies to incur charges related to their ultimate reinvestment rates.

Suggestion: Hedge all bets when it comes to interest rate movements. Making a big wager that rates will rebound soon could result in a lagging portfolio.

3. Cash-flow distortions

Some analysts misinterpret cash-flow statements, leaving advisors to clean up the mess. Focusing on free cash flow ignores roughly 60% of the cash-flow statement. We liken that to stopping at the gross margin line on the income statement—when’s the last time an analyst valued a company on a multiple of gross margin? You’re playing with fire if you ignore the investing and financing sections of the cash-flow statement since that could be where the real story is.

Suggestion: Read more about this problem in “Don’t be Suckered by Cash Flow Statements” and “Shielding Portfolios Against the Next Sino-Forest”.

4. Related-party transactions

This is just a nicer way of saying self-dealing, which is when a company does business with its executives, directors, related companies or otherwise non-independent entities. Related-party transactions are a hornet’s nest of potential problems.

Loblaw, for example, recently announced it would spin out some of its real estate into a REIT, over which it would maintain majority control. Would you invest in a REIT with overexposure to a single tenant with the ability to sell more assets to you on its own terms? What discount on the $9-billion to $10-billion asset value established by management would be appropriate when assessing the value of both Loblaw and the REIT?

Suggestion: Heavily discount any figures companies estimate on their own, especially when the deal involves a related-party transaction.

5. Changes in accounting standards

Canadian companies have the option to use either U.S. accounting rules or International Financial Reporting Standards (IFRS), with roughly 20% of the S&P/TSX 60 choosing the American standards. With the switch from old Canadian rules to IFRS occurring just two years ago, there have already been some second thoughts, which raises the spectre of standards shopping. Encana, for instance, switched to using U.S. rules after just one year with IFRS.

Suggestion: Check a company’s results under the accounting rules they just abandoned to quantify the impact of any boost in perceived value they got from switching horses mid-race. It might be enough to change your opinion on the stock.

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