Five Ways That Trading Statements Deceive

One of our most interesting jobs here at Stockopedia is digesting the daily news with our community.

Unfortunately, reading the daily company news is not as straightforward as it perhaps should be.

And if it's tricky for us, then it's downright tough for those who don't do this for a living!

Browse any popular bulletin board and it won't take long before you find beginner investors, unfamiliar with the standard practices of the City, who have been led astray.

In this article, I’m going to focus on five ways that trading statements deceive investors. I'm not going to name any particular companies, but I'm sure you'll be able to think of your own examples.

And whether you're a beginner or a long-in-the-tooth interpreter of company announcements, I hope this list helps to arm you well during the 7am rush!

The Voynich Manuscript is considered to be an indecipherable document, but it actually makes more sense than some RNS announcements. Image source: Wikipedia.

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1. Mealy-mouthed phraseology

There are numerous mealy-mouthed phrases that sound encouraging, but which lack specificity. The standout example of this over the past year has without a doubt been “profitable growth”.

This phrase has been used by good companies and bad companies, in both positive and negative trading updates. But never has it improved an investor's understanding of a company's performance.

The phrase itself is meaningless. Let’s break it in two:

• “Profitable” - can in theory refer to after-tax net income, or pre-tax profits, operating profit, or EBITDA, along with adjusted versions of all of these. But is a company with positive adjusted EBITDA really “profitable”, if all of the other measures are in the red? I would say No.

• “Growth” - this doesn't relate to profits, despite its proximity to the word "profitable". Instead, it relates to revenues, and in theory it should guarantee rising revenues. But depending on how this awful phrase has been used, even that achievement might just be a vague aspiration.

So when you read that a company is looking forward to achieving “profitable growth”, I would mentally write that sentence off completely.

The absolute worst thing you could do, when you see this phrase, is to conclude that the company is profitable - and furthermore, that its profits are growing.  It might be tempting to think that. But it would be wrong.

2. The secret profit warning

Novice investors might naively think that RNS announcements at the London Stock Exchange are the correct place to look for news relating to company earnings forecasts.

They would be right, but only half-right.

The reality is that while some companies use the RNS system to provide timely earnings guidance, it’s far more common for companies to let their appointed brokers do this, in their research notes.

This wouldn’t be a problem, except for two things:

• Access to broker notes is usually limited to the broker’s own clients.

• There can be surprising discrepancies between the message that you would infer from the RNS, and the message in the (company-approved) broker note.

The second issue gives rise to what I call “the secret profit warning”.

This happens when an RNS trading update does not make it clear that the earnings outlook has deteriorated. It may refer vaguely to certain difficulties, while also pointing to mitigating factors. A beginner investor might be left with the impression that events are going according to plan, more or less.

In this case, only those with access to broker notes can see what is really happening. It’s common, even for those of us who are experienced in this business, to find downgrades in broker notes that we would not infer from a straight reading of the RNS.

Large companies (e.g. FTSE-350 stock) should at least have earnings expectations on their website, so that you don’t need a broker note to see what the market is expecting. But small and mid-cap companies are unlikely to do this.

Thankfully, Research Tree has greatly improved access to broker notes for private investors, but the system does not require companies or brokers to use such a service. So it’s still very common for an information vacuum to occur when earnings forecasts change, until these changes feed through to the consensus figures you find on the StockReport.

To be totally clear, I might still invest in a stock that is prone to the occasional earnings vacuum. But as a general principle, I’d suggest that it’s a good idea to know if this is the case before making an investment, unless you're running an automated system.

3. The disappearing percentages

This is now so very common that you could almost call it standard practice.

When I cover an RNS, I typically do not have to calculate percentage growth figures - with the main exception being when they are negative.

In that case, it’s increasingly common that the percentage reduction - whether revenue or profits - has been mysteriously omitted.

Growth nearly always gets a percentage, but shrinkage is left to the reader to calculate.

Is there any good reason for this? If I had to try to justify it, I would come up with something like this:

Business growth can compound over time, and so percentage growth figures help investors to understand the rate at which the business is currently compounding. Shrinkage, on the other hand, is almost always the result of temporary problems, and so the percentage by which a business has shrunk is of less importance.

That’s me, trying my hardest to justify the omission of negative percentages.

But investors and analysts will nearly always calculate negative percentages anyway. And there's no really good reason for companies not to do it themselves.

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4. More games with percentages

There are many more ways that companies can and do play games with percentages.

Here are a few of the big ones:

Growth from a low base - when a new business or a new division gets started, it’s not all that unusual to see triple-figure percentage growth. The mistake is for investors to think that this is of any significance. 200% annual revenue growth from a base of £10 million might be very interesting for a small- or mid-cap company. 200% growth on £100k is... not.

Growth against poor comparators - we all know the mature businesses that have been around for a long time, that have their good years and their bad years, but which ultimately fail to live up to investor hopes.

The mistake here is to get excited about one year of strong growth. Compare the result against two and three years ago. You might be less enthusiastic about its near-term prospects when you see what this old company was achieving a little further back in the past.

Growth in a single division or geography - this is absolutely typical. Here's how it goes: present investors with the overall growth rate, and then highlight the best-performing division or geographic area within that overall performance. As for the worst-performing segment? Just don't mention it.

To create a fictional example: "Revenue growth was 5%, including 50% growth in our high-performing XYZ division." And how did the other divisions do? That's what footnotes and tables are for.

Investors and analysts must remember that the more impressive the best-performing division is, compared to the overall growth rate, then the worst-performing division must be equally unimpressive.

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5. Scrolling, scrolling, scrolling

This applies mostly to early-stage companies, but even larger companies have occasionally done this.

If you open a half-year report or even final results, and you are met with a wall of prose that does not include any important financial numbers, then I believe you should be very worried.

For pre-revenue companies, this can be understandable. But you may also spot it with well-established companies that are generating modest revenues. You might even spot it with larger companies that are going through a rough patch.

Broadly speaking, if you have to scroll through 5-10 paragraphs (or more) just to find basic information such as how much revenue the company generated, or how profitable it was, then I think you should treat that company with great caution. It might still be a wonderful investment - but I wouldn’t expect great financial results from it any time soon!

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So there you have it: five ways that trading statements deceive investors. There are surely many more that I could have picked. If you have any favourites of your own, please leave them below!