For the investors focused in the fundamentals, to rely in the financials statements of any company is routine. If they don’t rely on them, they can’t even have the possibility of putting in practice the financial analysis techniques that are at the core of the fundamental investor.
But this is a big leap of faith. For you to rely unconditionally on the auditors’ opinion, it would be necessary that in the last 30 years the world hadn’t watched a single accounting scandal under the jurisdiction of the auditors (this is for you to avoid a major bankruptcy).
As you know this isn’t the truth, the last decade alone saw a multiplicity of scandals for every taste. This meant big losses for investors, folks trying to apply value, growth or contrarian approaches saw themselves in the middle of a train wreck, and suddenly their valuations were considerably off the track.
This is a big risk, some might say that it is a small probability of being involved in a crisis like this, and that diversification will dilute your losses, but I still think that it is a big problem for the small investor. In my view the concentration of the portfolio might help reducing the risk because the investor might keep the company under more close watch. Either way this is one of the reasons why I always complement my analysis with an intangible strategy analysis.
I have to evaluate the strategy and the actual execution of that strategy. Otherwise you might be trapped in a fictitious wonderful business that generates beautiful books, but no actual profit.
That’s what happened to HP, backed by multiple investment bankers and auditors, they still ended with their hands blown in the midst of an accounting scandal involving Autonomy, a firm which cost HP around USD 11 Billion.
Now you say to me that if big companies, with resources to have deep detailed analysis fail in investing, how can a small private investor do better?
The answer is exactly because he is small, private, and answers to no one except himself and God. Look at the guys who are in the executive board that are now criticizing the deal, they are the same that one year ago signed the deal. Why did they sign it then? They did it to please the CEO at the time. So did the investment bankers, they are always ready to take your USD 50 Million to tell what you want to hear. You want to buy that company? So ask an investment banker if he wants a hefty commission to help you completing that transaction. He will tell that the company is the best (after your company obviously).
Bottom line is that investors must always be critical of the financial reporting even if the auditor has a clean opinion, and you can avoid this trap if you always try to take evidence that the financial reports have correspondence with reality.