Do accounting problems provide buying opportunities?

It never fails. As soon as a company runs into accounting troubles, the stock price tanks, analysts who cover the stock circle the wagons, and some (if not many) proclaim that it’s a buying opportunity.

It’s a tough pill for investors to swallow, especially coming from an analyst who was previously recommending the stock. But for those who didn’t own the shares before the sell-off, it’s tempting to sniff around for bargains.

At least that’s the strategy implied by a recent study that suggests there are outsized returns to be had from investing in companies after they make accounting restatements. The logic is that company share prices overreact on the downside after an accounting restatement is made.

An accounting restatement is when the company finds an error in its books and needs to reissue financial statements for a prior period. The situation could mean potential executive malfeasance, and may result in regulatory investigations and investor lawsuits. Since there are usually unanswered questions and a lack of transparency, investors risk overreacting in a rush to cut potential losses.

The study, undertaken by Audit Analytics, notes that other research has proven abnormal negative returns leading up to and after the announcement of an accounting restatement. This made the authors wonder whether there were notable positive returns after the market had digested the news and the accounting issues were resolved.

The study examined 966 restatements from companies on senior U.S. exchanges for which the share price was over $1 and where there was a lag between the announcement that there would be a restatement and the filing of the restated results. In short, the study found opportunity for abnormal positive returns in the 30 to 60 days after the financial statements were refiled (and for smaller positive returns in other periods as well).

Before turning this into a trading strategy, consider that the positive returns observed were only up to 3.28% and ignored trading costs. Perhaps the most interesting finding was that no abnormal negative returns were reported after the 90 days following the restatements. One possible reason is that investors return with more confidence, believing that the chance of a second restatement so soon after the first seems unlikely.

Canadian perspective

How would this strategy have worked for Canada’s most recent high-profile accounting collapse, Maxar Technologies? Previously known as MacDonald Dettwiler & Associates, Maxar is a provider of satellite imagery services and solutions, including the construction of satellites and other space technology.

In August 2018, Spruce Point Capital Management issued a 68-page research report outlining a “brazen accounting scheme” and warning that the dividend would be cut and the stock could become worthless. Since the Spruce Point report, the stock has fallen 89% in value and the dividend was cut by 97%.

Prior to the Spruce Point report, eight out of nine analysts who covered the company had it rated as a buy, with average expected upside of 40%. While analysts aren’t especially equipped or incentivized to search for accounting issues, the reaction to the report was remarkably sanguine. Even after the accounting problems were explained by Spruce Point, six firms (BMO, Canaccord, National Bank, RBC, TD and Veritas Investment Research) all predicted returns on the stock exceeding 275%. The shares remain at an all-time low as of this writing.

Advisor takeaway

Suffice it to say, it’s highly risky to invest in companies that are embroiled in accounting issues. Even after the concerns have been supposedly resolved, the potential upside (as measured by Audit Analytics) seems too low to warrant investing client funds. The easiest way to “win by not losing” is to avoid companies that have hallmarks of potential accounting issues (as Maxar did). If you’re lucky enough to avoid an accounting problem on the first go-around, try not to create a new one by picking up a fallen angel. There’s almost always a better alternative with less accounting risk.