by Robert Boucher, CFA

Valens Credit Strategist Joel Litman presented to the Society on the topic of adjusted fundamental analysis and discussed some of the unique tools Valens Credit applies in their analysis. Mr. Litman began by taking the audience through a number of examples of how, in his view, GAAP, IFRS and IAS accounting—both in design and because of management’s discretion—fall short in consistently providing measures useful for fundamental analysis.  Specifically he identified pensions, rents, R&D, acquisitions and divestures as areas an analyst should focus on and should consider analytically adjusting to arrive at adjusted cash flow and income measures. Importantly the adjustments have implications for valuation of both equity and fixed income securities, as equity analysts project growth and apply earnings multiples or discounted cash flow models; and as credit analysts focus on coverage and cash flow leverage metrics. Mr Litman also described how differences in incentive structures help to explain some of management’s accounting choices, with earnings per share incentives driving different choices than a cash flow incentive or a return on assets incentive. Unfortunately for the analyst looking for a quick fix, Mr. Litman says the only realistic approach is to roll up the sleeves and start digging.

In addition to performing the time-consuming work of digging into individual company financials, releases and other printed material, Valens also attempts to glean important nuggets from earnings calls and other recorded presentations using audio forensics tools. Mr. Litman describes Valens’ use of electro audiogram scanning technology to “listening” for cues in the tempo, timbre, tone etc, and that, for example, depending on the context, a management team signaling confidence and excitement in its cues can give Valens added confidence in growth prospects.

Mr Litman closed by framing the current credit cycle relative to historic measures through the lens of adjusted fundamentals, showing similarities to market signals from a century ago. Valens’ research suggests the U.S. is in the back half of a first stage bull cycle, with strong corporate profits, easing credit conditions around the world, credit demand that hasn’t yet moved into the important new-investment stage, and strong asset returns. On an adjusted basis, forward price-earnings multiples are still shy of prior peaks and capex is supportive of additional growth.

Joel Litman was an energetic and deeply knowledgeable speaker and, judging by the level of engagement throughout the presentation, the topic was an important one to attendees.