Eye-Poke to Investors Who Ignore the Small Print
By Herb Greenberg
The Wall Street Journal
Saturday, June 2, 2007
Journalist Michelle Leder learned the hard way about not reading
After buying 100 shares of Qwest Communications International
Inc. in 1999 for $39 each, she watched the stock price climb to
as high as the low $60s by early 2000 before plunging to nearly
$1 in 2002 after the company was rocked by accounting scandals.
"I didn't sell because there were people touting the stock and
talking about how it was unlike other telephone companies," she
says. "So I basically bought into the hype." Afterward, she
decided to go back to see what she might have found had she
looked more closely at the footnotes in the company's Securities
and Exchange Commission filings.
A close inspection? Don't be silly.
There was plenty, says Ms. Leder, who used the experience as the
launching pad for her Web site, Footnoted.org, which tries to
ferret out facts that otherwise might go unnoticed. This year,
she says, "there's just so much more disclosure" with "things
you didn't see before."
Investors might want to keep that in mind next month when
companies start reporting second-quarter results, which will be
followed several weeks later with more detailed reports to the
SEC. In those reports, sophisticated investors will dig into
the footnotes to determine if everything is as the company said
Doing so "is an art, not a science," says Thornton O'Glove,
whose book, "Quality of Earnings: The Investor's Guide to How
Much Money a Company Is Really Making," is regarded by many
investors as a forensic bible. Adds Ms. Leder, in a tutorial on
her blog: "Looking for a few key items shouldn't take much time
-- figure 20 to 30 minutes for a 10-Q and a proxy and an hour
for a 10-K -- and could save you a lot of money by helping you
avoid potential problems early on. Remember: there's no need to
read every word or even understand everything." The goal, she
says, should be to find "signs of aggressive accounting and any
significant changes that were not in the filing last quarter or
In quarterly filings, Ms. Leder often heads straight to the
footnotes on commitments and contingencies. This is where a
company, "in their own wording and language," discloses issues
they may be facing, she says. This section differs from that on
"risk factors," she says, because it tends to be more specific
and less boilerplate. It was in the
commitments-and-contingencies section that subprime-mortgage
New Century Financial Corp. disclosed it could be forced to
repurchase loans sold to investors if there were
misrepresentations about those loans. As the subprime market
stumbled this year, New Century was hit with an unexpectedly
high number of questionable loans, which in turn played a role
in its recent bankruptcy filing.
In 10-Ks, Bob Olstein of Olstein Funds, and a former partner of
Mr. O'Glove, starts with a review of the note on income taxes.
"What I want to see," Mr. Olstein says, "is a reconciliation of
the income the company is reporting to shareholders and the
income being reported to the [Internal Revenue Service]." A big
difference between the two can be a red flag that requires
further research, which he says was the case with Sunbeam, the
appliance maker that got caught up in an accounting scandal in
the late 1990s.
Sunbeam wound up filing for bankruptcy, agreeing to a $141
million settlement of a class-action lawsuit and settling civil
charges with the SEC; its former auditor, Arthur Anderson, paid
$110 million of that Sunbeam class-action settlement.
Mr. Olstein and Mr. O'Glove also look at the footnotes on raw
materials, work in progress and finished goods. "A huge build
in raw materials and work in progress relative to finished goods
can mean orders are picking up," Mr. Olstein says. "The reverse
can be if finished goods are building and raw materials are
My favorite footnote section is related-party transactions.
This is where companies disclose business they are doing with
top executives. Consider Synutra International Inc., an
infant-formula company based in China. The company, which has a
$1.2 billion market value, discloses that it buys from and sells
to a handful of companies controlled by its chief executive.
President Weiguo Zhang says while he understands why investors
may be concerned by the relationships, nothing untoward is going
on. That may well be, but such deals can make some investors
Of course, all investors may not agree and that gets to the most
important question of all: What makes something significant?
"That's difficult to say," Ms. Leder writes in her blog. "It's
kind of like the way the Supreme Court defines obscenity:
You'll know it when you see it."
• Herb Greenberg is senior columnist for MarketWatch. He
doesn't own stocks except those of his employer -- and doesn't
sell individual stocks short or invest in hedge funds.
MarketWatch is a unit of Dow Jones, which publishes The Wall
Street Journal. Email