Death Crosses will Kill your Portfolio
January 14, 2017
Which Stocks you Should Stay Away From
January 26, 2017
Show all

Montier C Score

Montier C Score – Who is Cooking the Books?

At its base, the Montier C Score is simply a way to give you, the investor, an idea of the probability that a company is cooking their books. This score is from 0-6, and basically, the higher the C-score the higher the probability that something fishy is going on with their books.

How do you build the Montier C Score?

The C Score is built of six different true/false variables. With every variable that is “true”, the score increases by one.

  • A growing difference in net income and cash flow from operations.
    • Though earnings are great, they are heavily subjected to estimates – unlike cash flows which are more set in stone in regards to financial documents. If cash flow is not increasing, but earnings shoot up there may be a problem in the accounting process or a more aggressive approach to the cost of capitalization.
  • Accounts receivable are growing faster than sales.
    • There are ways this can happen without cooking the books, but it doesn’t happen all that often. If a company’s accounts receivable are increasing faster than sales, there may be something fishy going on, or at least a discrepancy that should ward you off from investing in that particular company.
  • Increase in inventory
    • This could be because a company is growing rapidly and needs to increase the inventory they keep on hand, but usually it’s because a company has had recent problems with selling and they’re still bringing in their standard inventory order.
  • Increasing the current asset to revenue ratio
    • Since investors care about how much money a company is bringing in and how long they are keeping their inventory in stock, some accountants will use this line item to adjust the outlook of the company as this item works as a sort of “catch all” item in the balance sheet
  • Decrease in depreciation of property and plant equipment
    • Adjusting the “useful life” of property and equipment is incredibly simple to do inside of the books. These estimations are typically false and are done simply to improve the financial outlook of the company.
  • High increase in asset acquisitions
    • In order to distort earnings companies may go on an “acquisition spree” and begin to acquire an unusual amount of assets. In our case, we are looking for companies who have acquired 20% more assets than they previously had in the past quarter.

Does the Montier C Score work?

I created a simple screen that just started Montier C score > 3. Three being the halfway point I decided it was the perfect spot to test how well the score worked when it came to finding companies you don’t want to invest in. The below backtest are the results.

And here are the results. Not the complete failure that I was looking for, but it’s bad enough that I know I want to typically stay away from companies that have a C score of greater than 3 as they get a total return of just over 2% at a 7% Monthly standard deviation. Compare this to the S&P’s total return of over 600% at a much lower monthly standard deviation of 4.58%.

That being said, Montier himself suggests that you use a screener that states the following.

  • Price to Book ratio > 2
  • Montier C Score = 5

That’s much better. This “screen” actually lost money. Now, it’s a long way from a functional strategy but every investment strategy has to start somewhere.

So, what about the flipside?

This score was designed to find companies that may be interesting to short; but can it be used as a green flag to find companies to invest in? If a C score of greater than three means there is a higher probability that a company is cooking the books, does that mean that a lower C score suggests good bookkeeping habits?

It seems that it does. Though I wouldn’t use good bookkeeping habits as the sole reason to invest in a company, it is sure a fundamental factor that I would personally like to know before entering into a long term position.

Overview

In the end, the Montier C score is simply a way to identify companies that may be cooking their books in order to look better on paper. It was designed as a way to find companies to short, but has ended up working incredibly well as a green flag when looking at potential companies to go long on. Don’t be surprised if you see a couple of screens go up in the future where we utilize this score in our analysis.

Tyler McCain
Tyler McCain
A student of finance at Georgia State University, Tyler has had a passion for the world of finance for as long as he can remember. Joining the Equities Lab team in 2015 he attempts to juggle the perfect mix of school, work, and giving back to the community. When he isn't working at Equities Lab he can often be found helping teach programs at the Rosen Family Foundation - a non-profit that teaches financial literacy to middle and high school students.

2 Comments

  1. amit says:

    tell me sir , whether the metric would be biased in favor of software companies and other service industries .

    The reason is that software is not easy to measure in inventory terms (Increase in inventory) nor do these companies have depreciation of property and plant equipment as much as other .

    In other words the software companies or service industry

    Has any study conducted across sectors ?

    • Tyler McCain says:

      The average sector returned 9.52%. There doesn’t seem to be much bias between service and product based sectors.

      The worst performing sector in the green flag is communication services, with only 1.225% return on average. On the flipside, the highest performing sector is consumer defensive – which is product based in a lot of areas.

      That said, it appears there is little bias in this score based on sector as each industry falls fairly close to the 9% average.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.