Measuring the Cost of Red Flags

I’m in the process of updating the AQRM Score Portfolio analysis I did with 2018 data.

Here is the selection criteria for the AQRM 80- Portfolio:

  • Large accelerated filers
  • AQRM Score of 80 or below
  • AGR is dropped for missing data

This criteria yields a portfolio of 48 stocks. The stocks were equally weighted in construction of the portfolio.

Here are the results:

AQRM Score 80- Portfolio

As with the similar 2017 portfolio, this portfolio significantly underperformed relative to the market, as you can see in this graph.

Interestingly, the portfolio clearly starts to underperform in the second half of the year, long after the annual reports have been filed (and hence the point at which most of the red flags would have already been known). Before that it tracks the DJIA pretty closely.

  • $1 invested in the DJIA would have been worth $0.91 at the end of the year.
  • $1 invested in the Low AQRM Score Portfolio would have been worth only $0.81 cents at the end of the year.

Red flags cost real money.



Unsustainable Luxury

“It’s partly this colossal irresponsibility that sparked the idea for Veja, the footwear industry’s Parisian darling that has been at the vanguard of the sustainable fashion sphere long before the word ‘sustainable’ was even a buzzword. In 2005, while other brands were being born online, Francois-Ghislain Morillion and Sebastien Kopp saw opportunity with a physical emblem of their generation: the sneaker. Unlike the big names in the category that spend 70% on advertising and 30% on raw materials and production, they devoted all their resources to a sustainably manufactured product (that costs five to seven times as much to make as other sneakers cost) and the people who make it.” (“Beautiful and Sustainable,” Fortune, 1/1/19, p.50)

Sneakers that cost five to seven times as much to manufacture?

A good question is whether this is an average or marginal cost measure, though most likely average cost. If so, then it is a good question what the potential returns to scale might be. Are they being limited by the typical yearly cycle for fashion?

At the same time, returns to scale are probably limited, as textiles are a labor-intensive industry and most of the costs are likely at the margin, i.e. average and marginal cost are relatively close to each other.

Three points from this:

First, “sustainable” is costly. Of course, it is contrary to all economic logic that green or sustainable technology should be costless, but the falsehood is repeated so often that the evidence needs to be pointed out in every case as well.

Second, “sustainable” is a luxury. Half of the world lives in severe poverty, and one sixth of it in extreme poverty. They cannot afford to pay five- to seven times more to get a pair of shoes.

Third, “sustainable” isn’t really sustainable. How can any company compete in an industry that can produce a nearly identical product for five- to seven times less? Once the “sustainable” premium fades, so will the company as well. And as the middle class steadily disappears, so will its willingness to pay for the luxury of “sustainability.” (See the feature in the same issue of Fortune on the disappearing middle class.)

What Other Companies Are Threatened by Asbestos?

On December 14, Reuters reported that Johnson & Johnson had know for decades that its baby powder contained, or could contain, asbestos.

The Reuters article provoked a nearly instantaneous sell-off in the market and a press release from Johnson & Johnson denying the claims. Shares fell from $147.79 on December 13 to $131.28 on December 14 and then continued to steadily decline before eventually bottoming out at $122.71 on December 24.

The nearly 17% drop over the 10-day period represents a loss of more than $67 billion to investors.

The news came as result of discoveries made in conjunction with a class-action lawsuit that had been winding its way through the courts since February 10, 2018.

Two quick points. First, let’s consider the Efficient Markets Hypothesis. If investors had known about the lawsuit since February 10, why the market reaction? Shouldn’t the likelihood of such as disclosure have been priced in long before the Reuters article? But, of course, there is good reason to doubt the Efficient Markets Hypothesis for the simple reason that information is costly to obtain and evaluate. Just because data is available, even publicly available, does not mean market participants are aware of it, no matter how relevant it may be.

Second, red flags matter. Or, perhaps more accurately, red flags don’t matter until they do. A class action is definitely a red flag, and anyone with any sense of financial history should be aware of how devastating asbestos liabilities can be.

So who else is exposed?

The short answer is Honeywell, although not in the same way as Johnson & Johnson. Honeywell’s exposure comes from understating its liabilities in its financial reporting, not as the result of product liability. The other two cases are likely too old to provide much exposure to investors.

Here is a list of all of the case summaries containing the word “asbestos” from Audit Analytics litigation data:

Kanefsky v. Honeywell International Inc et al

Case started on: 10/31/2018

Plaintiffs allege that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. According to the complaint, throughout the Class Period, Defendants made materially false and misleading statements regarding the Company’s business, operational and compliance policies. Specifically, Defendants made false and/or misleading statements and/or failed to disclose that: (i) Honeywell’s Bendix asbestos-related liability was greater than initially reported; (ii) the Company maintained improper accounting practices in connection with its Bendix asbestos related liability; and (iii) as a result, Honeywell’s public statements were materially false and misleading at all relevant times.

Hall v. Johnson & Johnson et al

Case started on: 2/8/2018

In February 2018, a securities class action lawsuit was filed against Johnson & Johnson in the United States District Court for the District of New Jersey alleging that Johnson & Johnson violated  Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder by failing to adequately disclose the alleged asbestos contamination in body powders containing talc, primarily JOHNSONS® Baby Powder.  The lawsuit was assigned to the District Court Judge managing the personal injury multi-district litigation.

Safety National Casualty Corporation v. Garlock Sealing Technologies LLC et al

Case started on: 8/2/2017

Enpro Industries, Inc. is a party to legal proceedings initiated in August 2017 in the District Court with two insurers that collectively provide $15 million of coverage under the Garlock Coverage Block. The legal proceedings were initiated by one of the insurers seeking to compel arbitration of issues under its policy and, alternatively, a determination that its policy does not cover asbestos claims. Enpro counterclaimed, seeking a determination that the policy covers asbestos claims and that the insurer breached the terms of its policy by failing to provide coverage for these claims. Enpro joined the second insurer in this action and is seeking similar relief against it.     On October 12, 2017, the magistrate judge issued a decision denying the petitioning insurer’s motion to compel arbitration and holding that the arbitration clause in the policy was deleted by an endorsement. The insurer filed an objection to the magistrate judge’s decision with the District Court. The District Court issued an order on August 20, 2018 upholding the magistrate judge’s decision and the insurer has appealed that determination to the U.S. Court of Appeals for the Fourth Circuit. This appeal is pending.

Sitetech Inc v. Cross Environmental Services Inc et al

Case started on: 3/16/2016

A suit was filed against CES in district court of Michigan on or about March 16, 2016 by SiteTech, Inc. (“SiteTech”). In this suit, SiteTech alleges negligence by CES for failing to remove asbestos-containing materials in a timely manner allegedly resulting in damages in excess of $75,000.00. CES plans to vigorously contest the allegations made by SiteTech in this suit.


Background Reading

Girion, Lisa. “Johnson & Johnson knew for decades that asbestos lurked in its Baby Powder.” Reuters. Dated 12/14/18.

Johnson & Johnson Issues Statement on Reuters Talc Article.” Johnson and Johnson. Press release. Dated 12/14/18.

Joseph, Saumya. “J&J shares nosedive on report it knew of asbestos in Baby Powder.” Reuters. Dated 12/14/18.

Spector, Mike. “J&J moves to limit impact of Reuters report on asbestos in Baby Powder.” Reuters. Dated 12/14/18.


What Constitutes a Significant Insider Sale?

What constitutes a significant insider sale?

To answer this, we take a look at insider trading data for 2018 from Sharadar.

Here are the steps I took to process the data:

  1. Remove all non-derivative transactions (coded D, DA, DD).
  2. Remove restatements (formtype contains “RESTATED”).
  3. Aggregate rows to treat multiple transactions by the same person in the same company for the same security type on the same date as a single transaction. (This takes some doing.)
  4. Filter out all aggregated transactions where transaction shares equal zero.
  5. Check for consistency to verify: Initial shares + Transaction shares = Final shares. Filter out inconsistent records.

Measure the magnitude of each (aggregated) insider sale or acquisition (“acquisition” includes both awards and purchases of securities):

  • Sales are measured as a percent of initial holdings, i.e. holdings before the transaction.
  • Acquisitions are measured as a percent of final holdings, i.e. holdings after the transaction.

Measuring magnitudes of transactions in this manner means that all percentages will be between 0 and 100%. Insiders cannot sell more than 100% of their initial holdings or acquire more than 100% of their final holdings.

Insider Sales and Acquisitions Percentile Table, 2018

insider percentiles table 2018

Here are some insights from the analysis:

  • 10.3% of insider acquisitions are for 100% of final holdings
  • 45% of insider acquisitions are 10% of final holdings or less
  • 25% of insider sales are 1.58% of initial holdings or less
  • 65% of insider sales are 9.78% of initial holdings or less
  • 90% of insider sales are 52.5% of initial holdings or less
  • 7.05% of insider sales are for 100% of initial holdings

This analysis suggests the following rules for flagging insider activity:

  • Award a yellow flag if an insider sale represents 10% of initial holdings or more
  • Award a red flag is if an insider sale represents 95% of initial holdings or more

Here is the histogram for insider sales.

Insider Sales Histogram, 2018

insider sales histogram 2018

Here is the histogram for insider acquisitions.

Insider Awards and Purchases Histogram, 2018

insider awards and purchases histogram 2018