The modified C-score helps identify companies which may be cooking their books
15-Feb-2016 •Mohammed Ekramul Haque
The C-Score was originally developed by James Montier to look at companies that resorted to cooking their books. Montier remarked, 'In good times, few focus on such 'mundane' issues as earnings quality and footnotes. However, this lack of attention to 'detail' tends to come back and bite investors in the arse during bad times.'
Montier also found the C-Score an effective way to identify short-selling candidates. Stocks with a C-Score of five and a price-to-sales ratio of greater than two generated around negative 4 per cent absolute return every year. Think of the C-Score as a way to identify what companies to run far, very far, from.
Here is how Montier developed the C-Score:
Companies get a point for qualifying: one for yes and a zero for no. A higher C-Score is a higher probability of manipulation.
How do the BSE 500 companies score on this test? Eliminating for financials, 38 per cent of the remaining companies get knocked off for a score of three or more (the higher the score, the more risk of manipulation). Also of interest is that only 14 per cent of the stocks have a modified C-Score of zero (the best). The two sectors that top the list of the lowest C-Score include technology and pharma. At the opposite end of the spectrum, 19 per cent of the companies reported a C-Score of four or more.
Do keep in mind that the C-Score can be the starting point of investigating which stock to buy or avoid. When making that decision, ask why a company scores as it does on an individual parameter and never use a single parameter to come to a decision.