Montier’s C-Score is a discrete score between 0-6 which reflects six criteria used to determine whether a company is cooking the books (hence the term “C-Score”). It was devised by James Montier who was then the co-Head of Global Strategy at Société Générale. The points are added to give an overall score. If a company scores 0 there is no evidence of earnings manipulation whilst 6 suggests there is lots of evidence. The areas tested are:
- Growing divergence between net income and cash flow (1 point). A higher level of accruals is associated with a higher likelihood of profit manipulation.
- Increasing receivable days (1 point). A large increase in receivable days might suggest accelerated revenue recognition to inflate profits.
- Increasing inventory days (1 point). Increasing inventory days could suggest that input costs are being artificially flattered or that sales growth is slowing.
- Increasing other current assets (1 point). Companies might be aware that investors often look at receivables and inventory, and might disguise problems in current assets.
- Declines in depreciation relative to gross fixed assets (1 point). Firms have been known to lower depreciation charges in order to inflate profits.
- Total asset growth in excess of 10% (1 point). Some companies become serial acquirers and use acquisitions to distort profits.
We downloaded over 3,000 Asian companies with a market capitalisation exceeding US$1bn and applied the C-Score to their financials between 2011 and 2015. As Figure 7 shows, 14% of companies posted an excellent score of 1 or 0, whilst 11% of companies posted a poor score of 5 or 6. Worst scoring companies are likely to be found in Japan or China, whilst the best scoring companies are to be found in Taiwan and India (really…although it is a very small sample).
Montier found that for the period from 1993 to 2007 (portfolios are formed in June and held for one year), US stocks with high C-scores (5 or 6) underperform the market by around 8% p.a., generating a return of a mere 1.8% p.a.. In Europe, high C-score stocks underperform the market by around 5% p.a., although they still generate absolute returns of around 8% p.a.. When combined with a valuation metric, such as such price to sales in excess of 2x, the returns dropped dramatically resulting in a negative absolute return of 4% p.a. in both the US and Europe. However, while companies with a high C-Score underperformed, there was no evidence that they were actually cooking the books. As such, it might be a better guide to quality