With the rise of meme stocks and online investment mobs, long-time professionals are looking for advantages in the changed market dynamics. How can media analysis of accounting controversies help them to manage portfolio risk?
- Because corporate controversies have an impact on stock prices, in portfolio risk management it’s crucial to find them as early as possible.
- Wirecard AG and Luckin Coffee were two of the biggest financial stories of 2020. In both cases, sizeable accounting frauds were discovered and there was a corresponding impact on stock prices.
- We analyse whether other stocks embroiled in accounting controversies discussed in the media systematically underperform over time.
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We’ve been monitoring online investment community chatter since before Twitter existed, and through the years we’ve identified that there is occasionally wisdom in these crowds. In particular, online reports of corporate misdeeds often precede significant stock price declines.
The Wirecard AG and Luckin Coffee accounting controversies
Besides the impacts of COVID-19, two of the big financial stories of 2020 were the sizeable accounting frauds revealed at both Wirecard AG and Luckin Coffee.
The Financial Times published a report suspecting “falsification of accounts” at Wirecard AG on 30 January 2019. Meanwhile, the short-seller research firm Muddy Waters published a negative report on Luckin Coffee on 31 January 2020.
Following those reports, and despite company denials, online communities continued investigating and reporting on the purported misdeeds for months before the stock prices finally collapsed.
Accounting fraud is, like other scandalous corporate activities, a “controversy.”
Corporate controversies affect stock prices, and finding them early (and avoiding them) is a key best practice in portfolio risk management. Because accounting fraud typically occurs under weak management oversight (or outright deception), it is considered an ESG (environmental, social and governance) controversy.
In the plot below, the bright blue lines represent the prevalence of media stories containing references to accounting controversies at Wirecard, while the stock price is depicted in the plot beneath.
Despite an initial price fall following the Financial Times report, the stock remained relatively resilient over the course of 2019 and 2020 until the company itself admitted to missing €1.9 billion from its books on 18 June 2020.
Do advance media warnings work?
The frauds at Wirecard and Lucking Coffee were significant scandals.
To test whether there is an investable pattern across larger portfolios of stocks flying under the radar, we examined whether other stocks with accounting controversies discussed in the media systematically underperform over time.
Our accounting controversies score for each company measures the percentage of media references about that company describing accounting irregularities, doubts, fraud, and related topics – similar to the issues as reported by Wirecard AG and Luckin Coffee.
In the study below, we examine all S&P 500 companies each month. We rank them by their average media-derived accounting controversies score over the prior month.
The 10 percent of companies with the highest Accounting Controversies (top 10%) were bundled into a portfolio and the portfolio’s performance was tracked over the following month. The chart below displays the equity growth in this monthly rotation model.
The high accounting controversies portfolio underperforms the remaining 90 percent of S&P 500 stocks by 2 percent annually.
Media references to accounting controversies predict future stock price declines
This accounting controversies result suggests that specific controversies lead to prolonged impacts on stock prices. There are dozens of interesting specific types of controversies to test, and we encourage you to reach out for a data trial if interested.
We track over 1,000 types of corporate controversies internally, and because this is too much to report on here, in the second part of this blog we will examine a more general finding – the risk forecasting value of an aggregate score of all corporate controversies.