Using screens to sniff out manipulators and frauds

Insights from quantitative value, by Tobias Carlisle and Wes Gray

Warren Buffett famously quipped that more money has been stolen with a pen than with a gun.

Investing in a stock requires a degree of trust that I think we don’t give full credit for; we sign no contracts and we presume good intentions, but how often do we consciously think about how we’re entrusting our hard earned capital with a management team we’ve likely never met, on the other side of the world?

We don’t truly know their incentives, morals, and so forth. But it’s a risk we take, and unfortunately financial fraud is a constant danger. Without knowing how to detect it, the money that’s stolen with a pen is likely to be ours.

A critical pillar of our investment thesis will lay in the financials, and if those financials are manipulated or plain wrong, our analysis will follow suit. This problem is amplified in quantitative investing when screening for a business — where the sole dictator of a prospective investment is company data.

If you have a quantitative edge to your investment strategy, be that a screening process or a data driven ranking process, this post will be critical. I read a chapter from a great book recommended to me by a friend, and it has insight I felt should be shared. The book is called Quantitative Value — by Tobias Carlisle and Wes Gray — and in it they propose three measures to detect and remove manipulators from our screens and analyses.

Today we’ll discuss all three, but before we do, it’s critical to understand a few fundamentals behind earnings manipulation.