Master the Rules Before You Break Them

Joel Litman

'To break the rules, you must first master them...'

You might attribute this quote to Pablo Picasso, the famed Spanish artist, or Tenzin Gyatso, the 14th Dalai Lama, as it seems to fit segments of their life stories rather well. In reality, there's no proof that either of them ever spoke these words about mastering rules before breaking them. 

The adage is recognizable to some as an advertising slogan used by the Swiss watchmaker Audemars Piguet. But its origin is probably from a lesser-known author from a century earlier.

Regardless of its original source, the concept and value of the quote are not lost simply because of its misattributions. Enough people say it because of its essence.

The idea of mastering the rules before breaking them is incredibly relevant in financial analysis and investment research. I'm currently teaching an advanced accounting program on Generally Accepted Accounting Principles ("GAAP") for future certified public accountants ("CPAs"). It's quite an irony for someone whose firm preaches the failings of GAAP, the "so-called rules" of the accounting profession.

As much as I may fire salvos of accounting miscalculations and miscategorizations at governing accounting bodies, the fact remains that accounting is the language of business. And we're sort of stuck with the reporting that we've been given.

But for all of their faults, financial statement reports and filings are still the main ways companies communicate, report performance, and signal future prospects.

While a standard English dictionary may add a few new words each year, accounting rules can change dramatically from one year to the next. And while English may vary slightly from country to country, British English remains easily understood by Americans and vice versa. 

This is not the case with financial statement reporting. The calculation of earnings, assets, and liabilities has changed dramatically over time and is incommunicable across international borders. 

It's particularly the case in advanced accounting. The textbook that I'm using for my course is the 14th edition – updated from its 13th edition published two years ago. Before blaming that on some greedy accounting author and his publisher searching for repeat revenue, we first have to blame the actual changes in GAAP that occur that frequently. 

This particular accounting textbook does a great job explaining the GAAP accounting rules and how to follow and understand them.

How would one know which rules are problematic if one doesn't know the rules at all?

Ninety-nine times out of 100, when one of our readers says they don't understand our Uniform Accounting earnings calculations, it's not because of our adjustments. It's because that person usually doesn't understand how complex, confusing, and inconsistent the actual rules of accounting are in the first place. 

Much like in the accounting course that I'm teaching now, first, we need to master rules. Then, we understand which ones are broken and need repair. That's what inspired Uniform Accounting.

There is no better way to learn and refresh than with teaching… 

Teaching an advanced accounting course provides me with a forum for staying on top of the latest accounting debates and discussions. 

Of course, it also allows me to offer some new accounting minds valuable critical thinking skills. As many of these students are bound for the CPA exam, they first need to learn the accounting rules to pass.

Instead of encouraging blatant memorization, teaching what is wrong with the rules helps students better understand and remember them.

By the way, this is also why so many of our employees here at Altimetry are accountants by trade. We recruit people who have a strong understanding of the existing financial rules, so they are well-equipped to understand how to adjust them.

In any field, you need to master the facts and orthodoxy first before attempting to disrupt it. Otherwise, you're approaching the challenge with an incomplete data set. 

It should come as no surprise, then, that we focus so heavily on learning from the investment greats, such as Benjamin Graham and Warren Buffett in the value space and Richard Driehaus and Julian Robertson in the areas of growth and deep fundamental research. 

We can develop better investment strategies by understanding and learning from the greatest investment minds who have come before us. 

Much of their thinking, along with many others, has inspired our approach to investing, which is to apply what we call Uniform Accounting to as-reported financial data.

Because current accounting rules lead to many distortions, such as the inability to compare two similar companies that are allowed to report their finances differently, many companies' economic realities are obscured. 

Adjusting the as-reported numbers allows you to eliminate these distortions. We can see a more accurate representation of the businesses' true operations and a potential opportunity if the market is missing something.

Thanks to Uniform Accounting, we can identify potential gems in the rough before these stocks are picked up by the investing community and rocket higher...

We also know when to recommend or avoid a particular stock from decades of experience conducting "fundamental forensics" on companies of all sizes.

And our monthly Microcap Confidential newsletter details our favorite microcaps today with massive upside potential ahead.

Our repeatable process, accounting insights, and deep fundamental research have led us to average returns of nearly 80% in the Microcap Confidential portfolio. 

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Regards,

Joel Litman
September 10, 2021