These days we hear a lot about “fake news.” Wall Street is not immune to this “phenomenon.” Indeed, it’s been around for quite some time now, only we realists referred to it as a “free lunch.”
Good luck finding one of those, on Wall Street or anywhere else.
You see, very little is what it seems. For example, just because a company reported $1.00 of earnings per share doesn’t mean it’s true. It could all be a mirage.
Smoke and mirrors.
Yet, because we live in a day and age of 140 characters or less and our attention spans have been reduced to that of a fruit fly, investors see a glossy headline and pile money into a stock only to be burned a quarter or two down the line.
That’s after the real numbers come out, the ones in the Securities and Exchange Commission (SEC) filings practically no one reads that often have hidden “gems” buried deep into the notes of the financial statements.
More and more companies have resorted to “pro forma” financial reporting in recent years. That means their numbers don’t correspond to Generally Accepted Accounting Principles (GAAP).
Rather, management includes or excludes certain items that often favor the company’s bottom line.
That’s about as “fake” as “news” can get.
From 2009 to 2015 the gap between GAAP and pro forma earnings widened considerably. In 2015, S&P 500 earnings fell 12.5%, which was approximately 25% lower than the pro forma reported results.
The “faker” the better…
Since 1999, 62% of companies in the S&P 500 beat earnings estimates. As more companies resort to making up their own numbers, the number of earnings “beats” has risen dramatically. In the third quarter of 2016 it topped 74%!
Financial performance looks much better than it is in reality.
The deeper we get into this bull market the more earnings quality deteriorates.
So what exactly are companies doing to boost their bottom-line figures?
One of the biggest tricks is to exclude stock-based compensation. If compensation isn’t an expense, then what is it?
Many companies resort to acquisitions to obscure true fundamental performance. And restructuring charges and asset write-downs also muddy the waters.
Eventually, these kinds of shenanigans will matter. At the end of the day, an asset is only worth the discounted value of the future cash flows it produces.
No amount of magic financial sleight-of-hand can change that.
What can you do about it?
Your mindset should always be that all companies are guilty until proven innocent. This isn’t a court of law. It’s your money. After you conduct your due diligence, make the company prove to you that its financials are solid and that value exists.
My earnings quality model “truth test” includes analysis of reported revenues, cash flow, earnings quality, and shareholder yield. I also include valuation, because valuation still matters!
If a company is overstating its current revenues by offering favorable terms to customers that accelerate purchases, issues debt to buy back stock and fund the dividend, and artificially boosts its tax rate through complex maneuvers, we have no business buying that stock.
Oh, and this is a real company. I’m withholding the name of the guilty, but it’s one of the biggest companies in the world, and its shares are owned by some famous investors. It’s also been a profitable short in Forensic Investor despite the market hitting all-time highs.
Unlike other fundamental approaches that rely more on revenue or cash flow than earnings, my model looks beyond the reported results to determine where the landmines exist.
I take nothing at face value! My model tries to expose as much “fake news” as possible.
How do we use this to our advantage?
In Hidden Profits, we focus on companies that pay you first. They have respectable earnings quality and management teams dedicated to returning capital to shareholders. Over time, this leads to higher returns and lower risk (you have more money in your pocket, which reduces your initial exposure).
That reminds me of a point to make in general.
As is the case when companies pass off “too good to be true” results, if people promise you huge returns – such as gains of hundreds of percent per year – you should not walk but run in the other direction.
“Fake news” and fake promises will appeal to your inner greed. But, over the long term, investors who succumb to these temptations will be left holding the bag.
Slow and steady wins this marathon.
John Del Vecchio
Editor, Hidden Profits