Earnings season has started. For the next few weeks, the focus of the market will be heightened around these profit releases.
Last week I talked about how jobs growth is starting to slow and how the average American is pretty much broke. Both of these facts do not bode well for corporate profits and pushing the stock market to new highs.
For one, corporate profit estimates are too high. In 2016, the expectation is that operating profits will climb by 18% for the S&P 500. The rub is that “operating profits” leave out a lot of items that impact a company’s bottom line.
It’s accounting magic. Or as George W. Bush once said: “Voodoo math.”
Not only will companies not hit their estimates, but corporate insiders know it.
Profit margins look to have peaked. Revenue growth is very sluggish. The strong dollar is acting as a huge headwind against profits. And so many share buybacks were made when stocks were at all-time highs – a horrible misuse of the company’s cash on the balance sheet!
These corporate insiders wouldn’t increasingly be playing games with their numbers if they didn’t know all this. And it shows in that their accounting shenanigans are getting more aggressive.
According to statistics from Business Insider, the percentage of companies using adjusted earnings has risen from 70% in 2010 to 90% today. Yes, 90%!
When scouring a company’s profits, you need to do a much deeper dive into the press release than just the headline numbers.
If a company is buying back a lot of stock, look at the operating cash flow and free cash flow to make sure the underlying business is healthy. Otherwise, the company could be buying back stock just to boost its earnings per share.
Also dig around to make sure the revenue and profit margins are strong. These indicate that the company is operating well and has pricing power.
Pay close attention to any unsustainable sources of earnings. They’ll help you avoid stocks that could torpedo your portfolio.
Best of luck this earnings season!
John Del Vecchio
Editor, Forensic Investor