Investors: Don’t Fall for an Earnings Trap

John DVI’ll say it right out: I don’t know if the Federal Reserve will raise rates or not.

We’re stuck in this cycle where bad news supposedly equals good news. If the economy slips into a coma, the Fed won’t raise rates and stocks could march higher. Interest rates will remain low and investors will go where the money is.

I don’t buy it. The problem with that argument is that earnings stink.

Earnings estimates for the S&P 500 in 2016 have been trimmed by as much as 6%. A lot of the growth we have seen has been generated through financial engineering and accounting gimmickry – things like buying back shares.

While stock buybacks are an easy way to boost earnings per share, it’s just smoke and mirrors. A weak company can take on debt to buy back as much stock as it wants. That doesn’t improve its business. It isn’t a productive use of capital. It may not happen today or tomorrow, but the company has sealed its grave.

So why don’t these companies use the debt to make operations more efficient? To drive margins higher?

Simple: they’re more concerned with increasing earnings per share and making Wall Street happy.

That’s why you must make sure you don’t fall for one of these earnings traps.

Earnings by themselves can be totally meaningless if you don’t know what’s driving them. They’re either driven by fundamentals, or they’re not. Yet investors will hop aboard a stock that beats earnings without doing any of the leg work.

I don’t know if they realize positive earnings won’t stay that way if the source of earnings isn’t sustainable, or if they just don’t care. Some traders just get suckered into a positive bias.

That’s why you’ve really got to look at the companies you invest in to make sure those earnings come from a reliable source.

The first thing I look at is revenue. If management is stuffing the channel by getting customers to commit to a sale now rather than later, they’re affecting their future business. Little games such as these suggest demand for that company’s product is softening.

Cash flow is also important. If the income is low quality, cash flow is suspect, too. Looking at cash flow quality can highlight future negative earnings in the works that will catch most off guard.

These are just two of the six factors I look at to identify a failing business that’s ripe for shorting.

And while most investors obsess over earnings per share, I’m looking for aggressive accounting practices that show a company just begging for pain.

Right now I’m eyeing a couple restaurant stocks who fit the bill. Their sales are going the wrong way, and they seem desperate to mask the fact.

One of them has bought hundreds of dollars in stock buybacks by taking hundreds of millions of dollars in debt. Another is suffering from falling commodity prices and weaker consumer trends.

That one actually just got slaughtered after a disappointing earnings release, but I still see a lot of downside risk if the stock ticks back up.

Either way, there will be plenty more like these in the months ahead. The stock market, on the surface, is still in its heyday. It’s got a lot of people fooled, which leaves businesses with a lot of investors to impress. And that means more financial trickery to come.

John Signature

John Del Vecchio
Editor, Forensic Investor

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Categories: Stocks

About Author

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.