Becoming Too Complacent with Adjusted Figures

By Aline Wealth Management on May 4, 2016

Investors have been seeing green as of late—from the summer’s correction (long overdue every seasoned investor agrees) to now the S&P has jumped more than 10% –that’s a fast rebound; too fast? As many faithful readers know I have been in the caution camp (which served my client’s well as we were able to add to our equity positions at the August lows) based largely on the notion that a Zero Interest Rate Policy scenario –when unwound—will show pockets of misallocated capital. That the unwinding of such a massive (globally, still adding fuel to the fire) experiment in monetary stimulus will not go smoothly –that there are certain to be hiccups—maybe even more than just a hiccup—along the way. As a steward I take my fiduciary duty to heart and as such will always look at what could go wrong rather than the rosy-glasses, throw caution-to-the-wind crowd.

Under the heading of reading tea-leaves that suggest the caution trade is not front of mind for investors today I have come across this curious circumstance—it seems that earnings – net income—you know the stuff that companies yield after they pay all of their expenses—well these are no longer important in many investor’s minds today — we have entered into the “adjusted figures” realm. Feels like I have seen this “change in metric” movie before—and the ending was not good. Recall the late 90’s tech boom when analysts were no longer interested in earnings or even revenues—but eye balls or clicks. Or in 2006/07 when housing figures were growing to the moon –without any care of how these mortgages were going to be repaid. Or more recently when the mantra switched to “cash is trash” and the TINA trade (there is no other alternative –but stocks). Each market has its mojo juice—our job as serious investors is to see between the trees and look for value that others are missing.

Case in point—a recent article in the NYT (http://www.nytimes.com/2015/11/01/business/valeant-shows-theperils-of-fantasy-numbers.html?_r=0) highlighted this issue of adjusted numbers rather than good old earnings:

  •  The Analyst’s Accounting Observer, in a recent report, noted that 334 companies in the S&P 500 reported non-GAAP earnings last year, up from 232 in 2009. The dollar amount of these adjustments amounted to $132 Billion last year, more than double from 2009.
  • What does “adjusted” mean? What are they adjusting for? Well it comes down to taking out expenses (which of course inflate earnings)—expenses like amortization (costs related to acquisitions), stock-based compensation, and legal settlements. Now doesn’t that strike you as cherry–picking? It’s like saying—my portfolio performance is good if you take out this bad idea for whatever reason or that one.
  • Now you may be wondering about what the SEC says about all this? The SEC requires that all public companies report GAAP (btw, this stands for Generally Accepted Accounting Principles) figures AND pro-forma figures, if they choose to alongside the GAAP figures. So what’s the issue? Why would investors focus on the taste and not the calories? A 2002 study suggests that “fantasy numbers had replaced GAAP earnings as a primary determinant of stock prices”. So you have management thatchooses to show these non-GAAP figures – data they know will be helpful to their stock prices—the same stock prices that a majority of their income and net worth is tied up in . Hmm, I wonder how this will eventually play out…
  • As shown in the chart below, the phrase “adjusted Ebitda” — earnings before interest, taxes, depreciation, amortization and other items — appears in a growing number of Securities and Exchange Commission filings on companies’ results. Footnoted compiled the data through Morningstar Document Research.

Value Vs Growth

These 2 styles of equity investing are like 2 brothers playing tug-of-war; they go back and forth –sometimes with one winning over the other for years. Thomas J. Lee, managing partner at Fundstrat Global Advisors LLC., expects a transition toward value stocks, or shares that are the cheapest relative to earnings, sales and asset values, and away from shares of faster-growing companies. Value has been out of favor since a bull market peaked in 2007.

“Value over growth” is an emerging theme for 2016, Lee wrote in a Nov. 6 report. The Fed’s first rate increase since 2006 will contribute to the shift, in his view, because the companies in the value-stock category have more to gain from a move. This reflects the dollar’s tendency to weaken after the central bank’s initial moves in the past 50 years, according to an Oct. 30 report from the New York-based strategist.

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