Damned Lies: The Truth About Corporate 'Earnings' and 'Up' Markets

 | Nov 18, 2015 05:09AM ET

  • Corporate earnings aren’t always what they seem
  • The loudest headlines often give the wrong impression
  • We prefer to stick with oversold value, like those we suggest below…

    • “The stock market is never obvious, It is designed to fool most of the people, most of the time.” — Famed market trader Jesse Livermore

    One thing the market volatility of 2015 has done is decimate some of our best-laid plans, like owning hedges such as ProShares UltraShort QQQ (N:QID) into monster earnings from the PowerShares QQQ (O:QQQ) stalwarts including Amazon (O:AMZN), Alphabet (formerly known as Google) (O:GOOGL), Facebook (O:FB), Microsoft (O:MSFT) and Apple (O:AAPL). But on the good side it has also opened up some amazing opportunities, punishing brilliantly-run companies with great revenue and earnings potential just because they were in the wrong sector at a time when the markets’ primary participants wanted something other than what they offer. For the year thus far, for instance, that means New Tech / Social Media and Consumer Discretionary.

    So while Amazon, Google, Apple, Microsoft, Facebook et al have been on a tear, financials, utilities, most health care (particularly the high-tech biotechnology subset,) industrials, materials, consumer staples, utilities and energy are down for the year. That’s six of the original nine S&P sectors of our economy! (S&P just added two new sectors this month.) The V-shaped rally of October lifted health care to a 1.7% gain for the year, but the others are all still in the red.

    It’s important to recognize this because—in this too-much-data world we live in—people tend to be swayed by the biggest headlines, like the one recently on Marketwatch.com, proclaiming “Stock indexes enjoy best month since 2011.” This, no doubt make them think, “Wow, the market must really be up this year!” Not exactly.

    Even after October’s 8.8% rally, the S&P 500 is down 1.7% as of Friday, November 13th. For those who prefer the Blue Chips, alas, you are still down even more. I would rather see it up 2000 but, regrettably, facts are facts.

    This same “recency versus primacy” bias prevails in looking at individual companies’ shares, abetted by Wall Street’s desire to paint a rosy picture on the most ugly of earnings reports. They do this in two ways; first, by constantly lowering their “estimates” of earnings growth until they are certain that most companies will easily surpass expectations, and second, by ignoring massive losses as long as they are “non-recurring.”

    As to the first, suffice it to say that, if at the beginning of the quarter, success is measured as a 6-foot high-jump, it is one that is consistently lowered to a 5, then, a 4, then a 2-foot high jump, to the point where it is hardly exceptional to call it a high-jump when it requires only a simple step-over.

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    The less transparent but equally deceptive practice is to say, “After non-recurring items, the company made a profit of x.” If the company, say, sells a money-losing division or abandons a major project, the losses incurred in so doing are considered “non-recurring” and therefore not germane to future earnings flow. Two brief examples:

    Johnson & Johnson (N:JNJ) is a longtime favorite of ours (we currently own it via our Tekla Healthcare fund) The company released earnings for the 3rd quarter that most analysts gushed were a continuation of JNJ’s 4 consecutive quarters of “positive earnings surprises.” I have a problem with considering this the end-point of analyzing JNJ’s numbers.

    First, they once again showed less revenue this quarter. Earnings can easily be manipulated; revenue not so much. A company is either selling more of its products and services or they are not. One of the more popular ways to manipulate earnings is to buy back shares of your own stock rather than invest in R&D or customer acquisition. JNJ just announced another stock buyback going forward of up to $10 billion. This when its share price is within 10% of the highest it has ever been since the company’s founding in 1886.

    Second, JNJ only cleared the earnings hurdle after divesting itself of a smaller division at a loss, or as the WSJ put it, “Excluding special items, the company said it earned…” This ““excluding special items” clause also helped us decide to keep only a token amount in our family accounts of our once and future favorite, Royal Dutch Shell (N:RDSb) which, every quarter it seems, takes a “one time,” non-recurring action like $2.6 billion this past quarter to abandon its Arctic drilling exploration and another $2 billion to abandon its oil sands project in western Canada.

    The bottom line on these “one time” write-offs that companies take is: who knows how many other skeletons lurk in their closet for the next quarter and the quarter after that? More importantly, does it matter where the loss comes from? A loss is a loss is a loss. It means there is less money available to grow the firm going forward.

    In the first quarter of this year, my firm’s biggest and longest-served client died and his children have now effectively frozen the portfolio, squabbling in court over who gets what. Did I say, “Oh, well, it was a non-recurring event so our real earnings to pay salaries, pay for research, etc. is untouched?” Of course not! And if you live in an older home in California and don’t have earthquake insurance and The Big One moves the remaining pieces of your home a quarter mile from its foundation, do you tell your family, “Wow! Aren’t we lucky that was a non-recurring loss?”

    As a result of financial chicanery I have become less trusting of corporate “earnings” over the years. The whole stock buyback house of cards may bolster earnings per share by reducing the shares outstanding — and will also keep the stock price high (a boon to the few executives in the inner circle whose bonuses are tied partly to the price of the shares) but what really matters in securities analysis?

    If you are looking for growth, to me that means two things: growth in top line revenues and growth in bottom line earnings, unadjusted for “impairments, special items, divestitures, the high price of the US dollar” or any other thing. Just because a company makes less money because the dollar is strong — it still makes less money.

    This leaves us with a conundrum. Of the companies out there that are growing real revenues and real earnings, AMZN sells for nearly 3 times sales and 894 times what are likely real earnings, GOOG at 6.5 times sales and 40 times earnings, and FB at 19 times sales and 104 times earnings. Fortunately, AAPL and MSFT are still possibilities and we have indeed begun to nibble at AAPL. But at this point, it simply doesn’t make sense to chase the high tech darlings in social media, online sales or cloud computing —- with one against the grain exception. We are nibbling at stodgy old IBM (N:IBM), which has reinvented itself so many times over the past century that, especially at these prices, we aren’t going to count it out!

    If you can maintain a long-term viewpoint and avoid the emotion that inevitably accompanies volatile markets such as this one, I believe you will enjoy remarkable gains from these overlooked gems. We don’t need to chase the few already high-priced tech darlings to find hi-tech. Every sector and industry uses technology to increase its productivity and revenue. It is these innovators that use technology wisely that we are buying today — for profits tomorrow.

    There is high tech in industrials, materials, energy, health care and every other sector; it is seen in the ways in which productivity is enhanced and costs reduced. If we can buy stellar companies performing well in their business (but not seeing it reflected in their stock prices) at well below our assessment of their fair value, over any reasonable time frame we will do much better than we would by chasing the currently-highest-momentum Wall Street darlings that need just one mis-step to drop 31.8% in a week. (See: Netflix (O:NFLX) chart Aug 17 to 24…)

    h3 Energy High Tech/h3

    Last month I advised we were moving out of most of our RDS.B and BP (N:BP) positions to begin initial positions instead in Chevron (N:CVX,) Range Resources (N:RRC,) and Antero Resources (N:AR). Chevron is cutting-edge in LNG production and Range and Antero use technologies that didn’t exist a year ago to extract natural gas at lower cost than most of their peers. Yet all are held back by yet another decline in the price paid for their product. The reason? Projections are for a mild early part of winter. Somebody isn’t thinking very far ahead.

    We bought these 3 because we like their long-term growth. Here at Lake Tahoe, we’ve just had our first snow (it’s so beautiful!) but for most of the nation, early winter temps are expected to be pretty mild — see chart below. But then…