Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

MIND THE GAAP?

The earnings ayatollahs are back in force and some readers are enquiring whether the Rule of 20 uses GAAP earnings or not.

It does not, and it should not.

GAAP earnings are useful when analysing individual companies. Some companies abuse the system and investors should do their work before investing. Many people will research the whole web before buying a toaster but will invest in a stock without first spending 30 minutes perusing the annual report, the 10-K and the notes to the financial statements looking for clues about management’s conservatism and/or integrity. Looking back over the years, one can quickly check if “non-recurring” or “one-time” charges actually recur more often then not, raising serious doubts on management’s competence and/or integrity. Always avoid investing in companies using very liberal or doubtful accounting practices. Most corporate executives are pretty smart; those who also feature dubious morality can be highly dangerous to your financial health.

When it comes to index earnings, I use “operating earnings” for the following reasons:

  • companies included in the main indices are seasoned, widely followed and generally run by honest people.
  • the main earnings aggregators are also serious companies which understand the game. Most will actually adjust the reported operating earnings to make sure they are representative of the company’s actual operating performance and coherent within the index and with history.
  • The objective is to be objective, that is using numbers that reflect as closely as possible the true earnings power of companies composing the index. For example, a company may have to write-down an asset or restructure its organization, often incurring large one-time costs that reduce profits for that particular year. Blindly using reported earnings will likely distort the earnings potential of the on-going entity.

Asset write-downs or write-offs generally culminate during recessions when companies often need to streamline their operations or even simply bring an asset value down to its true value since, under GAAP, assets must be carried at the lesser of cost or value. Goodwill created in an acquisition must be periodically tested for impairment. Sharp economic downturns usually bring goodwill impairments which can seriously reduce an index GAAP earnings during the recession year but will often improve the continuing earnings potential. Blindly or dogmatically utilizing GAAP earnings will likely result in lost investment opportunities like was the case in 2009.

Here’s what I wrote on March 3, 2009 (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years):

Since the mid-1980’s companies have been showing 2 sets of earnings: “reported” GAAP earnings and “operating” earnings or GAAP earnings excluding non-operating profits and losses and write-offs. Companies which record “non-recurring” gains or losses or which book write-downs or write-offs in asset values in a given year also provide “operating” earnings so that investors get a “more accurate” picture of a corporation’s “true” profits from continuing operations and its realistic earnings power going forward.

The pros and cons of “operating” earnings are that:

  • It makes sense for corporations to segregate from operating earnings those gains or losses which are deemed outside of the normal operations of a company (e.g. asset sales, discontinued operations). This is also useful to investors who can better appreciate the recurring profit generating capabilities of companies.
  • Write-offs and write-downs are more debatable since they reflect a loss in value of certain specific assets which management or auditors deem inflated in a company’s books given present and expected circumstances. On the one hand, such losses in values reflect the inability of management to extract acceptable or appropriate returns from these assets at their current book values, justifying their inclusion in earnings. On the other hand, to the extent these write-offs or write-downs are one-time non-recurring events, excluding them from “operating” earnings provide a more accurate picture of the company’s earnings power under its new adjusted asset base.
  • There is admittedly a degree of discretion for corporations to classify gains or losses as “recurring” or “non-recurring”. Some companies have used this discretion in such a way that they report “non-recurrings” so often that they become recurring non-recurrings.

Reported vs operating earnings has only been a big factor in market valuation in early 2000, when the tech bubble burst, and …now.

And now. The main culprit this time is the sharp drop in oil prices which has compelled producers to revalue their assets to reflect the lesser of cost or value which, for many, meant taking big write-downs. The stocks of oil producers have adjusted down to their new earnings power long before the accounting charges have been recorded. Large asset write-offs by energy companies do not change the earnings power of non-energy companies nor should they affect their valuations.

RBC Capital charts the ratio of write-offs to “pro-forma” (operating) earnings to reveal the magnitude of recent energy write-offs and the fact that, outside of energy, write-off trends remain within their normal range.

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This chart plots operating EPS as a percent of “as reported” since 1988. The so-called conspiracy has not gotten worse:

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Both GAAP and non-GAAP EPS of S&P 500 ex-Energy companies are expanding.

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NEW$ & VIEW$ (6 MAY 2016): China’s Debt Problem

OF DEMOGRAPHICS AND PRODUCTIVITY

Following up on yesterday’s post dealing with demographics and productivity in which I concluded:

All this to say that we should all modify our mindset away from expectations for a return of rapid growth rates and understand that the economy is set to grow very slowly for many years.

Yesterday, David Rosenberg wrote this following the release of poor U.S. productivity stats:

We have basically a half-point trend in productivity and a half-point trend in the annual growth of the working-age population (…), so if potential supply-side growth is 1%, maybe we should start adjusting our expectations, in Japan-like fashion (okay, maybe more like Europe) to the possibility that 2% GDP growth in today’s sclerotic economy is a virtual boom!

Rosy went on to question why would businesses continue to hire more folks in such an environment and concur with me that we may well be in the early stage of a margin squeeze:

So compensation per hour rose at a 3% annual rate in Q1 while the implicit price deflator slowed to a mere 0.5% annualized pace (look at the pricing pattern over the past four quarters: 2.3%, 1.0%, 0.9%, 0.5%).

That is what is otherwise known as a margin squeeze.

Finally, Rosenberg commented on the negative trade flows to conclude

But net/net, the incoming data flow is not exactly deserving a market multiple two-to-three points above the norm, no matter the level of interest rates.

So, manage your risk accordingly. To help us all, Credit Suisse offers this analysis:

(…) Investor expectations about future revenue growth and profitability both play a key role in driving multiples. Investors obviously prefer high levels of both. But if there’s only one to be had, which combination do investors value more highly? Superior growth and low profitability? Or lower growth and high profitability? Credit Suisse recently analyzed the performance and multiples of companies with market capitalizations of more than $1 billion (excluding financial firms and utilities) between 2004 and 2015, to find out.

Not surprisingly, the bank found that companies with above-median projected growth in revenue and above-median projected profitability traded at an 11.5x EV/EBITDA multiple, compared to just 7.5x for firms with below-median estimates for future revenue growth and profitability. (For reference, the median projected revenue growth was 5.4 percent and the median profitability was 6.5 percent cash flow return on investment.)

But back to the question of revenue growth versus profitability. It turns out that firms with below-median forecasted growth but above-median projected profitability earned higher EV/EBITDA multiples (10.2x) than faster-growing but less profitable companies (8.7x). Furthermore, increases in expected profitability had more of an effect on valuations than did an increase in expected sales. Regardless of whether a company is expected to grow above or below the market median, if it manages to improve profitability above median levels, the effect is dramatic—an additional 2.7 times enterprise value relative to the company’s forward cash flows. That was more than twice the effect that improving revenue growth—an additional 1.2 times EV/EBITDA—awarded to those companies that managed to climb into above-median revenue growth territory. Those that were able to vault over the median in both categories saw multiples rise by 4x EV/EBITDA. In short growth matters more when you combined it with superior return on capital.

Source: Credit Suisse HOLT Corporate Advisory

Source: Credit Suisse HOLT Corporate Advisory

It’s interesting to note that the current preference for profitability over growth is a relatively recent phenomenon. Between 2004 and 2007, companies with above-average revenue growth expectations traded at higher valuations than those with high profit expectations. During the financial crisis, there was no clear pattern to investor preferences, but high-profitability companies began to deliver higher premiums in 2012.

One possible rationale for the shift: Over the past decade, it’s been easier to keep returns on capital up than to produce drastic increases in sales. Fewer than one-third (29 percent) of companies that produced above-average revenue growth between 2004 and 2009 did the same between 2010 and 2015, while nearly two-thirds (64 percent) of companies that were highly profitable in the first five-year period remained so in the second.

Investors, in other words, can be fickle. So how should that affect executive decision-making? For executives making resource allocation decisions, it’s clear that both profitability and growth matter. But understanding exactly what drives investor sentiment about a company is important not only in choosing between competing strategies — those promising faster growth or superior profitability (or, in an ideal world, both) — but also what to buy and how to buy it. Knowing how expectations of future growth and profitability drive valuations can help companies decide on the right price to pay for potential targets as well as secondary decisions, such as whether equity or cash purchases make more sense. In other words, multiples matter for more than just bragging rights.

Keep in mind that companies that have achieved high margins thanks to ample labor availability and low wages will find it tougher from now on. In this slow growth/rising wages environment, good and rising dividends and above average earnings visibility will attract higher valuations.

CHINA’S DEBT PROBLEM

Goldman Sachs sets the stage (via BI):

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The combination of rising indebtedness with slower growth can be lethal.

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Now read this:

Ghost CLSA Sees China Bad-Loan Epidemic With $1 Trillion of Losses

Chinese banks’ bad loans are at least nine times bigger than official numbers indicate, an “epidemic” that points to potential losses of more than $1 trillion, according to an assessment by brokerage CLSA Ltd.

Nonperforming loans stood at 15 percent to 19 percent of outstanding credit last year, Francis Cheung, the firm’s head of China and Hong Kong strategy, said in Hong Kong on Friday. That compares with the official 1.67 percent.

Potential losses could range from 6.9 trillion yuan ($1.1 trillion) to 9.1 trillion yuan, according to a report by the brokerage. The estimates are based on public data on listed companies’ debt-servicing abilities and make assumptions about potential recovery rates for bad loans.

Cheung’s assessment adds to warnings from hedge-fund manager Kyle Bass, Autonomous Research analyst Charlene Chu and the International Monetary Fund on Chi na’s likely levels of troubled credit. The IMF said last month that the nation may have $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of gross domestic product.(…)

Byron Wien: What Investors Need to Know About China

(…) I have just returned from a trip to Singapore, Hong Kong, Beijing, Shanghai and Tokyo, meeting with sovereign wealth funds, other clients, policy officials and business people. While everyone is aware of the slowdown in China, very few expect a hard landing caused by a real estate bubble, a banking collapse related to non-performing loans or other factors. (…)

Because the banking system is integrated into the People’s Bank of China, the assumption is that there won’t be a banking meltdown, but that may not be right. (…)

Banks also need to become more profit-oriented. One of the reasons there are so many non-performing loans on their books is that the managers know that big or small, they can’t fail: the government will bail them out. (…)

The key government objective is to maintain stability, not profitability. and the Chinese seem to accept that. One official told me that Xi is highly focused on the need to retain the approval of the people. Civil unrest is to be avoided at almost any cost. (…)

(Hint to access the Barron’s article: copy/paste the headline in your browser and click on it. Google will then display related links. Click on the link to Barron’s. It generally works fine.)

OIL
Americas, Asia do what OPEC wouldn’t: cut oil production Wildfires in Canada. Instability in Venezuela. Stalling U.S. frackers. Drops in oil output are happening so fast that it looks as if the Americas alone could resolve global oversupply.

(…) Output from the Americas dropped over 1.5 million bpd last quarter, while producers in Asia and Australia cut some 250,000 bpd, eating away large chunks of the world’s oversupply, government, industry and consultancy data shows. (…)

A raging wildfire in Fort McMurray, at the heart of Canada’s oil sands region, has forced more than 690,000 bpd out of production, according to Reuters estimates, with more disruptions possible. (…)

U.S. output, down by 410,000 bpd this year and 800,000 bpd since mid-2015, is expected to slide another 800,000 bpd in the next five months, according to the Energy Information Administration.

Latin America’s crude oil production, suffering from under-investment, fell 4.6 percent in the first quarter to 9.13 million bpd, a loss of 441,000 bpd from the same period a year ago, according to data from individual countries and OPEC.

The largest decline was in Venezuela, which lost 188,000 bpd in the first quarter as President Nicolas Maduro’s government wrestles a deep economic crisis.

Production is also on the wane across Asia Pacific.

China, the region’s biggest producer and consumer of oil, is expected to see a 6 percent drop in crude output in 2016 due to ageing fields and poor economics, Standard Chartered bank said. (…)

CEBM says China’s domestic oil output declined 4% YoY in March and 2% in Q1’16.

EARNINGS WATCH

The Q1’16 earnings season is almost over with essentially traditional retailers remaining to report over the next 2 weeks. RBC says that their earnings are projected to decline -1.5%. Early reporters have beaten by 2.3%, half the pace of other S&P 500 companies.

  • 431 companies (87.9% of the S&P 500’s market cap) have reported. Earnings are beating by 4.5% while revenues have missed by -0.4%.
  • Expectations are for a decline in revenue, earnings, and EPS of -1.9%, -7.0%, and -4.8%.
  • EPS is on pace for -4.3%, assuming the current beat rate for the remainder of the season. This would be +0.8% excluding Energy.
US stock funds suffer $11bn of outflows Redemptions since the beginning of the year top $60bn

chart: US stock funds hit by $11.2bn of withdrawals(…) Portfolios invested in US equities recorded $11.2bn of outflows in the week to May 4, accelerating redemptions from the asset class since January to more than $60bn, according to Lipper. (…)

Investors also continued to pull money out of equity funds for Japan, the UK and Europe, according to the latest weekly EPFR data.

European stock funds extended the longest streak of redemptions in nearly six years, with investors withdrawing $4bn from German equity funds since February.

UK stock funds suffered the biggest weekly redemption since mid-December. Japan extended its current outflow streak to six straight weeks, the longest since the third quarter of 2014. (…)

US investors have turned to money market funds — often seen as a proxy for cash — adding $6.5bn in the past week. Funds invested in US Treasuries recorded $44m in new investments. (…)

Trump raises prospect of replacing Yellen Likely GOP nominee says he could change ‘very capable’ Fed chair