The Most Meaningless Song and Dance on Wall Street

The most meaningless song and dance on Wall Street... One of the least-useful accounting metrics in the world... This premise doesn't matter in sports, so why does it matter in business?... You can't fake cash... Don't miss next week's event...

It's the most pointless exercise in the modern markets...

I (Bryan Beach) am talking about the perceived importance of Wall Street analysts' estimates and the "earnings season" saga that plays out every three months.

The entire song and dance wastes everyone's time. And as I'll help you learn in today's Digest... it's based on one of the world's greatest investment fallacies.

But before we get into all the details, let's start at the top...

This whole charade began when investment banks decided to offer a service to large trading clients...

Decades ago, the banks started hiring analysts to cover large public companies. Over the years, their roles expanded. They eventually began publishing detailed reports... issuing buy, hold, and (on rare occasions) sell ratings... and even setting 12-month price targets for the stocks.

As a result, the CEOs of the public companies soon realized that they should cooperate with these Wall Street analysts... These analysts had established relationships with big-money investors and worked for the same banks that would be able to raise money for their companies when needed.

So the CEOs and the Wall Street analysts started getting friendly with one another.

As it turns out, the big-money clients didn't care much about the analysts' price targets or write-ups... However, they did like that the analysts offered direct access to CEOs. Once they were in the room with the CEOs, the analysts' big-money clients could do their own due diligence. And so, a virtuous cycle formed...

Analysts write nice things, so CEOs like to work with them... Then, the analysts provide their big-money clients with access to their CEO buddies. Historically, nobody actually paid the analysts for their work. But they were paid for their trouble in a roundabout way...

In exchange for saying nice things, the analysts' banks earned investment-banking fees when the CEOs needed to raise money or buy companies. And in exchange for access to the CEOs, the big-money clients would use the analysts' banks for their trading needs – allowing the banks to earn fees that way. (Incidentally, the fee structure for "sell-side analysis" is changing completely, but that's not the point of today's essay.)

We've covered these dynamics in the Digest before...

Earlier this year, former equity-research analyst and current Cannabis Capitalist editor Thomas Carroll detailed some of the horrors he saw during his 17 years working on Wall Street. As he advised readers in the March 19 Digest...

If you read through the research produced by a sell-side analyst... please, please, please remember that things aren't always as they seem. Before you stake your investment dollars on these opinions, keep in mind that the accuracy of these projections falls far down the list of priorities.

Just remember, everyday individual investors like us are not the ones benefiting from this game... The analysts serve as matchmakers between the CEOs and the big-money clients. The financial analysis often takes a backseat.

Over the decades, a ritual has developed out of this symbiotic little ecosystem...

And that ritual – the quarterly earnings song and dance – has spun out of control.

As part of the back-and-forth relationship, companies provide Wall Street analysts with "earnings guidance." That's just a fancy way of saying, "This is how much we'll probably make next quarter."

Of course, management providing information about the future isn't completely worthless. But some CEOs – like legendary investor and Berkshire Hathaway founder Warren Buffett, for example – consider this whole process to be nonsense and refuse to play along. (By the way, if Buffett believes something is a stupid idea, you should pay attention.)

And the game doesn't stop there...

With management's earnings guidance in hand, the Wall Street analysts decided to make their own estimates. Eventually, media outlets and data aggregators began consolidating the various analysts' estimates into a "consensus"...

So now, during "earnings season," these media outlets compare the reported results from companies with the consensus estimates. And then, they use dramatic headlines to report their findings to the investing public.

This rigmarole has evolved for decades. But things really kicked into high gear in the early 2000s, when the current financial-disclosure regulations came out and financial TV became ubiquitous...

Now, Yahoo Finance's robo-journalists and TV networks like CNBC get free content for two straight weeks as they talk about which companies "beat" and "missed" analysts' estimates with the urgency once reserved for weathermen during hurricane season.

All of this noise builds up and leaves everyday investors with the false impression that something important just happened.

The thing is... Almost nothing important happens with quarterly earnings.

Imagine asking your friend how the football game went last night...

And he simply responds, "We were outscored 14-10 in the second quarter."

That would be worthless, right? You wouldn't know who won the whole game just from that response. In sports, quarterly results don't mean anything. It's about the entire game.

Yet somehow, we're convinced that the financial world is different... that it's bad news when well-educated 20-somethings fail to accurately pinpoint the quarterly earnings of a global operation with tens of thousands of employees and a long-term strategy that could span a decade or more.

All this nonsense can cause substantial moves in the market. But that's not the worst part...

Some of the so-called experts focus on one of the least-useful accounting metrics in the world...

That metric is earnings per share ("EPS").

As regular Digest readers know, I'm a certified public accountant who started my career auditing public companies for a "Big Four" firm. I then served as the accounting director and controller for a publicly traded company before starting my own accounting consultancy.

I used to audit financial statements for a living. Then, I helped build them. Now, I analyze and write about them. I meticulously analyze hundreds of financial statements. And yet...

I hardly ever look at a company's EPS.

EPS is simply a company's net income – its revenue minus its expenses – divided by the number of shares outstanding. Net income is the "bottom line" on the income statement.

Because of that, most folks assume it's pretty important. But some really smart, incredibly rich investors don't believe EPS is remotely important...

Just last year, Buffett told his shareholders that net income "is not representative of the business at all." Seth Klarman, an investing legend in his own right, called net income "an accounting fiction."

Beyond that, another problem exists with this whole process...

The application of generally accepted accounting principles ("GAAP") isn't black and white. It really can't be. The income statement is rife with gray areas and estimates...

For example, accountants must guess how much of the current accounts receivable balance will ultimately not be collected. This estimate is recorded on the income statement as "bad debt expense." Even the most well-meaning accountant will be inaccurate when making estimates like this.

And not everyone is well-intentioned... The prevalence of estimates allows aggressive or fraudulent accountants to exploit the system to their advantage.

I want to be clear... The basic principles of GAAP accounting are fine, and in most cases, offer an adequate representation of accounting reality. But I'm often critical of certain GAAP accounting treatments.

I acknowledge that regulators who set GAAP standards are smart, well-intentioned men and women. But setting rules in gray areas is an impossible task. So these regulators often miss the mark when it comes to providing useful information to investors...

As an investor, you should be aware that chief financial officers (honest or not) have many levers to pull – including dozens of "estimate" levers on the expense side of the income statement – to carefully land their net income number right on top of the earnings estimate.

Wall Street gets this...

Our good friend and Empire Financial Research founder Whitney Tilson recently quoted an old Wall Street adage: "Net income is an opinion. But cash flow is a fact."

That's why Buffett, Klarman, and most value investors focus on a company's "statement of cash flows" instead of its income statement.

The statement of cash flows comes with its own shortcomings, but I still consider it the most useful financial statement that a company puts out. By making a couple of minor adjustments and looking at two to three years' worth of cash flows, you can get an incredibly accurate view of a company's performance and prospects.

While Wall Street analysts understand that EPS isn't very useful for evaluating a company, the financial media has yet to catch on...

So every quarter, while Yahoo Finance's robo-journalists and CNBC's talking heads spray out EPS comparisons to whoever will listen, the analysts hop on a phone call with management and begin discussing the real results: the so-called "non-GAAP" numbers.

Some of these non-GAAP adjustments make sense – like adding back certain one-time expenses related to a large company restructuring. By adding back those expenses, analysts can normalize the company's potential earnings.

But you can see how this arrangement might create temptations for management to "over-normalize" its non-GAAP reporting. To continue the example... If management has had six company restructurings in the past eight years, then should it really be considering them "one-time expenses"?

Many other non-GAAP adjustments exist... including extraneous legal expenses, backing out large gains or losses on the sale of an asset, and other types of unusual payments or transactions. Wall Street analysts accept many non-GAAP adjustments without criticism.

But non-GAAP adjustments come with many flaws...

For one, the non-GAAP numbers aren't audited. So management has a ton of leeway in which adjustments to make. Even worse, the non-GAAP adjustments are never consistent among businesses – even within the same industry. Because of that, it's extremely difficult to compare two competing enterprises. It's unfortunate...

Quarterly earnings used to be a productive way for management to periodically check in with shareholders. But now, it has devolved into the most pointless exercise in the modern markets.

Management releases a couple of flimsy GAAP numbers that the financial press tries to spin as an important story... while at the same time releasing questionable non-GAAP numbers that Wall Street analysts just accept as fact. Everyday investors are left scratching their heads.

At its core, it's an accounting problem...

So accountants should be able to figure a way out.

GAAP is a well-intentioned but flawed effort to release comparable, meaningful numbers... That's why I always make my own GAAP adjustments when analyzing businesses.

But not everyone has time to carefully examine the minutiae of non-GAAP disclosures or tune in to every analyst's calls. And you certainly can't rely on the mainstream financial media to fill in the gaps.

This is a real problem. And unfortunately, it's a problem nobody is addressing. Well, almost nobody...

Professor Joel Litman is trying to do something about it.

Joel's vision is to create a completely uniform, standard accounting code...

Joel is the president and CEO of investment-services company Valens Research. More important, he is a tireless evangelist of uniform accounting. He frequently speaks at financial conferences and universities around the world about the benefits of uniform accounting.

I've done a lot of critical thinking about Joel's system...

As I said earlier, in many ways, I'm a GAAP skeptic. But Joel is far more "anti-GAAP" than I am. He doesn't just take a company's statement of cash flows and make a few manual adjustments. Instead, Joel and his staff of more than 100 accountants and researchers tear down the entire GAAP financials and rebuild them in their own way. Joel's methodology differs from the GAAP treatment in more than 130 ways...

Some of these changes are minor – like tweaking the classification of interest expense, for example. But other changes – like the treatment of research and development costs at a tech company, or how lease expenses are recorded – can move mountains of money around a company's financial statements.

It's a lot of work, but the result is a standardized set of financials that Joel and the rest of his team believe provides a clearer picture of a company's true business stature.

I first heard Joel speak at the Stansberry Conference in Las Vegas back in 2017...

As he began to speak about the need for a uniform accounting code, I began to alternate between nodding vigorously and rolling my eyes. I liked a lot of Joel's ideas, but I was also skeptical of some of his GAAP adjustments. Then, he lost me...

He told the audience that the "Valens-approved" financials of gym franchisor Planet Fitness (PLNT) suggested the business was significantly stronger than the GAAP financials let on.

I thought he was crazy.

At the time, more than 20% of PLNT shares were held short... And a lot of smart guys whose work I admire were bearish on the company. I simply wrote off Joel's work at that point.

Joel and his team believed that the GAAP treatment of Planet Fitness' tax assets greatly obscured its true earnings power. This distortion was the difference between an 8% return on assets – which is what the GAAP numbers suggested – and the 81% return on assets that the Valens-approved financials showed.

And eventually, the market caught on. Now, here we are, two years later... PLNT shares are up around 130% since his presentation at the 2017 Stansberry Conference. Clearly, Joel is onto something.

So where does this leave everyday investors like us?

I want to make three suggestions today...

First, unless you're a technical trader trying to skim profits off of erratic short-term price moves, you can completely ignore earnings season. Remember, it's the most pointless exercise in the modern markets.

Second, if you like to roll up your sleeves and get into the financial statements... remember that the income statement is often an "accounting fiction."

Other than studying revenue growth, I generally don't spend any time at all looking at the income statement. Turn the page and check out the statement of cash flows instead... That's where Buffett, Klarman, and other legendary investors will be. These guys know you can't fake cash coming in and out of the business.

And finally, I urge you to see Joel's remarkable system for yourself...

Joel intends to build "true" comparable financials completely outside the ridiculous noise that surrounds earnings season. The more people who hear Joel's message, the better our chances to change the status quo.

Uniform accounting is a noble and useful goal... but over the past several years, Joel has learned that his system has commercial applications, as well. In fact, Joel's client list now includes nine of the top 10 investment houses in the world.

Joel has traditionally targeted large institutional investors through his work at Valens Research. These investors have paid up to $100,000 per month – yes, per month – for access. Why so much? Because Joel has figured out a way to turn his uniform accounting system into a system for identifying investment ideas.

I continue to think critically about Joel's system, especially some of his GAAP adjustments.

The fact is, I was dead wrong about Planet Fitness... and he was right. And that isn't his only winner... Joel's system also identified an opportunity in chipmaker Advanced Micro Devices (AMD). It's up more than 1,000% since he took the story to Barron's in 2015. And over the past several years, the list goes on... Etsy (ETSY), RingCentral (RNG), and more.

Joel and Valens have my attention. And now is an exciting time to be following along, because he's planning to make this data available to individual investors for the first time...

Next Wednesday night, September 25, at 8 p.m. Eastern time, Joel will join Porter for a special online event. He'll go over everything you need to know to uncover the true earnings and profitability of some of the best- and least-known stocks in America... weeks – or even months – before this information goes public.

The event is completely free. So you have no excuse to miss it. Reserve your spot for this event right here.

New 52-week highs (as of 9/18/19): Hannon Armstrong Sustainable Infrastructure Capital (HASI), iShares U.S. Aerospace and Defense Fund (ITA), iShares U.S. Home Construction Fund (ITB), Lockheed Martin (LMT), and Sysco (SYY).

Gold manipulation... political intrigue... and a grammar lesson? Today's mailbag has it all. As always, send your notes to feedback@stansberryresearch.com.

"Dan, thanks for picking up [the subject of gold manipulation in Tuesday's Digest]. May I suggest you invite the [Gold Anti-Trust Action Committee] people to your show (Chris Powell, Bill Murphy, Ed Steer, or Ted Butler). Those guys have spent the past 2 decades(!) doing nothing but waving red flags on this topic. Give them 20 minutes to present indisputable facts only, no gossip. Ask them how big the total damage was over the past 10 years alone (potential lawsuits by investors?) and who else should be trialed. I bet Jamie Dimon comes up. Let them also tell their side of the story who else besides those 3 convicted traders from Bear Sterns/JPM has been involved. It'll make for an interesting episode!" – Paid-up subscriber Norbert W.

"You reference that Andrew Yang isn't quite the criminal that Nixon was. I would submit that Nixon is small potatoes compared to the likes of Clinton, Bush, and especially Obama. If the Ervin Commission was in session today Clinton, Bush, and Obama would be in jail. Nixon was a piker compared to those goons." – Paid-up subscriber Kevin W.

"So you don't see the need of government regulations? Re-read your just published article!!!" – Paid-up subscriber Will G.

Dan Ferris comment: The need to stop letting bankers get away with (financial) murder and theft doesn't mean we need more regulation. Quite the opposite, in fact. Financial regulations are largely crafted by people in the industry. The regulations wind up giving large incumbents a competitive advantage (in many industries) over smaller, less-financed competitors. A friend of mine is the CEO of a large bank whose name you'd recognize instantly. He once told me, "We just hit $50 billion in assets. Now I need another $2 billion to pay for it," in reference to the increased regulatory burden. He's well over $52 billion now.

Force and fraud are already illegal. We don't need special banking and securities laws. We just need to get a lot less lenient when Goldman Sachs, for example, screws its clients, loses them a ton of money, and admits to doing it on purpose. Somebody should go to jail for that. It's at least fraud, and amounts to a kind of theft. No special regulations needed.

As for the various levels of criminality, I believe Kevin W. (above) and Mark H. (below) have a point. I stand corrected. Though I'm not sure of the precise hierarchy, upon further reflection, you're right. Those other guys are definitely higher up than Nixon. Thank you. And like I said, give Yang time. He's young. He's learning the ropes. I believe in him.

"Dan, in the 17 September Digest you wrote: 'The most serious charges bear prison sentences up to 30 years. Will that encourage the traders to rat out the boss? If I was headed for a 30-year stretch in the big house, I might be inclined to turn snitch to get my load lightened. Gabish?'

"Really now, a quick look at Google Translator would have shown you that what you probably meant to say was: Capisce? Yours for accuracy in language." – Paid-up subscriber Ed M.

"Hi Dan: In your essay [Tuesday] you used the word gabish. I couldn't find that word in the dictionary. Could you have possibly meant capisce, the word derived from Italian meaning to understand?" – Paid-up subscriber Steve P.

"WTH does "Gabish" mean???? Does Ferris mean "capisci'? If you're going to try to appear sophisticated by throwing foreign words around, best not to completely mangle the spelling.

"And another thing – comparing 'Clinton-level' criminality to 'Nixon-level,' he's got it exactly backwards. Nixon got caught covering up a low-level crime that he wasn't even aware of until after the fact. The Clintons (both husband and wife) have been at the head of the most successful criminal enterprise in U.S. history since his days as governor of Arkansas. Even a mafia don would be envious..." – Paid-up subscriber Mark H.

"Whoever wrote the article 'The Conspiracy Theorists Were Right' needs to learn how to spell. Gapish is NOT a word. What you want is Capisce. Which is Italian for Do you understand? It's used as a threat by the Mafia, that you referred to in the article. If you're going to write, make sure you know how to spell the word that you want to use..." – Paid-up subscriber Mary M.

Dan Ferris comment: Wow, heavy snark from the grammar police.

It's "gabish," not "gapish."

A long time ago, I had an Italian roommate from New Jersey. An Italian friend from college lived next door to us. They both said "mootzarell" for mozzarella, "pruhzhoot" for prosciutto, "gabagool" for capicola, and "gabish" for capisce. Some of us waited tables in Baltimore's Inner Harbor at a (now defunct) restaurant called Paolo's. Guys – some "wise" – would come down from New Jersey and sit at my tables and you'd hear a "gabish" now and then. In the wedding scene of The Godfather, Paulie's friend throws sandwiches at him, saying, "I got two gabagool..."

Gabish? Now, go make yourself a gabagool and pruhzhoot and mellow out.

"[Manipulation in the precious metals markets] has been going on for a long time. I hope this time there will be serious consequences. I won't hold my breath. The big banks are the culprits. This needs to be exposed and people need to go to jail... not given a 'get out of jail free' card or a simple slap on the hand with an inconsequential fine and then business as usual. We'll have to wait and see." – Paid-up subscriber Craig S.

Regards,

Bryan Beach
Baltimore, Maryland
September 19, 2019