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It’s a Math Thing. How Ex-Items Accounting & Stock Buy-Backs Prove Over-Valuation in the S&P

boy writing on blackboard


Accounting is pretty boring. And these markets are exciting. Yet if we overlap the boring with the exciting, we discover another adjective: ridiculous.

Ok, I know that’s a loaded word, and I’m already anticipating blow-back from the optimists. It’s no fun, however, just being a realist. In fact, I’m tired of this bear vs. bull thing almost as much as we are all tired of the red vs. blue thing.

So let’s try to just make this a math thing—and without the yawns and calculator-phobia. Let’s try to make balance sheets, “earnings” reports and stock fundamentals interesting.

And I think you’ll find this interesting, in a comical, angry kind of way.

Scratching Your Head?

As markets reach all-time highs in the backdrop of sell-side pundits smiling for the camera, some of you might be scratching your heads. Many of you, I’m sure are hearing from your advisors, who have a vested interest in keeping you long the markets and long their asset-based fee models.

I’d also bet you’re being told not to worry. I bet you’re hearing a lot about companies being flush “with cash” and “beating their earnings expectations.” I bet you’re being told this market is uniquely solid and that the numbers confirm it.

But as a hedge fund veteran who knows some of the legal tricks and accounting stunts that keep CEO’s and, uh, hedge fund guys…well remunerated, let me confess what a lot of other hedge fund veterans already know: this market is lying to you.

The Fundamentals Have Left the House

Recently, Jeremy Grantham of Boston-based GMO, a legendary value investor (whom I have allocated to), effectively acknowledged that markets since 2000 have lost any sense of reality. Mean-reversion, price discovery, honest reporting, and dependable cycles of cheap and expensive stock determinants have left us.

What we have instead is what David Stockman calls a “casino” , not a market. Since 2000, PE ratios have averaged 60% percent higher than in the prior 50 years, and profit margins are averaging 30% higher. Grantham called that a “double whammy.” I call it ridiculous.

So how have earnings skewed to such nose bleed extremes? Has nearly every publically traded company since the era (notwithstanding Enron…) suddenly become an A+ student? Are CEO’s and CFO’s so much smarter than before?


Legalized Cheating

In fact, what we have are a lot of D+ and C- companies masquerading as phi beta kappa’s and they pull this off by legally hiding behind a safe harbor of bogus accounting, stock buy-backs and an unknown little trick called ex-items accounting.

In short, today’s companies aren’t smarter than our dad’s generation, they’re just less ethical.

Shocker? Probably not…

What happened? Values have changed. A new kind of Darwinism and greed is more sexy today than the days of old. Basically, it comes down to this: stock based compensation in the C-suite has seduced executives into thinking more about 2nd homes and 3rd cars than the 8th Commandment or the 6th Deadly Sin.

Today, more than ever, executive compensation is largely tied to stock performance. A miss on earnings means a miss on an entire swath of executives’ American Dream. In such a twisted setting of executive incentives/temptations, the well-funded finance officers behind the stocks you are buying will do almost anything to manipulate earnings and distort reality.

As an Associated Press report recently concluded (and your advisors probably over-looked), 72% of the companies they reviewed had adjusted profits that were higher than net income. (From 2010 to 2014, the S&P as a whole showed adjusted profits that came in $583B higher than net income.)

Perhaps one of the best examples of this legalized fraud is Klaus Kleinfeld’s Alcoa (AA). In the last 7 years, this creative CEO has generated just under $11B in cash flow while simultaneously spending the same amount on CapEx and another $3B in dividends, yet managed, despite $2B in cumulative losses, to report positive earnings and thus earn a gold star from your advisor or spin-artist du jour. But AA is not alone. In fact, Kleinfeld and his ilk are the norm, not the exception

What’s even crazier: this kind of institutionalized fraud is legal. Today, we’ve got to the point where only 13% of the total revenue growth reported since the financial crisis of 08 is coming from actual earnings. The rest is just accounting tricks .

No way?


So how do they do it?

The Ex-Items Game

A lot of it comes down to clever book-keeping called “ex-items”—a parallel little accounting universe (and an open secret in the hedge fund world) where CEO’s are allowed (a bit like Al Capone’s CPA) to carry two sets of books: one (GAAP) which they report to the SEC (nod to Sarbanes-Oxley) under penalty of prison, and another (non-GAAP), which they report to sell-side analysts and retail suckers (you and me).

The repeal of FASB Rule 157 which eliminated “mark-to-market” accounting has opened the door for gaming earnings season, which means you’re the one getting “played.”

It’s this non-GAAP, ex-items smoke and mirrors which makes it to the retail investor, and it’s, well: ridiculous. It allows CEO’s to write off millions and millions and billions in goodwill, plant closing losses, severance and health benefits, lease cancellations, investment banking fees, or new operations costs as a “non-recurring expense.”

In short, this “second book” basically allows companies to skip past (i.e. ignore) over-head and report mostly cash-flow. That’s a bit like a lemonade stand that reports only lemonade sales but not the cost of lemons…

These legalized write-offs allow executives to sweeten their valuations going into bad M&A deals or “beat earnings expectations” at nearly every earnings season. (PS: another Wall Street trick is for bank analysts to set expectations deliberately low, so they are easy to beat—a bit like your kid’s teacher telling you “Junior’s report card beat expectations: he got a C- when we only expected a D+.”)

When I was a hedge fund guy, we ate this up. We looked at bad companies (there were many) with uncorrelated earnings and cash flows, sudden changes in reserves, suspiciously consistent earnings growth and other red flags and took the monotonous time to look at GAAP rather than ex-items fiction. Then we bought these goosed-up lemons prior to what we knew was a bogus earnings season for cheap. Then we just dumped them for a profit after they “beat” expectations… I guess it pays to know who’s cheating.

Who Gets Hurt? You.

But then again, if you trust the pundits and CEO’s on CNBC, the only one getting cheated is you. For example, those reduced PE ratios they peddle are mostly fiction, because the earnings against that price are legally doctored. And when you add stock-buy backs (at record levels since 08) to this distortive and largely unknown witch’s brew, you get even more dishonesty, because the buy-backs shrink the share pool and distort the PE ratios one more turn, or two, or three…

Don’t want to believe me? As of today, the S&P is up over 35% from its 2007 peak, yet when you get into the boring math (which hedge fund jocks do) and use GAAP and inflation adjusted earnings calculations along with over $2.5 TRILLION in stock-buy-backs, you’ll discover that today’s S&P earnings are lower than they were before the last crisis. So today’s stocks are trading more than 1/3 higher than the last bubble, yet with lower earnings.

In other words, this S&P peak is ridiculously over-valued. It’s a C- masquerading as an A+. Just do the math.

4 thoughts on “It’s a Math Thing. How Ex-Items Accounting & Stock Buy-Backs Prove Over-Valuation in the S&P”

  1. So we work hard all our working life only to invest in a rigged system? Few of us can afford to put it all under our mattress and hope for the best. What’s a person to do?

    • The first step, I suppose, is just to know that “system” and not fall under its spell. After all, knowing there’s a truck heading toward you, gives you the chance to step out of its way. The market volatility you see coming is one you can step way from simply by getting more to cash –which is no longer a “timing trap” but common sense. (In fact, see the blog entitled “Common Sense.”) Get back in the markets (on the road) when the market mean-reverts and bottoms. This takes patience and contrarianism. Nor will you (or us) precisely time the “bottom”–but close is good enough. As for now, the tops we saw in the S&P in September may not be THE top, but they are close enough. Get away from it before it falls. For those with the profile, time or inclinations to trade in volatile and falling markets, shorting etc is an option; otherwise, just getting out is wise. Remember: if you lose 30% (or more) in a bear correction, it takes far more than a 30% subsequent rise to recover your losses. Sometimes the simplest way to make money comes down to not losing money. You may want to read the blog entitled “Risk vs. Uncertainty.”

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