Don’t let facts get in the way of a good story. That’s what we tend to see towards the end of a bull market, whether we’re talking about tulip bulbs, Nifty Fifty stocks of the 1970s, tech stocks in 2000, or our present spate of unicorns (IPO startup stocks with business plans and valuations that are hard to believe). When a bull market goes on for so long, people seem to relax. Unfortunately, that attitude also seems to include accounting standards. A very popular way to do this, in terms of the numbers you tend to actually see over the last two decades or so, is the widespread use of non-GAAP (non-Generally Accepted Accounting Principles) earnings, which have been used to tell stories of earnings without including the “bad stuff.” To my mind, it seems harder than ever to get the real (GAAP) numbers in a timely manner.
Now, I’m not going to spend an entire blog talking about accounting, as I can feel people falling asleep already. For that matter, there are people out there who understand these things better than I do and have written about it extensively. In particular, I’d point to Howard Schilit, who also wrote the great book Financial Shenanigans, and Jim Chanos. Some of their recent material is worthwhile reading if you have the time and desire.
Instead, I want to talk about the broader effects of fast and loose accounting. For instance, the spread between financial accounting (what the company tells investors) and tax accounting (what the company tells the IRS) is as big as it was in the late 1990s. Why? Probably several reasons, but what I’d focus on is in both periods we had a roaring bull market which saw a great deal of capital gains reported. In the nineties the non-GAAP earnings were shown to be unsustainable, which frankly is always true. Should we expect anything different here?
Who watches the supposed watchmen? There’s a constant war on how earnings are presented to us. Investors have been losing that war for decades, and it’s only gotten worse. The problem is that there are three parties at the table in determining how and what gets reported to investors: companies, Wall Street banks/brokers, and government. In theory, the Wall Street banks should be on the investors’ side. Welcome to the downside of those low (or no) stock trading commissions that investors pay. Investors don’t really matter to the big banks. They’re making far more money with M&A (mergers & acquisitions) and hedge funds. They don’t care about you, and they don’t even particularly care about forecasting earnings accurately. If forecasting earnings isn’t a real focus, how seriously should you take their earnings estimates?
As for the companies, they want to report the best-looking earnings. Since the banks want the companies’ M&A work, there rarely is an issue about what to report to investors. As for the government, well, that is why you have lobbyists and trade associations. I know this all sounds a bit cynical, but why don’t companies just report the same earnings to investors they report to the IRS? Doesn’t that simple idea make the most sense?
For that matter, other than investors, who cares about earnings? No one has gotten paid for pointing out accounting problems in reported earnings, at least not broadly, particularly with most major domestic markets near highs. But recently, the steady growth of Wall Street earnings estimates have broadly been slowing down. And year over year even non-GAAP estimates are getting closer to flat. Most interesting is that, according to the BEA (Bureau of Economic Analysis), taxable earnings reported by all corporations in aggregate have gone nowhere over the last five years!! But GAAP earnings haven’t mattered, as stocks just keep going up. Why should anyone care about earnings?
The financial world is cyclical. There are good times and there are bad times. After the seven plump cows, you have seven lean cows. (For the full story of how only Joseph could interpret the Pharaoh’s dreams of the future, see Genesis, Chapter 41.) Considering I just cited a story that is thousands of years old, it’s fair to say this idea has been around for a while. During the good times it’s easy to forget about problems. You can ignore inconvenient metrics, but as Warren Buffett has said, “You only find out who is swimming naked when the tide goes out.”
Do you need something to anchor stock prices? Something to tell you when risk has gone too far? I sure think so. For centuries that basic risk metric has been earnings. You can change the measuring stick now if you want to, but I’d rather stick with the tried and true. The thing is, what do you do when the “earnings” that everybody is celebrating may not even be real? For example, you can try to ignore the effect of massive stock buybacks, paid for by increasing leverage and risk, which also make earnings look better – at least temporarily. Ultimately, the idea is that you’re paying for an income stream. In 2018, Netflix, for example, reported a profit of $845 million, but claimed a $22 million federal tax refund (they did pay $131 million in taxes worldwide.) I think it’s worthwhile to look at all of the numbers, but at the least I think the tax earnings numbers are worth considering. Should we be concerned that tax earnings growth is so anemic?
Why should we care now? Probably the main reason is that we can better see stresses ratchet up everywhere. Unicorn IPOs are struggling, some never even made it to market. Even the happy non-GAAP version of earnings is flattening out. The global economy has fared poorly for a while. Tariff wars may be having a negative effect. Despite that, hopes are high. Is the tide going out? If you don’t believe so, what are your reasons?
“Let’s be careful out there.” -Sergeant Phil Esterhaus, Hill Street Blues
 (N Mahalakshmi & Rajesh Padmashali, “Most Companies, If Not All, Use Some Kind of Tricks To Smooth Out Earnings”, Outlook Business, September 1, 2017, https://www.outlookbusiness.com/specials/masterspeak_2017/most-companies-if-not-all-use-some-kind-of-tricks-to-smooth-out-earnings-3784.)