Would you invest in a company with no managers and no legal documents?
Believe it or not, that’s a question thousands of “investors” just answered with a resounding “Yes!”
Last week, I told you that the future had already arrived, that hundreds of tiny start-ups are already changing the way we live, work, conduct business through innovations in financial technology, or fintech.
I teased a breaking story about a “company” whose extraordinary name is itself indicative of the future of fintech.
The company, if you can even call it that, goes by the name of The DAO, which stands for Decentralized Autonomous Organization.
Since April 30, 2106, DAO has raised over $152 million via crowdfunding, which is by far the largest amount of “money” ever raised that way.
It closes its “creation phase” on May 28, 2016. So there’s still time for you to get into the “deal.”
But what is DAO? And how do you invest? And should you even consider it?
“The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”
The inimitable Matt Taibbi gets well-deserved credit for that exquisite description of Goldman Sachs from his April 5, 2010, Rolling Stone expose titled “The Great American Bubble Machine.”
(If you never read the piece, you owe it to yourself. You can find it here.)
Well, the Vampire Squid’s at it again…
Not that it hasn’t been at it all along – that was the point of Taibbi’s warning, that Goldman is everywhere, always looking for the next opportunity.
The word “fintech” is defined in the Oxford dictionary as “Computer programs and other technology used to support or enable banking and financial services.”
That’s an underwhelming and frankly shortsighted definition of what fintech really is.
Fintech is an emerging financial services sector that began as technological window-dressing for the back end pen-and-paper processes of finance.
But as we speak, fintech is gaining a head of steam as a hugely disruptive force in the markets, and it encompasses everything from online banking and mobile payments to bitcoin and innovations in financial literacy.
And a whole lot more…
This week, I’m going to tell you what fintech really is and how it’s going to change the world. I’m also going to tell you how you can make money investing in the tiny companies about to become the next Microsoft, Apple, Google, Visa – in short, the owners of the fintech future.
Here’s just a small sampling of newly architected fintech solutions:
Cutting costs and improving quality of financial services.
Leveraging advanced analytics to interpret customer behavior.
Supporting delivery of personalized services.
Advancing agility, innovation, and capabilities to leverage new technologies.
Disintermediating traditional intermediaries and generating frictionless transactions.
The most obvious impact fintech providers are having is on the banking industry, where these smaller, more nimble startups are moving into every banking activity in every corner of the markets.
And banks should be worried…
Cracking Open Fintech’s Huge Market
Let’s start with something we’ve talked about a lot in recent months – online lending, a fintech assault on traditional bank lending.
The projected value of online lending is expected to be at least $290 billion by 2020, according to Morgan Stanley.
And that’s just a small slice of the larger fintech pie…
The $3.6 trillion predicted value of digital payments to be processed in 2016, as estimated by Juniper Research, is being aggressively targeted by a multitude of fintech companies.
In a global $100 trillion economy, there’s plenty of room for fintech disruptors.
A McKinsey & Co. report, “The Fight for the Customer: McKinsey Global Banking Annual Review 2015,” identified 12,000 fintech companies and said 60% of traditional bank profits and revenues could go to fintech companies in the next 10 years.
Maybe that’s why a 2015 PwC survey found 83% of financial services professionals were worried about losing business to upstart fintech companies.
It’s not that there are so many of them, it’s that they’re getting some serious financial backing.
McKinsey reported venture capital investments in fintech totaled $12.2 billion in 2014, up from $4 billion in 2013.
Global investments in fintech in 2015 was over $16.6 billion, according to Bill Sullivan, head of Global Financial Services Market Intelligence at Capgemini.
And fintech is only going to get bigger, disrupting more than just the banks while growing into one of the most powerful transformative forces the market has ever seen. It’s going to affect the mechanics of every single financial transaction – it’s already happening thanks to things like Square and Apple Pay.
However, there’s a bit of work that needs to be done first.
Fintech’s First Order of Business
In spite of the extraordinary reach of computerization, the increasing “Internet-ing” of everything, transactions across computer networks being an all day, every day event, and the advent of the cloud, today’s systems are still exclusive, centralized, monopolistic, opaque, and vulnerable. Exclusivity and control is why providers of every service that isn’t on a “blockchain” continue lobbying for the status quo.
Blockchain is fintech’s principal battling ram, and it will singlehandedly upend established, entrenched, even what are now “new paradigm” providers of traditional services.
Blockchain is essentially an ongoing digital record of asset ownership or contracts.
Think of a giant nugget of gold you find in your yard, that’s the “block.” As you chip off pieces and use them, everything you do with every piece of that block creates a chain of records. If you buy a car and use a piece of your gold, that gets recorded on the digital ledger, both on the chain of records associated with your original block, and as part of the chain of records that proves you bought the car, who you bought it from, where it came from (the dealer, who got it from the factory, even the parts can be blockchained), how much you paid. When you sell the car in the future, clear title can be proven without an intermediary because of the chain. The gold you used for payment continues down a chain of its own.
Because all the transactions are recorded on a vast network of computers, your network, the auto dealer’s network, the manufacturer’s network, the chain theoretically can only be verified by the most recent parties to the transaction. If another party claims the gold was his, or the car was his, it’s immediately disproven by the clear chain. The more individual transactions are connected across different networks, the easier it is to verify and safeguard ownership rights, or contract rights, or whatever is being chained.
Theoretically, if someone tried to enter a false claim on an asset that’s been extensively chained, they have to access an untold number of computers and networks to alter all kinds of chains to get away with theft or some other criminal act. As blockchain grows across the global economy, it becomes more secure, more powerful, faster and cheaper to transfer assets.
But that’s just the beginning…
Blockchain Will Pave the Way for More Fintech Innovations
Blockchain technology will totally change wholesale and retail banking, counter-party validation, trading, how trades are cleared and settled, risk management, money management, credit scoring, financial education, insurance, title to and the transfer of real estate, lawyering, healthcare – everything from birth certificates to social security payments.
For example: Blockchain will make derivatives trading more secure as counter-parties and contracts won’t ever be in doubt. Being more interconnected won’t mean increased risk – thanks to blockchain likely results will better be able to be predicted. “Smart contracts” with terms that get triggered will be registered on the blockchain and transparent to all parties. Ownership of assets will be able to be traced backwards and forwards, creating an undisputed chain of title and conveyed rights.
While global blockchains are the future, they may be “too aspirational” to be immediately accepted by everyone.
That’s why corporate technologists are pushing “siloed” blockchains, where assets can be stored and moved privately on closed-loop blockchains and can be accessed by outside parties with permission, and then enter more expansive networks, which will become the global blockchain.
The simplicity and transformational nature of blockchain will make digital information unique and unchangeable by any party without the agreement of all parties. It will create trustworthy, efficient transactions across a transparent distributed ledger, where each participant has an exact copy of all the ledger’s data and all additions to the chain are propagated throughout the network.
For blockchain to work on a global basis, ledgers must be open, interoperable, nonproprietary, completely transparent, open-source, available via liberal licensing terms, and, most importantly, strictly governed.
Once that happens, the fintech revolution will truly begin.
That’s all for today. On Friday, I’ll show you just how blockchain will revolutionize the way we live. I’ll also tell you who some of the big fintech players are, and who’s going to end up getting left behind in the coming fintech future.
It shouldn’t surprise you that the topics I cover here have their impact on the markets – and seriously affect your pocketbook.
That’s why I write about them – to give you an inside look at how Wall Street thinks, why they do what they do, how they get away with it, and who’s responsible. That way, you can have a fighting chance every day – whether you’ve got a few thousand or a few hundred thousand in the markets.
In the last few weeks, we’ve covered some of the biggest stories in the world – and have taken advantage of some great profit opportunities in the process.
Here’s a quick follow-up on a few of those stories, and how we’ve made money and are going to continue making money on these good, bad, and ugly trends.
Let’s start with two of our biggest opportunities…
And then I’ll tell you about a Disruptor I’ve been tracking that’s about to change everything…
For the past year, I’ve been warning you about the “fintech” (financial technology) darlings known as online lenders (otherwise known as marketplace lenders or P2P lenders). In fact, last December, I told you that you’d be better off borrowing from an online lender than investing in one.
Since I started writing about the problems facing the online lending model in April 2015, things have been going downhill – quickly.
Two of the biggest online lenders – LendingClub Corp. (NYSE:LC) and OnDeck Capital Inc. (NYSE:ONDK) – have seen their stock prices fall 71% and 78%, respectfully, since May 2015.
Just take a look:
LendingClub, in particular, is in huge trouble. The stock tumbled to $4.25 yesterday on news that the board of directors demanded the resignation of CEO Renaud Laplanche following an internal probe into the company’s business practices. That’s never a good sign.
What’s really going on there is a whole story in and of itself – which I will fully flesh out for you soon. So stay tuned for more on this.
The other online lender we’ve been watching isn’t even really an online lender – not yet, anyway.
This is another fintech darling that made its name in the mobile payments space and announced last year it would move into the online lending space.
Square Inc. (NYSE:SQ) is down more than 30% from where I recommended you short it some 43 days ago in “One Trade to Profit from Online Lending’s Latest Headwind” – precisely because it decided to dip its toe into the online lending waters.
I really hate to say I told you so – but the fact is, we’ve been absolutely spot on with our moves in this space for the past year.
But here’s the thing…
There’s much more going on with fintech than almost anybody realizes. I should know – I’ve spent the last two years amassing data on this exciting, nascent corner of the markets.
And next week, I’ll tell you everything you need to know about this hot-to-trot field, including which companies will conquer the space, and which companies will end up as tiny historical footnotes.
Look for something in your inbox next Wednesday.
One More Thing I’m Watching… and It’s Huge
Last year, I identified a new Disruptor, a tiny biotech company that was poised to revolutionize healthcare as we know it through a little-known diagnostic test called “liquid biopsy.”
Liquid biopsy is the next step towards taming the eight deadliest diseases faced by mankind, and I’ve found the one company that can truly lay claim to the best technology in this red-hot, rapidly growing field.
You see, liquid biopsy is a simple blood test that can detect cancer DNA in the bloodstream – sometimes years before any other symptoms emerge.
Once it identifies a cancer by its genome, doctors can use that information to tailor their treatments to treat very specific forms of cancer. So it’s also next step towards totally personalized medicine.
The company I’ve identified is a small-cap biotech and the only company in the world that offers a full suite of highly validated best-in-class commercial assays for genomic treatment. It’s got lucrative partnerships with Big Pharma players, including Roche and AstraZeneca. It’s C-suite is stocked with biotech veterans.
But here’s the most important part…
The reason this stock stood out for me, the reason I recommended this company over all others in the field – and there are plenty of companies in the liquid biopsy space – is because of one thing: its liquid biopsy “factory.”
Six months ago, I predicted that the company would roll out its liquid biopsy factory this spring, and I was right within a matter of weeks – it took just a bit longer than I thought to get it up and running… can’t win ’em all I guess.
I also predicted it will roll out to 246,000 doctors’ offices, treat 100 million patients, and create $30 billion in new wealth this year.
But there’s been an exciting new development that changes everything – a single line from the company’s most recent earnings call:
Right now, the company gearing up to open a new laboratory – essentially a second “factory”- and soon. They’ve already got a multi-year lease, the equipment, and hired more than 12 people to run it.
The company is basically doubling its capacity – that can only mean good things for the future. My current price target (which from here would represent more than 700% gains) is likely too conservative given this new development.
That means this is the last time I can give you access to this exciting research. Because once this company really starts to move, it’s going to be too late – investors will have already missed the boat.
I’ve got a complete rundown of everything you need to know… all you have to do is click here.
Last Friday proved my point. Square’s stock fell 21.69%… yep, in a single day.
If you shorted Square on March 30th, when it closed at $15.02, or waited until the next day when it closed at $15.28, you’re probably short somewhere just above $15.
Assuming you shorted at only $15, based on where Square closed on Friday at $10.22, you’re up 32% on the trade in just 41 calendar days.
That’s not bad.
Here’s what happened to Square, and what to do with your trade now.
Square’s quarterly earnings, illuminated for the world on Friday, weren’t even a mixed bag. Investors quickly looked past the one or two so-called “positives” and realized earnings were a bag of bricks.
So what if “gross payments across devices” grew 45% to $10.3 billion? So what if revenue was up 51% and beat analysts’ expectations? So what if the company offered better guidance for the next quarter and rest of the year? So what if Jack Dorsey said the company could break-even next quarter (on a non-GAAP basis)? So what if hardware sales rose 7 times (from $2.29 million to $16 million)?
Hardware “costs” rose more than 525%.
Overall operating expenses were up 72%.
The company lost 29 cents a share, while analysts had expected a 9 cents a share loss.
Square set aside $50 million to deal with legal costs in a battle it’s having with professor Robert E. Morley Jr. (of Washington University), who actually owns the patents Square uses in its devices, and he wants his due.
But the worst news for Square has to do with what I warned you all about back in March. The online lending business is full of pitfalls – and Square stepped into a big one.
The bottom line is two “unnamed investors” didn’t step up and buy Square’s “credits.”
That means the money Square put out to lend and make “advances” to its online borrowing customers – which Square touts as a huge growth area for the company – didn’t come in and buy the loans Square made.
In other words, without investors buying the loans Square makes, which then gives them money to lend out again, they’re not going to be able to expand that business without incurring huge risks themselves.
Investors hated that news and sold the stock.
Square isn’t a bank. It can’t rely on “sticky” deposits to fund loans it wants to make.
If investors don’t step up and buy the loans Square makes, it’s game plan to be an online lender is no plan at all.
Then there’s the 20% of additional shares that can hit the market when the company’s 180-day lockup from its IPO ends on May 16, which is only a few days away.
If you shorted the stock, it can go lower. But I’m not greedy, so I like using a stop to lock in a profit if Square jumps today or in the near future.
I recommend using a $11 stop to get out there if the stock rises from here (as I write this, it’s down about 4% from Friday’s close, trading around $9.81).
If the stock doesn’t get there and goes down, we’ll continue to enjoy the ride lower.
The Federal Reserve’s manipulation of interest rates and regulatory pressure from the likes of the Basel Accords are impacting big banks’ earnings growth across the globe. How the banks are working around impediments to their profitability could trigger the next big “system shock” along the lines of what we saw in 2008.
Today, we’re going to take a look at what that “system shock” will look like, and how the big banks’ Q1/2016 earnings are just more evidence that the next catastrophe is inevitable.
Take a look…
What the Next “System Shock” Will Look Like
Much tougher capital requirements and liquidity set-asides like what the FDIC is now requiring of U.S. banks and foreign banks with operations in the U.S., are part of the Basel III Accord, which subject all big banks to similar constraints on their ability to generate the same revenue they used to when capital requirements, reserve requirements, and liquidity mandates were considerably lower, or nonexistent.
Any big bank considered to be on the verge of failure would suffer immediate “reputational risk,” causing the bank’s equity cushion, in the form of its stock price, to plunge and precipitate a bank run as depositors flee and funding sources evaporate.
Not only do all big banks face individual reputational risk, all big U.S. and big European banks are counter-parties with each other on trillions of dollars of derivatives trades.
Systemic risks impact all big banks almost equally on account of interconnectedness in terms of interest rate risks, credit risk, derivatives risks, syndicated loan risks, and concentration risk resulting from most of the world’s big banks plying the same trades, going after the same business lines, relying on the same liquidity measures, the same types of capital, and each other.
The impact of systemic risk across all big banks is front and center in the banks’ first quarter 2016 earnings reports.
They’ve all claimed “volatility” affecting all the markets and business lines they all rely on for revenue, impacted their earnings.
Looking at big banks earnings in Q1/2016, seeing how interconnected they are and how they are all subject to the same systemic and structural risks, is a good indication that their difficulties, because of their size, and the need for central banks to continue to support them, is having a huge impact on global economic growth.
Big Bank Earnings Are a Huge Red Flag
In the U.S., it’s no surprise that the big six American banks – JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp. (NYSE:BAC), Wells Fargo & Co. (NYSE:WFC), Citigroup Inc. (NYSE:C), Morgan Stanley (NYSE:MS), and The Goldman SachsGroup Inc. (NYSE:GS) – all managed to beat analysts’ steeply ratcheted-down earnings estimates for the first quarter, providing a positive spin for management.
JPMorgan reported earnings per share of $1.35 vs. analyst’s average EPS estimate of $1.26. But revenue fell from $24.1billion in Q1/2015 to $23.2 billion. Net profit fell from $5.9 billion to $5.5 billion. Trading revenue fell from $5.8 billion to $5.2 billion. Return on equity was 9%.
Bank of America reported earnings per share of $0.21 vs. analyst’s average EPS estimate of $0.20. But revenue fell from $20.9 billion in Q1/2015 to $19.5 billion. Net profit fell from $3.1 billion to $2.7 billion. Trading revenue fell from $3.9 billion to $3.3 billion. Return on equity was 4%.
Wells Fargo reported earnings per share of $.99 vs. analyst’s average EPS estimate of $.97. Revenue rose from $21.3.1billion in Q1/2015 to $22.2 billion. But net profit fell from $5.8 billion to $5.5 billion. Trading revenue fell from $0.4 billion to $0.2 billion. Return on equity was 12%.
Citigroup reported earnings per share of $1.10 vs. analyst’s average EPS estimate of $1.03. But, revenue fell from $19.7 billion in Q1/2015 to $17.6 billion. Net profit fell from $4.8 billion to $3.5 b. Trading revenue fell from $4.4 billion to $3.8 billion. Return on equity was 6%.
Morgan Stanley reported earnings per share of $0.55 vs. analyst’s average EPS estimate of $.46. But, revenue fell from $9.9 billion in Q1/2015 to $7.8 billion. Net profit fell from $2.4 billion to $1.1 billion. Trading revenue fell from $4.1 billion to $2.7 b. Return on equity was 6%.
Goldman Sachs reported earnings per share of $2.68 vs. analyst’s average EPS estimate of $2.45. But, revenue fell from $10.6 billion in Q1/2015 to $6.3 billion. Net profit fell from $2.8 billion to $1.1 billion. Trading revenue fell from $5.5 billion to $3.4 billion. Return on equity was 6%.
While the big numbers were all mostly negative – they don’t give a clear picture of the actual stresses these banks felt from hits to their big revenue-producing areas, the business lines where revenues generally can amount to as much as 60% of earnings.
JPMorgan’s earnings, in spite of beating analysts’ estimates, were actually down 16%. Investment banking revenue fell 24% on lower debt and equity underwriting. Fixed income trading revenue was down 13% and equity trading revenue was down 5%.
Bank of America’s earnings were actually down 25% on the quarter. Investment banking revenue was down 22%. Fixed income trading revenue was down 17%, Equity trading revenue was down 11%. Net interest margin (NIM) dropped 2.6%. And the bank increased its credit loss provision from $9 million to $553 million, mostly based on impaired energy-related loans.
Wells Fargo fared better than all other big banks in the quarter. While Q1 profits were down 5.9%, revenues rose 4.3% and total loans rose 10% on strong consumer demand. NIM fell slightly from 2.95% to 2.9%. And the big energy lender charged off $204 million of energy loans, an increase of 75% from Q4 2015. But Wells comforted investors identifying only 2% of its loan book being exposed to energy.
Citi’s earnings were down 27%. But while loans and deposits grew, investment banking revenue was down 27%. Trading revenue was down 15%, with fixed income trading down 19%.
Morgan Stanley’s earnings were down 53%. Investment banking revenue was down 34%. Fixed income trading revenue was down more than 54%. Equity trading revenue fell 9%. And wealth management revenue, typically Morgan Stanley’s strongest division, fell 4%.
Goldman Sach’s net earnings fell a whopping 59.9%. Trading revenue fell 37%, with fixed income, commodities and currencies trading revenue falling 47% and equity trading revenue falling 23%. Advisory fees were down 20%.
Besides the big six U.S. banks, the rest of America’s sizable banks also suffered through the first quarter.
But American banks haven’t fared nearly as badly as all the big European banks…
Things Across the Pond Are Even Worse
Earnings at big European banks have been dismal.
In 2015 the 12 largest European banks earned $0.18 on every $100 of assets, while their American counterparts earned an average of $0.92 on every $100 of assets.
In 2015 Credit Suisse, Deutsche Bank, and Royal Bank of Scotland all lost money. Royal Bank of Scotland has lost money every year since 2008.
The price of credit default swaps, insurance against their default and bankruptcy, on big European banks in the first quarter of 2016 doubled.
According to the IMF, European banks – which lost over $600 billion in the mortgage meltdown of 2008 – are sitting with just over $1 trillion in bad debts on their balance sheets.
Some 20% of the “assets” on Italian banks’ balance sheets are “impaired” or in default.
As earnings roll out from big European banks, Europe and world markets are reeling.
Deutsche Bank’s profits are down 58% and their revenues are down 22%.
Barclay’s profits are down 7% and revenue is down 13%.
Earnings and revenues at the rest of Europe’s big banks are coming in somewhere between Deutsche Bank’s and Barclays, but are generally terrible.
Eight years after the credit crisis, most big American banks and almost all big European banks are relapsing in spite of extraordinary central bank efforts – not to stimulate economic growth, but to liquefy and engineer profits for the big banks.
One reason global growth’s been so anemic is that big banks have been the recipients of central bank largess, which was supposed to trickle down into economies as cheap loan money to spur demand, production, and economic growth.
But that hasn’t happened to any meaningful degree.
Because the world’s big banks are in constant need of central bank backstopping, and use central bank asset purchasing schemes to enrich themselves instead of increasing the velocity of money throughout the world, economies lack the capital they need to grow.
As long as big banks pose colossal risks to the global economy and draw tens of trillions of dollars of central bank spending (which they mostly hoard on their balance sheets to survive and thrive) away from productive economic use, global growth will continue to stagnate, until it contracts dramatically and implodes the big banks all over again.
In the meantime, big banks are going to pursue earnings growth at all cost.
They’re already being accused by some analysts and regulators of end-arounding stricter capital requirements by reclassifying assets as less risky (reducing the amount of reserves and capital they have to set aside) via changes in how they “mark” their assets against internal risk models.
Given their size and the need for economies of scale, big banks will increasingly push the limits of regulations, trading, product development, and leverage to grow their earnings and profits to flush-up bankers’ bonus pools.
The only way to escape the financial terrorism imposed on countries by big banks and their government-sanctioned central bank backers is by breaking them all up so they’re not too big to fail.
Only by breaking the stranglehold central banks and mega-bank oligopolies have on the entire world will credit be freed up and capital markets be free to perform their function of allocating capital and credit.
The United States and global economic powers increasingly rely on big banks to facilitate government borrowing, fund commercial and consumer loans, underwrite economic growth, and act as originators, principals, and agents in capital markets.
Now that reliance increasingly looks to be the cause of lackluster global growth.
Today, we’ll look at the size of big-banks, their structural issues, and how the need to “socialize” their losses, because of their size, fundamentally retards economic growth.
Then, on Friday, we’ll examine last quarter’s earnings for the biggest banks in the country, and I’ll show you exactly why the big banks are headed for big trouble, and how they could drag the entire global economy down with them.
On Wednesday, I told you that companies and Wall Street analysts are playing a game with your money, and everyone’s in on it. The analysts, the media, the data compilers, and the company executives are all working in concert to make earnings look a lot better than they are.
Stocks can be affected by central bank policies, macro-global events, and existential crises. But in spite of, and especially in the absence of those “big-picture” market impactors, it’s earnings that drive stock prices.
But as I told you, headline earnings numbers fed to us by companies, analysts, and the media are more often than not jacked-up by means of creative accounting tricks.
The headline earnings reports investors take as gospel every quarter when the circus comes to town are non-GAAP, pro-forma, “Street” earnings, not bona fide earnings based on Generally Accepted Accounting Principles.
As you know, the difference between non-GAAP and GAAP earnings can be huge and can trap investors.
If you’re making investment decisions based on headline earnings metrics, and you don’t know what you don’t know, chances are you’ve been burned… or you’re going to get burned very soon.
Here’s some of the fluff you’ve heard, the underlying truth, and how, with just a little guidance, you can analyze real earnings yourself – just like the pros.
The Rift Between GAAP and Non-GAAP Numbers Is Getting Wider
Last year is just another example of the disparity between real and unreal earnings numbers. According to the Wall Street Journal, headline or pro-forma earnings for companies in the S&P 500 in 2015 were 25% higher than GAAP earnings. That’s the biggest disparity since 2008. A CNBC.com analysis found a similar gap in 2015 earnings.
In February 2016, regarding 2015 earnings, FactSet reported that:
…67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, that the difference between the GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014.
If you just follow the yellow brick road, paved for us by the likes of Bank of America Merrill Lynch, you’re probably feeling positive about the earnings reports coming at us like a fire hose this quarter.
A BoA report last week said,
With the conclusion of Week 2, 133 companies representing 40% of S&P 500 earnings have reported. Overall for the S&P 500, 67% of companies have beaten on EPS, 57% have beaten on sales, and 44% have beaten on both-an improvement from the prior week, and much better than we saw this time last quarter, when just one-fourth of companies beat on both EPS and sales.
Of course there are a lot of “beats” this quarter. Analysts have been furiously ratcheting down their earnings estimates since January, while company accountants, with executives standing tall over them, have been making “adjustments” right and left in their earnings and expense columns.
And regulators are starting to raise concerns that all this gimmickry is going to eventually cause trouble in the markets…
Regulators Are Starting to Take Notice
The SEC is worried about how investors are being misled.
Last month SEC chair Mary Jo White, addressing a U.S. Chamber of Commerce audience, told guests, “We have a lot of concern about the use of these measures and whether they may be confusing to investors and analysts.”
She shouldn’t worry they’re confusing to analysts – that’s bunk. Analysts know the game.
And SEC chief accountant James Schnurr criticized the rampant use of non-GAAP measures in a recent speech, saying, “SEC staff has observed a significant and, in some respects, troubling increase… in the use of, and nature of adjustments within, non-GAAP measures.” Schnurr additionally stated that non-GAAP measures should “supplement … not supplant” the information in the financial statements.
Even Warren Buffet’s been chiding non-GAAP earnings, noting the difference between GAAP and non-GAAP results is challenging for the average investor to interpret, and that they can’t count on analysts to clear it up because executives and some analysts are “guilty of propagating misleading numbers that can deceive investors.”
Case Study: GAAP Earnings vs. Non-GAAP Earnings
I want to illustrate the distinct difference between GAAP numbers and Non-GAAP numbers with two recent, real world examples.
You may have noticed that Apple Inc.‘s (NASDAQ:AAPL) earnings grossly disappointed this week – the company posted its first quarter-to-quarter revenue decline since 2003 – and the stock got beaten down.
The company released earnings after the bell on Wednesday, when the stock closed at $104.30. On Thursday, the stock opened 8% lower.
It’s disappointing, even troubling – since the company didn’t forecast any growth, and in fact lowered their guidance for Q3 – but Apple doesn’t report non-GAAP earnings, they only report earnings derived from generally accepted accounting principles.
While the truth hurt them, at least their investors know how the company’s really doing and can make investment decisions accordingly.
Facebook Inc. (NASDAQ:FB)? Not so much.
FB trumpeted their non-GAAP earnings on Wednesday after the close and the stock took off like a rocket.
While the immediate focus was on the $5.382 billion in revenue FB posted for the quarter vs. last year’s revenue of $3.543, under the hood, non-GAAP numbers rolled out to the public masked less robust GAAP metrics.
FB pointed to income from operations being $2.977 billion, GAAP income was $2.009 B. Operating margins looked great at 55%, but the GAAP margin was 37%. And non-GAAP net income at $2.229 billion and diluted earnings per share of $.77 looked a lot better than GAAP net income of $1.510 billion and GAAP EPS of $.52.
That’s what good non-GAAP numbers can do, especially in a tough market looking for companies that clobber consensus estimates.
Still, Facebook is making huge strides no matter how they tell the tale of their earnings, so perhaps the stock would have gone up anyway.
But would it have gone up as much as it did? Maybe not.
How to Protect Your Investments from Shady Earnings Reports
So with all these different numbers, different accounting practices, and different reporting methods, what’s an investor to do?
My advice: When a company announces earnings, pay close attention. Read the reports, listen to the conference calls, and pay as much attention to the numbers they aren’t talking about.
Here’s a quick checklist that you can use to help you assess viability of Non-GAAP earnings numbers:
Always compare Non-GAAP and GAAP numbers side by side.
Make sure company executives adequately explain the reasons for the adjustments represented by Non-GAAP numbers. If they don’t, I don’t trust them.
If Non-GAAP numbers are the norm for the company, check explanations and footnotes to see if they are consistently calculated and when and why and how they’re applied from quarter to quarter.
Non-GAAP numbers work both ways – accounting for both nonrecurring expenses as well as nonrecurring gains, if some non-recurring gain magically fills what would otherwise be a bad number, apply the bad smell test to that entry.
Additionally, I always look at all numbers sequentially.
For example, I look at changes in top-line revenue sequentially over the past four quarters to a year ago, because how a company is doing in sales and generating revenue is hard to mess with.
If you look at all the components that make up earnings numbers through the sequential prism, it’s a lot easier to pick up anomalies anywhere they might otherwise be missed if that quarter’s numbers are just compared to the year ago quarter.
At the end of this earnings season, I’ll follow up with a complete breakdown of the highs and lows, the good, the bad, and the ugly stories that will give you the whole picture of 2016’s first-quarter earnings and how to value the market.
Every day you’re in the market – whether you own shares of your favorite company in an individual account, have a thick IRA, or you’ve got a portfolio through a pension plan – you’re being lied to.
That’s because everyone on Wall Street – the analysts, the investment banks, the media, the data compilers, and the companies themselves – are all playing a game with your money.
It’s called “hide the earnings.”
Today, I’m going to tell you everything you don’t know about analysts’ earnings reports, consensus estimates, actual reported earnings – and how we’re all openly lied to.
It’s going to make you very uncomfortable, scared even.
But don’t worry – on Friday, I’ll tell you the truth about the recent earnings numbers.
I’ll name some names – and I’ll show you how to avoid getting hoodwinked by trumped-up earnings reports… and how to make money cutting through all the crap being fed to you by Wall Street
Two – Very Different – Ways to Calculate Earnings
The game that everyone on Wall Street is playing is legal because there are two ways to calculate earnings.
One way is by using Generally Accepted Accounting Principles (the GAAP way). As you might guess, GAAP earnings are dictated by a common set of accounting principles, standards, and procedures. The combination of authoritative standards and commonly accepted methods give investors a level of consistency in the financial statements they use to analyze companies and make their buy/sell decisions.
But the preferred way analysts, data compilers, the media, and companies talk up earnings is by talking up non-GAAP earnings. These are sometimes called “pro-forma” earnings, or “Street” earnings, or “earnings before the bad stuff happens.”
All companies are required to report GAAP earnings, but to get to them you have to be proactive – you have to get ahold of the company’s quarterly reports and analyze them.
But here’s the thing…
Everyone else is focused on non-GAAP earnings, which companies also include in their quarterly and annual company reports – and may even highlight at the expense of their actual GAAP earnings.
What’s crazy about non-GAAP earnings is they can be calculated in all kinds of different ways – there’s no industry standard of what can be done on a non-GAAP accounting basis, and nothing stopping reporting companies from being “creative.”
Companies use non-GAAP accounting because they say it gives a “more accurate picture of earnings from day-to-day operations.”
They say their earnings shouldn’t include “non-recurring” one-time charges, or write-offs for things like restructurings, asset write-downs, writing off goodwill charges or other merger, acquisition or company divestiture related charges, and certain kinds of compensation schemes.
In short, if a company thinks their earnings are going to be negatively affected by something that’s deemed to be non-recurring, that doesn’t relate to day to day operations of the business – which is what they say investors really care about – they simply side-pocket those items which makes their earnings look a heck of a lot better.
Whether those non-recurring items recur, and keep recurring is another story. Of course, a lot of the time they do.
Analysts Are in on the Shakedown
As far as analysts, they’re all over non-GAAP numbers.
Most “Street” analysts don’t bother with GAAP because the companies they cover want them to focus on non-GAAP numbers, because, that’s the game.
And of course, not all analysts come to the same conclusions about what will be included or not included in a company’s non-GAAP numbers. But, they, meaning the principal analysts that make up the consensus of analysts whose consensus estimates are used, are pretty well informed by the companies themselves, about what they’re doing for the most part. About what they’re accounting for, or not accounting for.
Do company executives tell analysts what they’re doing, to guide analysts’ estimates in line with what management wants the analysts’ estimates to be?
You bet they do.
It’s not legal, but there are ways around that, for sure. I’ll get to that in a minute.
Here’s how a consensus of analysts gets convened according to Michael Patton, director of earnings estimates at S&P Capital IQ, “Let’s say 20 analysts cover a stock, and 13 do it one way and seven do it another way. Which are in the consensus? We go by the majority rule. We go with the 13.”
In other words, if the minority use GAAP to arrive at their earnings estimates, they’ll never be in the consensus. That would be way too messy.
The other data compilers of analysts’ earnings estimates, Thomson Reuters, Zack’s, and Fact Set (Fact Set is starting to come around to GAAP realities and may in the future be the only data compiler worth following) have their own ways of convening the “right” analysts, which mostly means they’re in the game.
It usually happens that the mainstream sell-side analysts, those that work for banks and investment banks who want to help land all kinds of business from the companies they cover for their employers (we know how that works in spite of the rules and regulations and fines paid in the past for doing exactly that) have a good relations with executives at the companies they cover.
It’s absolutely in a company’s best interest to help guide analysts’ estimates. They almost always want to guide them below what they’re actually going to report, because they want to beat consensus estimates to try and boost their share prices.
It’s a thin line, guiding analysts.
According to law firm Skadden, Arps, Slate, Meagher & Flom LLP’s Sept 2012 Corporate Finance Alert in its section on Regulation FD Considerations (emphasis mine):
Regulation FD (Fair Disclosure), which addresses selective disclosure of information by SEC- reporting companies, provides that when an issuer discloses material nonpublic information to certain individuals or entities – generally, securities market professionals, such as stock analysts, or holders of the issuer’s securities who may trade on the basis of the information – the issuer must make public disclosure of that information simultaneously, in the case of intentional disclosures, and promptly, in the case of unintentional disclosures. Regulation FD prohibits “selective disclosure” of material nonpublic information. Violators of Regulation FD are subject to SEC enforcement actions, but there is no liability under Rule 10b-5 for failure to make a public disclosure required by Regulation FD. The SEC has issued guidance stating that Regulation FD does not change existing law with respect to any duty to update.13 In other words, Regulation FD does not create a duty to update forward-looking guidance information, but it does create important considerations for companies that issue earnings guidance. Any decisions to provide guidance or to update earnings guidance (or to respond to direct or indirect inquiries that address future earnings results) must be made with sensitive consideration to Regulation FD. In addition, companies must be careful not to selectively share any material information that affects previously issued guidance, which may create a duty to update where there was no prior duty.
So what does that all mean?
It means under Regulation FD, analysts aren’t supposed to be privately guided by company mangers or executives, but they can get the information executives want them to get if they all get it and they all change their estimates, which can be viewed as “informing the public.”
Now you know companies use non-GAAP methods to spruce up their earnings. And now you know analysts use the same methods to come up with their estimates, and how they can be guided by company executives, and how they’re convened into a consensus that companies can beat when they come out with their quarterly earnings.
That’s the game.
On Friday, we’ll talk about the recent earnings numbers, and I’ll show you why they’re bunk. I’ll name names.
And I’ll show you how to cut through the crap… and how to calculate a few numbers on your own that will tell you how a company’s really doing.