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.
Last week, we dove deep into the Panama Papers – the scandal that’s implicated dozens of world leaders and several big banks – and I told you that ordinary investors routinely use shell companies as a perfectly legal way to protect their assets.
Many of you have asked just how you can use these advantageous structures to protect your assets from lawsuits, creditors… and just about everything else.
So today, I’m going to answer your best questions about how you can get in on the shell game.
There are slippery brokers everywhere who want to manage your retirement money – and now they want to get their hands on it as fast as they can.
That’s because starting next April all brokers will be held to a much higher “fiduciary” standard rather than the simple “suitability” standard they’re held to now.
Believe it or not, there’s a huge difference between being a fiduciary and offering up suitable investment advice.
And not knowing the difference could be costing you a fortune.
Today, I’m going to tell you about the new standard for brokers managing retirement accounts – including the difference between the suitability standard and the fiduciary standard, the new rule changes going into effect next year, and what it all means for your money.
And make no mistake – it means a lot. Americans have stashed about $14 trillion in IRAs and 401(k) plans, and brokers have been making a killing giving so-called “suitable” advice.
So you better read this now to figure out whether you’re currently getting screwed and how you can safeguard your money in the future…
With huge numbers of Americans retiring – and with retirees and workers planning their retirement increasingly worried about Social Security benefits, low interest rates, volatile markets, how to navigate investment pitfalls – and with more people than ever turning to advisors and brokers, the new rules are a welcome outcome.
The fight over elevating standards to which brokers are held has been a messy one.
The proposed rule changes received 3,000 comment letters. And over a four-day period of hearings on proposed changes, 80 parties – both for and against changes – made their cases.
In the end, the Labor Department (which oversees pension and retirement account rules) prevailed in its six-year battle against entrenched Wall Street interests, who argued the proposed changes in the rules would hurt investors, not help them.
The most popular Wall Street pushback was enunciated by Andy Blocker, executive vice president of public policy and advocacy at the Securities Industry and Financial Markets Association (SIFMA), who said, “Our biggest concerns are reduced access to advice for the lower end of the investor spectrum and higher costs for individuals, either investors will be put in an account where they pay more, or they’ll get less service.”
I’ll debunk that bunk in short order. But first, let me tell you the difference between a fiduciary and a broker giving “suitable” investment advice.
The Fiduciary Standard vs. the Suitability Standard
All registered investment advisors (whether through the Securities and Exchange Commission or through a state agency) are held to a “fiduciary” standard.
A fiduciary can be anyone – a banker, an asset manager, an accountant, an executor, a board member or other corporate officer – responsible for managing the assets of another person or group of people. Fiduciaries have an ethical and legal responsibility to act in good faith and in the best interest of the party whose assets they’re managing. They are not allowed to personally benefit from their fiduciary duties.
In short, a fiduciary has to, by law, put their client’s needs and best interests above their own.
Brokers, on the other hand, are directly overseen by their firms and the Financial Industry Regulatory Authority, or FINRA, a “self-regulatory” body (itself another story for another time) and have been held to a very different standard.
Instead of having to act as fiduciaries, brokers only have to make “suitable” recommendations and give “suitable” advice to their clients.
The short version of offering suitable advice means brokers aren’t required by law to act in their customers’ best interests.
I know it’s amazing – but it’s true.
As an example, a broker can put a client into a fund or product that has a high “YTB” (“yield to broker” is an industry term used derisively by brokers), meaning a fat payday for the broker, as long as they can prove it was “suitable” for the client.
A fiduciary couldn’t do that if there were competitive products available with lower fees or commissions.
Of course, the suitability standard can be a money-maker for unscrupulous brokers.
With $7.3 trillion held in individual retirement accounts (IRAs) at the end of 2015, according to the Investment Company Institute (ICI), and employer-based pension 401K accounts holding another $6.7 trillion, which can be rolled into IRAs, the new rules to better safeguard retirement account management by brokers is really good news.
But, typically when the industry, meaning the FINRA, ICI, brokers and brokerage firms who want to make as much money as they can, and insurance companies and product manufacturers who want their products to fly off shelves with the help of well-compensated broker intermediaries, not all the proposed rules made it through the gauntlet.
The Biggest Changes to How Brokers Can Manage Your Retirement Savings
Here’s a short and simple explanation of the most important rules changes:
They only apply to retirement accounts.
Brokers don’t have to recommend the lowest cost products, value is a consideration.
Brokers cannot accept any payments creating conflicts of interest, unless they qualify for an exemption. The rules here are a bit complicated, but ask your broker if they ever are going to seek an exemption, and have them put their answer in writing.
Education of clients is a “carve-out,” meaning a broker educating clients on retirement products, etc. isn’t acting as a fiduciary.
Lifetime income products, like annuities, passed the grade (thanks to all the pushback from insurance companies and broker big-commission lobbing efforts).
Brokers can still sell “proprietary products” (products their firm’s manufacturer), but they must be in the client’s best interest.
An advisor can recommend themselves or another advisor without being considered acting as a fiduciary when they do so.
Recommending that a client rollover any employer-based retirement 401k into an IRA the broker will direct will now be considered a fiduciary recommendation.
New rules still allow commission-based services alongside flat or “level fee” charges.
Not all of the new rules will go into effect in April 2017. Some will phase in all the way up to January 2018.
Important note: Some old allowances under the old rules will be “grandfathered” in. Check with your broker to see what they might expect to grandfather in, and how that might impact how they manage your money.
While the new rules are a great start to fixing cracks the size of the Grand Canyon some brokerage clients fall into (are pushed into?), they will likely be challenged before they are fully implemented and most definitely challenged once they’re in effect.
As far as Wall Street rhetoric that the new rules will cost clients more and that smaller clients may not be of interest to big firms, since the new rules will cost more to comply with (the old “it’s expensive to comply with consumer protection laws” argument) – they’re wrong.
Costs to administer retirement accounts might well tick up because of additional compliance and regulatory oversight expenses, but in the end fees charged to clients will come down because service providers will have to be more competitive among themselves.
And if they’re not competitive, or if “little” clients aren’t welcome at big brokerage shops, the rapidly growing robo-investment advice revolution will level the playing field and put out a welcome mat for all kinds folks seeking advice on managing all different kinds of accounts.
On Wednesday, I told you that the world was just beginning to reckon with the fallout from the Panama Papers, the 11.5 million emails hacked from Panamanian law firm Mossack Fonseca.
That’s because investigators around the world have only just begun to sift through the wreckage.
After U.S. tax authorities, the U.S. Justice Department, Panamanian, Brazilian, Thai, British, and a handful of other outraged countries launched their own inquiries, the Joint International Tax Shelter Information and Collaboration (Jitsic) Network convened a meeting of 28 nations in Paris on Wednesday to coordinate joint investigations.
The unprecedented international coalition intends to look into the 210,000 companies domiciled in 21 different offshore jurisdictions uncovered in Mossack Fonseca emails.
Not only are investigations going to lead to a lot of buried treasure, they’re going to bury a lot of rich, powerful, and crooked people.
And that’s not all…
Of the over 500 banks and bank subsidiaries implicated in the Panama Papers, some are major global banks.
That creates a major trading opportunity for us – and I’ll show you how to get into position to catch profits as investigators follow the paper trail.
But first, let the digging begin…
Digging Up the Dirt
So far, we know 15 people already named are either current or former heads of state or government leaders. They include: Sigmundur Gunnlaugsson, the prime minister of Iceland, who already temporarily stepped aside over disclosures of his interest in a shell company; Saudi King Salman bin Abdulaziz Al Saud; UAE President and Emir of Abu Dhabi Khalifa bin Zayed Al Nanyan; Ukrainian President Petro Poroshenko, President of Ukraine; UK Prime Minister David Cameron; former Italian Prime Minister Silvio Berlusconi; and former Pakistan Prime Minister Benazir Bhutto, former prime minister of Pakistan.
Hundreds of other government officials and friends of government bigwigs are disclosed in the Papers, including: Former minister of finance of France and former managing director of the IMF Dominique Strauss-Kahn; former president of the Supreme Federal Court of Brazil Joaquim Barbosa; former head of North Korea’s Daedong Credit Bank Kim Choi Sam; eight current and former members of China’s Politburo Standing Committee; family members of China’s past and present presidents and party leaders; and friends of Russian President Vladimir Putin.
And of course a lot of rich and powerful moguls, celebrities, Hollywood royalty, and sports icons are beneficial owners or investors in uncovered shell companies.
Entertainment billionaire mogul and co-founder of Dreamworks David Geffen is on the list. So is actor Jackie Chan and American Idol creator Simon Cowell. And sports legends: golfer Nick Faldo, winner of three Master’s tournaments, and soccer icon Lionel Messi, are all implicated.
Even the CIA shows up in Mossack Fonseca’s email files. We may never know who they were fronting, backing, enriching, for what reasons, and to whose ultimate detriment. But maybe some of it will come out.
As I told you on Wednesday, there are lots of legitimate reasons to set up so-called shell companies – and it’s possible that many of the people listed above were not party to any illegal activity.
It’s the shady setups rigged to evade taxes and clean dirty money that investigators are going after – ad there plenty of those domiciled in Panama and elsewhere around the world.
Department of Justice spokesman Peter Carr said of the Panama Papers:
We are aware of the reports and are reviewing them. While we cannot comment on the specifics of these alleged documents, the US Department of Justice takes very seriously all credible allegations of high-level, foreign corruption that might have a link to the United States or the U.S. financial system.
We already know there are direct and indirect links to the U.S., to U.S. citizens, and U.S. intermediary shell companies. More than 200 scanned U.S. passports were in Mossack’s email files, and more than 3500 listed shareholders have U.S. addresses. As far as shell companies, the Papers reveal 3100 companies tied to offshore “professionals” based in Miami alone.
Besides direct and indirect beneficiaries and investors in the questionable shell companies set up by Mossack Fonseca, there are thousands of other linked shell companies set up by other law firms in other jurisdictions that investigators will have to chase down.
But don’t count on too many law firms getting into hot water. For the most part, firms manage to protect themselves and their practices by distancing their interests from the activities that go on inside companies they create.
Still, not all of the hundreds of law firms in the U.S. and around the world that set up these offshore shells are going to be clean. There will be lawyers and law firms that sink along with the shady characters and companies they’re involved with.
Mossack Fonseca maintains it’s done nothing wrong. Ramon Fonseca, the law firm’s founding partner, distances the firm from beneficiaries and investors – who may be evading taxes or laundering dirty money by saying – normally the firm required banks to provide “due diligence” information verifying owners’ identities and confirming that they were not involved in overt criminal activity before setting up or managing companies created for banks’ clients.
Whether or not that’s entirely true, it directly points to banks as intermediaries and facilitators, if not outright masterminds.
These Banks Are in Hot Water Again
Back in 2013 when banks were once again under intense scrutiny for aiding and abetting U.S. tax cheats, a Credit Suisse private banker explained that “the current trend is that lawyers prepare the structure, and the bank’s focus is on managing the bank accounts (and not the structure).” That quote comes from a Mossack Fonseca employee’s notes of a meeting with the bank.
Banks are in the thick of it again.
While lawyers in the U.S. and in some other countries are under no legal requirement to report “suspicious activity,” all banks doing business in the U.S. are required by law to do so.
So far, no big U.S. banks have been implicated in any of the Panama Papers, but that might change. However, it looks like a lot of the “usual suspects” who have been implicated, investigated, found guilty and fined by U.S. regulators and the Department of Justice are back to their old tricks.
Past offenders caught aiding and abetting U.S. tax cheats, now featured prominently in the Panama Papers, include UBS and Credit Suisse.
In 2009 UBS paid $780 million in fines, interest and restitution to avoid prosecution in a highly charged case that drew the ire of the Swiss government over Swiss banking secrecy laws UBS thought would shelter it from U.S. authorities looking into tax shelters UBS bankers set-up for thousands of U.S. citizens.
And in 2014 Credit Suisse pled guilty and paid a $2.8 billion in fines to settle criminal charges for among other actions “assisting clients in using sham entities to hide undervalued accounts.” Eighty Swiss banks subsequently settled with U.S. authorities over matters related to helping U.S. citizens evade taxes.
More than 500 banks and their subsidiaries registered at least 15,600 shell companies through Mossack Fonseca, according to the Papers.
There’s little doubt bankers may face fines and jail time for their part in the gaming.
Mossack emails show that from 2010 some banks began transferring companies out of the banks’ names and into the names of individual bank employees.
According to McClatchy, the newspaper company with complete access to all the Mossack emails, a 2010 email from Mossack Fonseca to HSBC “reveals the firm put companies into the personal names of seven HSBC bankers, including Judah and Nessim el-Maleh. Nessim el-Maleh was later convicted along with another el-Maleh brother in a cannabis-for-cash scheme in Paris, where bags of money from drug deals were laundered through HSBC accounts.”
Investigations are going to be the end of some bankers – and maybe even some banks. But, to be sure, none of the big European banks that just pay fines for their misdeeds, like you and I pay a toll to use a bridge, are going down.
But their stock prices just might head that way…
The Best Way to Short the Dirty Banks
One way to play the exposure of big European banks to fallout from the Panama Papers is to short the iShares MSCI Europe Financials (NASDAQ:EUFN). HSBC Holdings PLC accounts for 7.74% of EUFN’s portfolio and UBS Group AG another 3.75%.
Fallout from the Panama Papers is just beginning to stir some dark waters, so shorting EUFN now may be a bit premature. The ETF looks like it could get above $19 and make a run for $21-$22 if more stimulus out of the European Central Bank tickles bank investors.
But with the Panama Papers hanging over some giant European financial institutions, shorting EUFN above $21-$22 is a good bet.
I’ll be keeping you up on everything to do with the Panama Papers, and as more specific details come out, I’ll be making some very specific recommendations on how to profit from what could prove to be a treasure trove of salacious facts.
Editor’s Note:Shah’s EUFN recommendation is just the beginning. Right now, Shah’s working on a new, high-octane opportunity that could bring big profits as the world learns more about global banks’ involvement in the Panama Papers scandal.
Shah’s releasing this trade – and more dirt on the banks – to readers of his high-end research service next week.
You don’t want to miss it – click here for everything you need to get Shah’s next trade on the big banks, and you’ll also get a special look at what Shah’s calling his “Buyback Boomerang” trade, the aim of which is cash in on Wall Street’s $2.4 trillion buyback scam.
On April 3, the first news reports surfaced detailing leaked information in what’s known as the “Panama Papers” hacked email documents exposing more than 214,000 shell corporations created by Panamanian law firm Mossack Fonseca.
The Papers identified heads of state and government leaders from over forty countries as beneficiaries and investors in secretive off-shore shell companies.
The short list of who’s been “outed” is already having profound effects across the globe.
But the leaked Panama Papers are the tip of a giant iceberg that’s going to melt and drown more world leaders, powerful politicos, entire governments, moguls, bankers, and banks.
As more facts and figures come out of the 2.6 terabytes of data contained in 11.6 million hacked Mossack Fonseca emails, it’s going to be impossible for shell company beneficial owners and tax haven purveyors to escape regulatory and tax authority investigations.
Today, I’m going to tell you everything you need to know about how the shell game is really played – and how ordinary investors can use legal shell companies to protect their assets.
Then, on Friday, I’ll explain whose been caught swimming naked and what pending investigations will do to shell company beneficiaries and the law firms and banks that aid and abet what amounts to a giant international asset juggling act… and I’ll let you in on secret of your own – how you can profit from the outcome of these investigations.
The Truth About Shell Companies
First of all, most shell companies are set-up for perfectly legitimate purposes.
Shell companies are created using different entity structures. They’re mostly set up as corporations and limited liability companies, but other structures designed to limit liability and provide anonymity for their beneficial owners can be used.
There are millions of legitimate “shell” companies just in the U.S., set up for different reasons.
The buyer of a sought after piece of real estate, for example, might want to create a shell company to bid anonymously for the property, not wanting the seller to know who they are and that they’re capable of paying a lot more money.
That same buyer might keep the property in a shell company to protect it as an asset.
While the beneficial owner of the shell company and the property is a person, the law recognizes the shell company as a separate entity, distinct from its beneficial owner.
If something happens to the beneficial owner of the shell and property, such that he is at risk of losing what he owns, since he doesn’t technically own the house, the shell owns it, the property may be safe from creditors.
An automobile can be put into a shell company. That way, if the beneficial owner of the car, who is authorized to use it by the company they set-up to own it, gets into an accident in the car, injured parties who want to sue the owner of the car for more than their insurance covers won’t get far. That’s because the actual owner of the car is a company whose only asset is that car. There would be nothing to sue for, since the company housing the car has no other assets.
Still, that wouldn’t stop injured parties from suing the driver of the car. However, the driver may have put all their other assets into shell companies and not directly own any assets themselves, and thus not be worth pursuing.
It’s called asset protection, it’s totally legal, and the richest families in the U.S., from the Fords and the Rockefellers to a lot of smart people you probably know have shells.
University of California Berkeley economist Gabriel Zucman estimates $7.6 trillion or 8% of global financial assets of households (not businesses) are held in shell companies, mostly in tax havens, which includes the U.S.
A Few Bad Apples…
Of course, shell company structures can be used for lots of other purposes, including legitimate tax minimization and tax avoidance purposes, as well as tax evasion schemes, which are illegal.
Ill-begotten money, from activities like bribery payments and drug smuggling, to dealing in conflict diamonds, can be hidden and “cleaned” through a process of moving money through different shell companies.
The Panama Papers give the world an insider’s view into the tax haven shell game.
Panamanian law firm Mossack Fonseca, which has offices around the world, sets up and helps manage shell companies in Panama and across the globe.
One reason shell companies are set up in Panama is that the cost to create them is cheap. Depending on the purpose of the shell, what it will be used for, how it will be used, if there will be other shell companies that have to be set up in other jurisdictions and what “assets” might move through the shell companies, the cost of a “structure” can run from less than a $1000, to millions of dollars.
Another reason Panama is popular is foreign sourced money coming into Panama usually isn’t subject to tax. And there is no capital gains tax (except on real estate) on interest income in Panama.
Interestingly, most of the asset protection vehicles and shell company structures used by Mossack Fonseca, other Panamanian companies, and tax haven jurisdictions around the world, are modeled on corporate laws established in the state of Delaware in 1927.
Most Mossack-created shell companies, as is the norm, are established by other shell companies to hide their true beneficial owners. In other words, a company sets up another company, so there are no persons named.
The shell company uses “nominee” directors, who are paid directors willing to act on behalf of the shell’s real beneficiaries.
The secrecy is all well and good until the “corporate veil is pierced,” usually through legal proceedings against a shell company that isn’t set up properly or doesn’t file proper paperwork when and where it has to.
That’s why law firms are used. They keep clients on the proper paths as best they can.
That’s all for today… on Friday, I’ll go over who has resigned, who’s going to have to resign, which governments are in serious jeopardy, and who the biggest losers will be.
And that’s not all…
I’ll tell you how law firms are going to be impacted, and more importantly, how bankers and banks are going to get hit by the fallout… and how you can make money when they get taken to the woodshed.
The auto loan business is booming – total auto loans in the U.S. are up 50% from 2010 to December 2015.
But of the more than $1 trillion auto loans outstanding, Experian estimates that between $205 and $388 billion are subprime loans, with 15% to 20% of those loans securitized.
We’ve been here before – though in much worse trouble – back in 2007.
Now, when you consider that U.S. subprime mortgages outstanding in 2007 were $1.3 trillion (based on Ben Bernanke’s remarks from May 2007) and mortgage-backed securities and MBS derivatives based on those subprime loans outstanding probably totaled another $2-$4 trillion, subprime auto loans don’t come close to the depth and breadth of subprime mortgages back in the day.
Still… when the subprime auto bubble pops, it’s going to be messy – and smart traders are going to have the opportunity profit… if they know where to look.
Today, I’m going to break down the growing subprime auto loan bubble, including how we got here and where I think we’re headed.
Then, I’ll show you how to profit…
The Securitization of Subprime Auto Loans
The mortgage meltdown that triggered the Great Recession started with late payments, and right now subprime auto loans are starting to head down the same road.
According to Fitch Ratings the 60 day delinquency rate (loans at least 60 days past due) on an index of securitized subprime auto loans just hit 5.16%. That’s more than during the Great Recession and the highest level since 1996.
Net losses on securitized subprime auto loans are 7.5%, based on S&P data.
The market for subprime auto loans is big and getting bigger every day because more players are getting into the business.
Besides banks like Wells Fargo and Ally Financial that make subprime auto loans, small, rapidly growing non-bank lenders backed by hedge funds and private equity shops are popping up everywhere.
Companies that specialize in subprime lending like OneMain Holdings in Evansville, Ind., and Avant, a Chicago-based online lender who has generated $2.8 billion in unsecured personal loans since 2012 and jumped into the auto lending game, are all the rage.
Sheila Bair, the former head of the FDIC from 2006 to 2011, just joined Avant’s board, citing her long-held desire to make credit more widely available. But that, of course, is another story for another time.
The reason it’s so easy and lucrative for so many upstarts to get into the business and grow is that most of the loans they make are being securitized and sold off to investors.
As proof of the rapid growth of the securitization of subprime auto loans, Exeter Finance, which securitizes loans and markets them and is now the third-largest issuer of subprime auto bonds, grew its portfolio from $150 million three years ago to over $2.8 billion today.
It’s a profitable business all around… but it’s not sustainable. That’s thanks to increasingly questionable lending practices brought about by increased competition.
It’s Only Going to Get Worse
Lenders not only finance new and used cars, they finance everything from down-payments and warranties to undercoatings. And believe it or not, they are now offering “cash out” refinancings.
That’s right – subprime borrowers can refinance their already expensive auto loans and take cash out.
And because the game is so lucrative, increasing competition is lowering standards and making lenders stretch further and further out on the “bad borrowers” tree to find takers of their high interest rate loans.
You know this going to end badly.
Lenders typically charge between 9% and 36% interest, with 9% being pretty rare.
For comparison purposes, the average 60-month new car loan to prime borrowers is 4.05%.
The average loan term on subprime auto loans is 72 months.
While longer terms make monthly payments smaller, there’s a problem with depreciation of the underlying asset while the loan’s outstanding.
It’s just an accident waiting to happen…
One Way to Profit from the Subprime Auto Bubble
As I said, subprime auto loans imploding won’t have the same impact that subprime mortgages had on the global economy. So you don’t have to worry about betting on the world tumbling into another Great Recession.
That said, there aren’t a lot of ways to make money on rising defaults on subprime auto loans – as of right now, banks aren’t lining up to take the other side of derivative short trades.
But there is one trade that makes a lot of sense right now and can make you some good money when the bubble finally bursts.
One of the biggest players in the subprime auto loan game is Santander Consumer USA Holdings (NYSE:SC), a unit of Banco Santander SA (NYSE:SAN), the giant Spanish bank.
SC is a stock you want to short.
They’re already bleeding. SC just delayed its 10K filing twice because it was forced by securities regulators to restate three years’ worth of earnings because they didn’t properly account for “material weaknesses” in their loan book.
Presumably by accident, SC did not adequately provision for bad loans, which funnily enough, were worse than they knew. After adjusting “troubled debt restructurings,” Santander Consumer’s fourth quarter 2015 profits were knocked all the way down to $12 million… from a previously trumpeted $67.7 million.
That’s bad… but believe it or not, it gets even worse.
What I find really disturbing is that in spite of that “correction,” when the company restated earnings for all of 2014 and all of 2015, profits were only adjusted down 5% each year.
Something’s not right there.
And, as far as guidance, the company just said in January that 2016 would be a tougher year on account of increasing competition.
Now I think you get it. This whole subprime auto merry-go-round is eventually going to throw a lot of riders off their painted ponies.
If you want to bet on the crash of the subprime auto loan game, I like shorting Santander Consumer USA Holdings (NYSE:SC) at the market.
Use a tight stop if you want. But I’m going to short more on any big jumps in the stock.
For several months now, I’ve been telling you about the dangers of online lending, also known as peer 2 peer lending.
Back in December, I told you that you’d be better off borrowing from online lenders than investing in their stock.
And I was right.
Since then, online lenders have seen their stock prices pummeled by various market forces – however, things could soon get much worse…
Right now, the Supreme Court is giving serious consideration to a case that could undo decades of precedent… and absolutely crush online lenders.
Today, I’m going to tell you why the case could represent a landmark in finance… and more importantly, I’ll give you a trade that can deliver profits no matter how the court ultimately rules.
But before we do that, I need to give you a short history lesson on how we got here.
Let’s do it…
Undoing Decades of Legal Loopholes
While some states have usury laws that limit how much interest lenders can charge, other states have no usury laws.
The way lenders get around state usury laws is by setting up their businesses in states that don’t have usury laws and “exporting” their high interest rate charges across the country.
Now you know why your credit card bill comes from company headquarters in places like Sioux Falls, South Dakota, Las Vegas, Nevada and Wilmington, Delaware.
Back in 1978 the Supreme Court ruled in Marquette National Bank of Minneapolis v. First of Omaha Service Corp. (a subsidiary of the First National Bank of Omaha) that the Omaha bank, being a nationally chartered bank, could “export” the interest rates allowed in its state to customers in Minnesota and throughout the country.
Fast forward to May of last year, when the Second Circuit Court of Appeals ruled in Madden vs. Midland Funding (a Bank of America subsidiary) that Midland, which sold charged-off credit card debt (including the debt Madden owed) had no legal authority to transfer its ability to charge in excess of state interest rate caps to buyers of its charged-off debts.
While the Second Circuit Court’s ruling is only binding in New York, Vermont and Connecticut, if it’s upheld by the Supreme Court, it would apply to all 50 states.
Of course, banks and lenders want the Supreme Court to overturn the Second Circuit’s ruling.
For its part, the Supreme Court looks like it wants to hear the case. While it hasn’t decided yet to put it on its docket, the court has invited the Solicitor General of the United States (part of the Justice Department) to file a brief in the case.
That means the Court wants the Obama Administration to weigh in, potentially letting the Consumer Financial Protection Bureau advocate on behalf of consumers it fights for against the likes of loan shark lenders.
Typically, if the Supreme Court asks the government for its view on whether an appeal should be granted, they usually end up taking the case.
So the odds are good that Madden v. Midland will make it to the high court.
Here’s what it means for online lenders…
Online Lenders Could Be Crushed by This Decision
While the case has ramifications for banks, credit card companies, other lenders, and the securitization market, online lenders may be the most exposed to an adverse ruling.
Online lenders (or peer 2 peer lenders) partner with small, nationally chartered banks that act as the lending intermediary between online funders and online borrowers.
Online lending companies like Lending Club Corp. (NYSE:LC) and OnDeck Capital Inc. (NYSE:ONDK) have their small national bank partners initiate loans, with whatever interest rates they can charge, which are then immediately packaged and sold to the online company whose funders provide the money to buy the bank initiated loans.
The whole online lending business model, at least the ability to charge high interest on loans, would be jeopardized if the Supreme Court rules online lenders can’t hide behind any small national bank’s ability to circumvent state usury laws by extending that authority to a non-bank lender.
Both Lending Club and On Deck’s stock prices have been pummeled almost since they debuted. Part of the reason is fear that the online lending business has never faced a recession and if the U.S. enters one, high-risk borrowers on lending platforms could default in droves, causing serious pain for funders and the companies whose platforms are in the line of fire.
There’s no chance those stocks are now going to pop higher if the Supreme Court takes up Madden Vs. Midland. In fact, the only chance they have of seeing any light is if the Court hears the case and reverses the appellate Court’s ruling.
The Best Bet Against Online Lenders
One way to bet against online lenders is by shorting the newest player on the field.
Square Inc. (NYSE:SQ) the Jack Dorsey company that invented the little white square point-of-sale credit card reader, is about to get into the online lending game.
Square debuted back in November 2015 and has been on a rollercoaster ride ever since. It traded as low as $8.06 and is now at $13.95 – very close to its all-time high of $14.78.
Some of the buoyancy the stock’s been enjoying of late is in anticipation of SQ getting into the online lending business.
But based on how the other publicly traded online lending companies stocks have fared, I’m inclined to think Square is headed right back down to its lows.
SQ could get knocked back just on the news that the Supreme Court will hear the case – meaning we could see some quick profits regardless of how the court ultimately rules.
And if the Supreme Court decides against national banks’ ability to export their high interest rates, Square could collapse quickly.
I like shorting Square Inc. (NYSE:SQ) here, near its highs and using a 20% stop to cover your short if legal questions about the online lending model get favorably resolved.
It’s a reasonable risk/reward way to take a shot on Square getting potentially flattened if the Supreme Court overturns decades of precedent in Madden v. Midland.
Stocks have been on a tear. After looking weak in February, when the bottom could have fallen out, stocks have soared close to 13% in a matter of weeks, we’re finally here: positive for the year, above the market’s important moving averages, above resistance, and just plain sitting pretty.
So why does it all feel like a magic trick? Why isn’t the market giving investors any solid feelings? Why is everyone so nervous?
The reason it’s hard to get a handle on the market is because the old free market is gone. The free market isn’t free any more.
There are two major forces manipulating markets right now – but it’s nothing more than smoke and mirrors designed to push stocks higher and give the illusion of healthy markets.
I’ll tell you what’s going on, who’s responsible, and what you need to do now.
So far in the first quarter of 2016, companies have spent a combined $146 billion buying back their own shares, already surpassing the total for the entire first quarter a year ago. According to research from Bloomberg, that number could hit $165 billion.
Some of the biggest companies in markets are using buybacks to boost the value of their own shares, including:
FedEx Corp. (NYSE:FDX) – Announced $3.25 billion in new buybacks (on top of the $8 billion it’s already spent since September 2014).
General Motors Co. (NYSE:GM) – Expanded announced buybacks from $5 billion to $9 billion (ending in 2017).
Schlumberger Ltd. (NYSE:SLB) – Authorized $10 billion in new buybacks (after cutting 10,000 jobs in Q4 2015).
Wells Fargo Co. (NYSE:WFC) – Expanded its buyback plan to as much as $17 billion.
If you’ve got exposure to any of these companies, it might be time to rethink your investments…
I’ve already told you that stock buybacks represent one of the most insidious bits of financial engineering in the markets – executives that authorize these lavish buybacks can claim that they’re doing so to return money to shareholders when what they’re really doing is lining their own pockets.
But analysts and other market watchers are finally starting to take notice… because right now, the gap between investor capital in the markets and corporate money in the markets that’s being used on buybacks is wider than it’s ever been.
It’s not an overstatement to say that the majority of interest in stocks is from companies buying up their own shares. In fact, Liz Ann Sonders, chief investment strategist at Charles Schwab, recently told Business Insider, “On a cumulative basis there has not been a dollar added to the US stock market since the end of the financial crisis by retail investors and pension funds.”
You read that right – the bull market that’s raged since the end of the financial crisis was, by one measure, due entirely to buybacks.
This is unsustainable. Someone needs to fix this mess, and soon.
Unfortunately, the very people who could fix it aren’t going to lift a finger…
Why hasn’t a single “I want what’s right for the economy” politician in Congress, or a single economic hack in the Obama administration (to say nothing of the master giver-awayer himself), or a single wannabe presidential poser on the political trail in 2016 ever talked about how bad stock buybacks really are for the economy?
It’s because the dirty truth about stock buybacks is they’re part of dirty politics.
Share buybacks used to be frowned upon. In fact they were considered a form of stock manipulation by the SEC.
But 33 years ago, Congress pushed the SEC to make buybacks kosher due to the uptick in stock options as part of executive compensation packages. Obviously, those executives want to push their stock prices up to exercise those options profitably while not diluting earnings per share.
Fast forward to financial engineering.
Buyback programs are now the preferred way executives legally manipulate their stock prices.
The justification for buybacks – whether they’re funded out of cash flow or debt financed – includes rubbish like they’re a good investment when shares are “undervalued,” they’re an effective way of returning capital to shareholders, and they reduce share count against which dividends have to be paid out.
But the truth is different.
Just because executives believe their shares are undervalued doesn’t mean they actually are. The market might be discounting the share price because it doesn’t see earnings growth ahead, or maybe because earnings are going the wrong way.
If a company is generating regular excess cash flow and can’t find an earnings-building avenue to invest it in, why don’t they pay a dividend, or up the dividend payment they’re making?
Note to managers: you’re not a “growth” company if you’re generating regular free cash flow and not reinvesting it. You’ve matured to the point where you should pay dividends.
And if you’re debt financing your buybacks while calling yourself a growth company, you’re immature, or worse.
The justification about buying back shares to reduce the number of shares that dividends are paid out across has some merit. But if a company keeps buying back shares because it keeps generating more cash, at some point as an investor I’d have to ask management, why don’t you just pay me a bigger dividend?
If share buyback programs were still viewed as manipulation schemes, the trillions of dollars spent – and the hundreds of billions wasted when share prices went down – would have been spent instead on capital improvements, paying higher wages, growing businesses, and paid out in the form of dividends.
Investors of all stripes would benefit and so would the economy. Whether dividends are reinvested, added to the savings pool, or spent, the economy benefits.
Here’s the Dirty, Rotten Truth
The truth is if buybacks weren’t allowed and companies paid out all that money as dividends, there wouldn’t be any “double taxation.”
Corporations would order their lackeys in Congress to change the laws so their dividend payments could be deductible at the corporate level. They could get that passed in a second… if they wanted to.
But it’s better for companies to complain that dividends are double taxed, first at the corporate level and again when investors are paid out. That way they can justify a “better” way of distributing capital to their shareholders, through the magic of buybacks.
How convenient that the “better” way to return capital to shareholders enriches executives at the expense of growing the business, at the expense of investors in the business, and ultimately at the expense of the economy.
Forget about the math of a few worried analysts who estimate that as much as 100% of the stock market’s rise since 2009 is attributable to the more than $2.4 trillion in buybacks since the financial crisis, and if the market collapses most of that money will have essentially evaporated.
What matters is if all that money had made its way through the economy, the economy, the country, savers, and investors would be better off, not just the handful of executives who’ve grossly enriched themselves while pretending their financial engineering wasn’t manipulative.
So, ask your senator or representative, ask anyone in power, ask anyone on the wannabe political trail – what are you going to do about the buyback game?
Ask if they understand how the economy could have benefited if those trillions of dollars would have been efficiently circulated throughout the economy in the form of capital expenditures, more jobs, higher wages, dividend payouts.
Ask them how much the corporations who buy back their shares spend on lobbyists.
Ask them how much they contribute to their campaigns.
Ask them why they aren’t fighting to end double taxation of dividends.
Ask them if they understand how the economy works, if they know how the stock market works, and if they have any idea that buybacks are a stock manipulation scheme that screws everybody working in the real economy.
And if you get a straight answer from any of them, send me an email or drop a note in the comments below. I’d love to hear from you.