Category Archives: Local Charterholders

How Investors Should Navigate the Non-GAAP Earnings Confusion

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Adam Schwab, CFA, CFP

An Introduction and Three Guiding Principles

There has been a recent surge in the controversy surrounding non-GAAP earnings. While the debate continues on the proper use of non-GAAP metrics, investors can’t expect outside help and need to take control of their own understanding and interpretation of non-GAAP adjustments. Investors can’t rely on “guidance” from companies or regulators.

The problems run deeper than the GAAP vs. non-GAAP debate. The actual problem is investor’s lack of commitment to a thorough, fundamental understanding of the company. Without adequate understanding, investors will never be able to tell non-GAAP truth from fiction.  There is never a hard and fast set of rules to determine the validity of GAAP exceptions. Like any set of standards, there are exceptions and situations that don’t fit the model. The extreme doubters of GAAP or non-GAAP miss the point: no system is perfect. It’s the investor’s responsibility to determine the best representation of economic reality. Blind devotion to SEC guidance, FASB standards, or company management is a dangerous path.

This series of articles will help guide investors into asking the right questions involving non-GAAP metrics. This advice cannot replace actual analysis, but will give investors a better framework for thinking about these issues.

3 Rules to Remember

  1. Always reconcile each adjustment using the GAAP to non-GAAP reconciliation

Regardless of a company’s adjustments, investors should always reconcile to GAAP earnings. This figure, required by the SEC, allows investors to see a clean breakdown of non-GAAP adjustments. Unfortunately, that’s the easy part. The hard part is understanding what items are legitimate and which are not. Analyze every line item on an individual basis to determine its validity. One or two adjustments account for most of the deviations from GAAP. Unfortunately, there are no clear cut answers on which expenses are legitimate and which are egregious. Materiality depends on the company and industry dynamics. The only way to know is to dive deep into the business and financial statements.

  1. Pull up and compare reconciliations for the past 5 years

Don’t limit your analysis to the current year. Compare what “recurring”, non-recurring expenses have been consistent over many years. Repeated appearance is clear evidence that these charges are recurring in nature, even as management argues “one-off” or too volatile/unpredictable. In fact, a quick glance at successive reconciliations should show no yearly correlations between line items. Also, understand that the absence of repeated charges doesn’t mean one-time charges are legitimate. Evaluate every adjustment on its own merit.

  1. Match the reconciliation to the business model

Serial acquirers should not have their acquisition-related charges excluded. Acquisitions are part of their strategy and the associated expenses are legitimate and recurring. Major problems develop when analysts and management teams guide to high top and bottom line growth without the necessary acquisition spending to support that growth. It’s unfortunate that overconfident/aggressive companies and investors permit this mismatch to make valuation, free cash flow, and EPS more impressive. Some quick investor math on the implied ROICs would show an unsustainable level of ROIC into the future.

Look for Part 2 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.            

Too Big To Fail

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Susanna Gibbons, CFA

On May 16th, The Heller Hurwicz Economic Institute at the University of Minnesota hosted Neel Kashkari, President of the Minneapolis Federal Reserve, in a conversation on his Too-big-to-fail initiative. During the financial crisis, Mr. Kashkari ran the much-maligned TARP program, in which all banks in the US were infused with cash in an effort to “un-clog” the financial plumbing and allow markets to return to normal functioning. Mr. Kashkari was very clear that he felt the TARP program was necessary, that the Fed’s primary mistake in the crisis was that they were always reacting late, but that they were nonetheless very uncomfortable with the interventions which they felt were required. He was also very clear that the conversation he has started is intended to explore a wide range of transformational options with respect to the banking system, including breaking up the largest banks, or regulating them as public utilities, and that the Minneapolis Fed  is in the process of gathering information and opinions on this topic.

Mr. Kashkari was, however, resolute in his opinion that some action needed to be taken, and that the perhaps-majority opinion at the Fed that Dodd-Frank should be allowed to work before they shake things up was not an acceptable outcome. Something needs to be done, he believes, to put an end to too-big-to-fail forever. The basic philosophy, which on its face sounds quite reasonable, is that the public should not have to risk anything to support banks, that it is inherently unfair to use public funds to protect banks’ equity holders during a crisis since banks are private, for-profit institutions.

But does this philosophy actually makes sense? What we are really concerned about is having a banking system that is able to withstand a crisis, but we do not want to be forced to rely on systemically-focused tools like providing crisis-based market support. Instead, we are determined to identify a banking structure – whether through a better mix of businesses or a higher capital requirement – that has no negative impact on the public wallet.

The underlying philosophy, in my opinion, is illogical. Let’s just focus on the capital requirement. Many theoreticians would like us to believe that higher capital requirements are costless (or even beneficial), since they result in lower debt costs and greater capacity for risk-taking by banks. This is essentially a souped-up version of Miller-Modigliani, an application of that frictionless world of firm capital structure to the entire economy.  Most bankers are on the other side of this argument – they believe that higher capital requirements result in a higher overall cost of capital, which constrain a bank’s ability to lend, thereby limiting economic growth overall. A recent review of academic literature in a DNB Working paper titled Effect of bank capital requirements on economic growth: a survey, found that most empirical evidence suggests that an increase in capital costs of 100 basis points reduces lending by anywhere from 1.2 – 4.5%. While the paper was careful not to extrapolate from this to an expected impact on GDP overall, I would argue that a lending reduction of this amount spread across an entire economy would have a measurable impact on GDP. If the growth impact on our $18 trillion economy was just 10 basis points annually, over a ten year period this lower growth would cost the US Economy about $1 trillion in GDP – more than the 2008 bailout. And let us not forget that the entire amount lent under TARP was repaid, so the cost to the taxpayer is probably best summed up as the interest paid on funds borrowed.

I fully realize that in that last paragraph I am just making numbers up. My point is to simply place what seems like a modest growth impact in context with respect to the perceived unfairness of providing stability to the banking system during a crisis. There is no solution to this problem that is costless to the public, and it is entirely possible that the cost of building an unassailable fortress around the banking system is significantly greater than the cost of supporting the system in crisis.

A Letter from Our Society President

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Joshua M. Howard, CFA

With less than one month to go candidates are now in crunch time for the CFA examinations on June 4th. If you are a charterholder, you likely vividly remember the anxiety of these last few weeks before the exam, hoping that certain topics will be tested heavily, and that other topics will be avoided. You may also remember the constant checking to make sure you have the right ID, verifying that you packed enough writing utensils, practicing the route to River Centre (and maybe a backup route as well) and wondering how many backup batteries you really need for your calculator (is four too many?).

As we have for the past three years, CFA Society Minnesota provided prep classes at all three levels this year, offered over the course of three weekends in April and May. More than 60 candidates attended these classes, including a sold out Level II class. A big thank you to Travis Simon, our class coordinator, and all the instructors for the work they put in over the past few months helping candidates prepare for the exam.

In addition to those who took our classes many other candidates were involved in our study groups or used their Society membership to receive discounts on Schweser products. Candidate preparation is a core component of the work CFA Society Minnesota does, and I wish all candidates the best of luck on June 4th.

If you already are a charterholder please don’t forget about our post exam party, beginning at 4:30pm on exam day at the Eagle Street Grille in St. Paul. Come celebrate with the test takers at all three levels as they enjoy a much needed respite from studying and taking practice tests. Tell the candidates how great it will be when they finally pass Level III and receive the charter, at which point they can burn their CFA books in a celebratory bonfire – or, for the CFA nerds out there, prominently display them in their office. Just don’t tell them that the CFA exam nightmares will go away (e.g. forgetting your ID, being asked only FSA and quant questions, going to the wrong location, the Institute deciding to add a fourth level before you finish, etc.). As a couple coworkers of mine were discussing just the other day, including one who got the charter over 30 years ago, those nightmares still occasionally occur.

Joshua M. Howard, CFA
President, CFA Society Minnesota

Department of Labor Fiduciary Rule, End of the World or No Big Deal*

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Jonathan Levy, J.D.

Unless you have been living in a cave, you have probably heard that on April 6, 2016, the Department of Labor (“DOL”) announced that investment professionals that provide investment services to IRA’s and other employer-sponsored retirement plans will be subject to fiduciary duties.  This event has been described as the coming of the apocalypse by the brokerage industry, or about time by investment advisers because these folks have always been subject to fiduciary duties.

Suitability vs Fiduciary

Prior to the effectiveness of the DOL’s action, investment professionals that provide advice to IRAs are not subject to ERISA’s prohibited transaction rules.  This means that broker-dealers and their registered representatives are subject to a suitability standard under FINRA rules.  Suitability essentially requires that the investment professional have a reasonable basis to believe that a recommended investment strategy is suitable for a client based on information available to the investment professional through reasonable diligence.  A fiduciary standard generally requires that the investment professional put the client’s interests first, act with utmost good faith, provide full and fair disclosure of material facts, avoid misleading clients, and disclose conflicts of interest.

Conflicted Advice

The DOL claims that investment firms not subject to a fiduciary standard steer IRA clients into investment products that have higher fees and lower returns.  The DOL alleges that these conflicts of interest cost $17 billion a year, and result in a 100 basis point lower annual average return.  The DOL claims that $1.7 trillion of IRA assets are invested in products that provide payments to investment professionals that generate conflicts of interest.  What the DOL is focused on are traditional securities brokerage commissions, revenue sharing with plan administrators, front-end loads, 12b-1 fees and other payments to brokerage firms for IRA asset management.

Best Interest Contract Exception

In response to the very loud complaints and political influence from the brokerage industry, the DOL adopted a special exception for fees to broker-dealers.  Under the Best Interest Contract Exemption or BICE, brokers can advise IRAs and receive revenue sharing, 12b-1 fees, brokerage commissions and even sell proprietary products managed by the broker, if the broker-dealer commits to putting client’s interests first, adopts certain anti-conflict of interest policies and procedures, and discloses conflicts that could affect the broker’s judgment as a fiduciary.

IRA Beneficiaries Can Bring Claims; Effectiveness

Finally, the new DOL rules permit IRA and other retirement plan beneficiaries to bring private causes of action or claims against investment professionals that violate the new rules.

Because these rules will require significant and expensive changes in the documentation and compliance policies of many large broker-dealers and their registered representatives, there is a long period of time before the rules take effect.  The new fiduciary standard is scheduled to take effect in approximately one year, and the BICE provisions will go into effect in January 2018.  But stay tuned, the brokerage industry is still complaining, and Congress has threatened to act against the rules.  Certain players in the brokerage industry have also threatened to try to block the new rules in court.

Why the Big Fuss?

What is the big fight really about?  As usual for big policy debates, it is about money, lots and lots of money.  With the baby boomer generation retiring there is a lot of retirement money to be managed in IRAs.  According to the Investment Company Institute’s 2015 Fact Book, as of the end of 2014, employer-sponsored retirement plan assets in the United States were approximately $24.7 trillion.  Of that sum, $14.2 trillion consisted of defined contribution and IRA assets, with the remainder in defined benefit plans.  Over the past fifteen years, the total assets in retirement plans have increased significantly, and the share of assets in defined contribution and IRAs has continued to grow as defined benefit plans continue to shrink.  IRA assets have grown from $4.7 trillion to $7.4 trillion in the past seven years, with mutual funds by far the largest asset class of IRA assets.  For the next 14 years, approximately 10,000 baby boomers will turn 65 every day.  There is a lot of money to be made on investment management of those assets  and therefore a lot of stakeholders are fighting about these new rules.  To be continued….

 

* Jonathan Levy is a securities lawyer at Lindquist & Vennum LLP, and is a member of the Board of Directors of the Minnesota CFA Society.

How I Became a Quant

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Susanna Gibbons, CFA

The International Association of Quantitative Finance (“IAQF”) has been participating in a series of panels around the country titled “How I Became a Quant”, one of which was hosted locally by the University of Minnesota’s MCFAM (Minnesota Center for Financial and Actuarial Mathematics in the School of Math) on Friday, April 15 2016.  The discussions are focused on providing students and practitioners a personal view into the careers of a range of quantitative finance professionals. I had the good fortune to be asked to participate on the panel which presented in the Twin Cities, along with Anna Kincannon, Capital Planning Manager at Bremer Bank; Dharini Loknath, Petroleum Products Analyst at Cargill, and Michael Szwejbka, SVP Risk Analyst at US Bank. The panel was moderated by Chris Prouty, an instructor with the Master of Financial Mathematics (MFM) within MCFAM and exotics trader at Cargill.

To be clear – I am not a quant, nor did they expect me to be one. I introduced myself as a “Quant-a-be” (rhymes with “wannabe”), which basically means that my career in fundamental analysis, portfolio management, and asset management has repeatedly crossed paths with our more quantitative brethren, while my actual skills remain mired in prose and poetry rather than mathematics. In spite of my deficiencies, the discussion was excellent, and focused on a few key themes.

First, all of the panelists were in agreement over the importance of communication skills, and the need to work closely with business units on the development and implementation of models, whether they are risk management, decision making, or business analysis tools.  Without clear understanding of the business need, it is very difficult to develop successful tools, and yet much of our industry remains sharply divided along quantitative / not-quantitative lines. There is great opportunity for students who are successful in developing their skills in both areas.

Second, the panel dwelled on history for some time, and the importance of knowing exactly how we have gotten to where we’ve gotten. There is a lot to be learned from understanding market failures of the past, and the role that quantitative finance may (or may not) have played in those episodes. While the development of quantitative models seeks to guide forward-looking decision making, they are based to a large degree on history, and having a solid understanding of that history can help to identify key assumptions and potential weaknesses.

Third, there was a fair amount of conversation around the role that quantitative finance currently plays in the banking world, particularly around the implementation of the capital planning process and stress testing required by the Federal Reserve under CCAR. While there is not necessarily strong agreement around the ultimate effectiveness of CCAR, it is clear that this has become, and will continue to be a driving force around the employment of students with strong quantitative skills.

Finally, there were many topics covered of a significantly more technical nature, during which time I felt rather like Winnie the Pooh roaming the Hundred Acre Wood, humming a little hum to myself until something came ‘round which I recognized. And perhaps, in the end, that is all that we can ever do as Investment Professionals. By I really do believe that the continued evolution of quantitative finance provides those of us who wander with the best of hope of charting a course through the woods.