Tag Archives: CFA

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.            

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

A Letter from Our Society President

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Joshua M. Howard, CFA

CFA Society Minnesota’s Immediate Past President, Kim Brustuen, and I hosted a call last week for all Midwestern U.S. Society leaders to discuss best practices in building and running an effective Board. This is something our society has been focused on for a few years now, and we have made tremendous strides in moving from an operational board to a strategic board. During the call we shared our growing pains, struggles and accomplishments with over 20 other regional Society leaders and Institute employees.

One of the reasons we have such a respected Board is our ability to source volunteers. We have a large board (currently 24 members) and over 100 active volunteers that serve on our committees and help with individual events. This allows us to be innovative and try new things while still maintaining our popular events and programs. One of our main points on the call to Society leaders was that it is never too early to start planning for the next round of new volunteers. Although we currently have an abundance of energetic, thoughtful people on our Board and our committees, we must continually replenish our volunteer base. Every year we have 3-5 Board spots open up as long-time volunteers roll off the board, and committees frequently have volunteers who join or leave throughout the year.

When we prepare for Board transition we look for new Board members and committee volunteers from a variety of industries – some even outside of finance, such as people with experience in human resources, accounting or law. We look for a diversity of ages, experience and viewpoints. We strive to represent the interests of the entire body of local members and of all occupations either directly or indirectly related to investment management. Many people do not realize that you do not have to be a charterholder to be on our Board or to volunteer with one of our committees. Event and committee volunteers technically do not even need to be local society members, though most choose to join once they start volunteering.

Our Nominating Committee for the upcoming fiscal year will begin their work in May, but it is not too early to put out the call for new volunteers. If you have an interest in joining our Board, assisting with a single event, or helping one of our committees please let me know and I will get you in touch with our staff or a committee chair.  If you want to learn more about volunteering in general please send Kris Kautzman or me an email and we can discuss the current opportunities. I guarantee we have a spot for any level of time commitment. If you know of someone who might be a good fit we also accept referrals.

To all our past, current and future volunteers, thank you so much for your contributions to the CFA Society of Minnesota.

Joshua M. Howard, CFA
President, CFA Society Minnesota

Distinguished Speaker Series Featuring Bob Doll, CFA, CPA – Event Recap

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By Harvey R Peck, CFA

On Thursday, February 11, 2016, CFA MN hosted a presentation by Bob Doll, Senior Portfolio Manager and Chief Equity Strategist at Nuveen Asset Management. After a light dinner at the Minneapolis Club, Mr. Doll shared his highly respected views and perspectives on the global equities markets. You may recognize Bob Doll as a regular on CNBC, Bloomberg TV and Fox Business News with Doll being quoted in other business publications.

Vicious negative feedback loop
Doll opined the equity markets are in a “terrible funk”, a vicious negative feedback loop. As global growth estimates decline, oil prices drop, earnings estimates are revised down, stock prices fall, there is forced selling, credit standards tighten, then global growth estimates decline, and the cycle repeats itself.

How do we extract ourselves from this funk? Oil needs to stop going down. The U.S. dollar needs to stop appreciating. Problem: Oil and commodities are in a multi-year bottoming process.

Can the U.S. economy avoid importing these global deflationary trends?
Doll noted the U.S. economy is doing better than most other developed economies. It is primarily a domestic consumer economy. Doll is forecasting U.S. real growth at mid 2% and nominal GDP growth at 3-4%.

The U.S. consumer economy is doing relatively well as supported by strong new housing starts, firm home resale prices and record auto sales.The Federal Reserve’s inflation targets are within reach. Rising U.S. domestic inflation expectations is supported by two factors: (1) a tightening labor market showing upward labor price pressures and (2) housing rents and home prices increasing.

Bull market in bonds over
The bottom in yields likely occurred back in July 2012. By 2016 year-end, Nuveen forecasts U.S. Treasury yields to be higher. Doll expects high yield credit spreads to be narrower and yields to be lower by year end. Nuveen contends high yield spreads are currently overreacting to the declining creditworthiness in energy and materials. However, these factors should not affect other non-industrial areas of the economy such as medical, information processing technology and media. Currently the high yield markets have corrected too much and the correction was too fast.

Political Issues
The U.S. federal deficit improvement trend is over. Rising entitlement costs over the coming years will cause the deficits to expand. The growing deficit is not yet problematic. Investors are encouraged to wait until the government’s ability to service debt is rising faster than GDP before implementing defensive strategies.

The U.S. needs bipartisan congressional action to address the problem of corporate income taxes on foreign based earnings. The current tax law is fostering large capital outflows from the U.S. economy. This is a very important issue for the long-term viability of the U.S. economy.

Recommendations
Nuveen recommends overweighting allocations to equities, underweighting bonds and fixed-income and holding an overweight in cash reserves. They expect above average volatility. Most investors will be frustrated by the current environment of higher volatility and low returns.

We thank Bob Doll and Nuveen Asset Management for sharing their thoughts and recommendations. You can follow Bob Doll’s commentaries and other Nuveen Asset Management research publications at www.nuveen.com/home. Thanks again to Nuveen Asset Management for their support of CFA MN.

Developments in Volatility & Option Markets – Event Recap

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by Steve Dixon, CFA

On January 12, 2016, Mr. Russell Rhoades from The Options Institute shared his insights and observations on the options market with Society members and other event attendees.  The discussion centered around the innovation of Weeklys just a few years ago and the proliferation of more frequent settlement of stock and index options that has resulted.  Weeklys are now available on about 350 stocks and about 70 ETFs.  Still, Mr. Rhoades was puzzled by the relatively slow uptake by institutions to utilize options contracts that settle each week compared to the traditional monthly settled contracts.  Outside of the institutional realm, trading in Weeklys has been the source of growth of the CBOE over the past several years.

Mr. Rhoades spent time explaining the opportunity inherent in selling at-the-money options with a week or less to expiration to capture the time decay of the contract premium.  This time value, which erodes gradually during much of the contract’s life, accelerates toward zero in the final few days to expiration thereby providing the sweet spot for traders looking to capture the natural decay of part of the contract’s value.  This acceleration isn’t as prevalent for contracts trading in-the-money.

The discussion turned to VIX, as all do these days.  Weeklys on VIX were introduced about six months ago and seem to provide the closest replication of VIX that is possible at present.  In a graphical display, Mr. Rhoades showed the overlay of a VIX Weekly contract over the final five trading days to expiration with the index itself.  The two moved very similarly even when VIX experienced sharp changes.  The mean-reverting nature of VIX provides opportunity for traders and hedgers as well.  The complication has been the effective replication of VIX, to which Mr. Rhoades believes short-dated VIX options provide the best solution to date.

Noting that “the market takes the stairs up and the elevator down”, Mr. Rhoades highlighted several indexes that the CBOE has created that pair traditional long-only positions with a variety of options strategies.  Among his favorite are the CBOE S&P 500  PutWrite Index and the CBOE S&P 500 2% OTM BuyWrite Index.  The former generating absolute and risk-adjusted returns superior to the S&P 500 Index over the past 25-plus years.  Displaying his innovative foresight, one society member suggested that the CBOE consider a 30-Delta PutWrite Index, which seemed to preoccupy Mr. Rhoades with excited anticipation for the remainder of the presentation…only at a CFA luncheon could such a sentence be written!

Mr. Rhoades was an effective presenter, drawing on CBOE trading data and personal experience to illustrate what’s new in the world of options.  Keep an eye on Russell 2000 Index options as they have been the fastest growing index option series of late and as volume improves may offer better opportunity for more effectively hedging portfolios.