Tag Archives: CPA

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.            

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.