For the past several months, the Securities and Exchange Commission (SEC) has been working to crack down on the use of adjusted earnings practices.
They’re threatening to tighten regulations and force companies to be more transparent.
That word always comes with a sting. Regulations – the dreaded “R” word. It’s perhaps the most hated word in all of finance.
Indeed, new regulations could pose a major problem for thousands of U.S. companies. Investors might finally realize the emperor has no clothes.
Last week, The Wall Street Journal published an article stating that the SEC will continue to expand its recent policy. Beyond the increased use of adjusted earnings per share, companies have also been relying on non-GAAP measures of accounting. The SEC realizes that’s got to stop.
GAAP stands for “generally accepted accounting principles.” So, non-GAAP basically stands for “free-for-all.”
Of course, what’s acceptable isn’t always easy to understand. Management teams have a lot of leeway in the presentation of quarterly results. This can make it difficult for investors to determine what factors actually drive the company’s reported results.
So when it comes to non-GAAP earnings, companies are deliberately masking expenses to paint a rosier picture of their performance.
Is anyone really surprised the SEC has a problem with this?
It’s the same reason why I’ve been harping on and on about the use of adjusted earnings. Non-GAAP, by definition, means using accounting principles that aren’t even standardized. Much of it is left to discretion. It makes it easier for companies to pull the wool over investors’ eyes.
Recently, I talked about how over 90% of companies are using these measures, compared with 70% in recent history.
I target many of these companies in my newsletter, Forensic Investor. I believe that every investor should know that earnings are being adjusted to better reflect on the company. These reports don’t necessarily include factors that are important for analyzing the company’s business.
But, in a day and age where we live in bite-sized bits of information of 140 characters or less, people often just look at the headline earnings report.
They don’t give due diligence to really understand what’s driving the company’s performance in a given quarter.
In fact, the earnings release is largely useless. There’s not a whole lot of meat on the bone. Yet it often coincides with when a stock goes up or down the most! That’s why it gets so much attention.
The good stuff doesn’t come out until weeks or even months after the earnings reports. All the juicy details are buried in the notes of the SEC filings. Sadly, very few people actually read these documents.
It’s this type of analysis we conduct in Forensic Investor.
It should be no surprise that management teams will adjust earnings to their benefit. A large part of their compensation is tied to keeping the stock prices headed in the right direction – that is, up. Wall Street is very short-term focused. Quarterly results hold huge consequences for a stock price, even though businesses should be managed for the long-term.
And the impact of non-GAAP earnings is huge. According to the Journal article, GAAP earnings didn’t grow from 2012 through 2015, while Non-GAAP earnings were up 14%!
So given the SEC’s increased focus on these adjusted measures, companies might get the carpet dragged out from under them. It could expose them for excluding items that should not have been excluded.
For example, if profits suffer due to extreme weather, companies might write that off as an anomaly, no matter if it actually affected their earnings. Opening a new store? It’s a one-time expense. Supposedly, it doesn’t reflect normal operating expenses. Investors don’t have to worry about it.
These expenses might be non-recurring in nature, but they’re still expenses. Yet, they’re excluded from non-GAAP earnings.
What remains to be seen is whether investors will continue to ignore these low-quality sources of reporting and buy into the non-GAAP measures…
Or, will more SEC scrutiny give investors cause to sell stocks.
Generally, investors tuck tail and run from a stock when the SEC is sniffing around…
Whichever way you look at it, earnings are coming under pressure. At this point, normal market forces could tighten the noose just as well as the SEC is threatening to tighten regulations. The market’s been artificially propped up. One way or another, it’s going down.
In the meantime, we’ll continue to expose low-quality sources of earnings in Forensic Investor, and catch management teams with their hand in the cookie jar.
John Del Vecchio
Editor, Forensic Investor