Tag Archives: earnings-center

Why EPS And Share Price Don’t Predict Future Performance

Most analysts, and especially “chartists,” put a lot of emphasis on earnings per share (EPS) and stock price movements when determining whether to buy a stock. Unfortunately, these are not good predictors of company performance, and investors should beware. Most analysts are focused on short-term – meaning quarter-to-quarter – performance. Their idea of long term is looking back 1 year, comparing this quarter to the same quarter last year. As a result, they fixate on how EPS has done and will talk about whether improvements in EPS will cause the “multiple” (meaning stock price divided by EPS) to “expand.” They forecast stock price based upon future EPS times the industry multiple. If EPS is growing, they expect the stock to trade at the industry multiple, or possibly somewhat better. Grow EPS, hope to grow the multiple, and project a higher valuation. Analysts will also discuss the “momentum” (meaning direction and volume) of a stock. They look at charts, usually less than one year, and if price is going up, they will say the momentum is good for a higher price. They determine the “strength of momentum” by looking at trading volume. Movements up or down on high volume are considered more meaningful than those on low volume. But unfortunately, these indicators are purely short-term, and are easily manipulated so that they do not reflect the actual performance of the company. At any given time, a CEO can decide to sell assets and use that cash to buy shares. For example, McDonald’s (NYSE: MCD ) sold Chipotle and Boston Market. Then, the leadership took a big chunk of that money and repurchased company shares. That meant McDonald’s took its two fastest-growing and highest-value assets and sold them for short-term cash. They traded growth for cash. Then leadership spent that cash to buy shares, rather than invest in another growth vehicle. This is where short-term manipulation happens. Say a company is earning $1,000 and has 1,000 shares outstanding – so its EPS is $1. The industry multiple is 10, so the share price is $10. The company sells assets for $1,000 (for the purpose of this exercise, let’s assume the book value on those assets is $1,000 – so there is no gain, no earnings impact and no tax impact.) Company leadership says its shares are undervalued, so to help out shareholders it will “return the money to shareholders via a share repurchase” (Note, it is not giving money to shareholders, just buying shares.) $1,000 buys 100 shares. The number of shares outstanding now falls to 900. Earnings are still $1,000 (flat, no gain), but dividing $1,000 by 900 now creates an EPS of $1.11 – a greater than 10% gain! Using the same industry multiple, analysts now say the stock is worth $1.11 x 10 = $11.10! Even though the company is smaller has weaker growth prospects, somehow this “refocusing” of the company on its “core” business and cutting extraneous noise (and growth opportunities) has led to a price increase. Worse, the company hires a very good investment banker to manage this share repurchase. The investment banker watches stock buys and sells, and any time he sees the stock starting to soften, he jumps in and buys some shares so that momentum remains strong. As time goes by and the repurchase program is not completed, he will selectively make large purchases on light trading days, thus adding to the stock’s price momentum. The analysts look at these momentum indicators, now driven by the share repurchase program, and deem the momentum to be strong. “Investors love the stock”, the analysts say (even though the marginal investors making the momentum strong are really company management), and start recommending to investors that they should anticipate this company achieving a multiple of 11 based on earnings and stock momentum. The price now goes to $1.11 x 11 = $12.21. Yet, the underlying company is no stronger. In fact, one could make the case it is weaker. But due to the higher EPS, better multiples and higher share price, the CEO and her team are rewarded with outsized multi-million dollar bonuses. But over the last several years companies did not even have to sell assets to undertake this kind of manipulation. They could just spend cash from earnings. Earnings have been at record highs – and growing – for several years. Yet, most company leaders have not reinvested those earnings in plant, equipment or even people to drive further growth. Instead, they have built huge cash hoards , and then spent that cash on share buybacks, creating the EPS/multiple expansion – and higher valuations – described above. This has been so successful that in the last quarter, untethered corporations have spent $238B on buybacks, while earning only $228B . The short-term benefits are like corporate crack, and companies are spending all the money they have on buybacks rather than reinvesting in growth. Where does the extra money originate? Many companies have borrowed money to undertake buybacks. Corporate interest rates have been at generational (if not multi-generational) lows for several years. Interest rates were kept low by the Federal Reserve hoping to spur borrowing and reinvestment in new products, plant, etc. to drive economic growth, more jobs and higher wages. The goal was to encourage companies to take on more debt, and its associated risk, in order to generate higher future revenues. Many companies have chosen to borrow money, but rather than investing in growth projects, they have bought shares. They borrow money at 2-3%, then buy shares – which can have a much higher immediate impact on valuation – and drive up executive compensation. This has been wildly prevalent. Since the Fed started its low-interest policy, it has added $2.37 trillion in cash to the economy. Corporate buybacks have totaled $2.41 trillion. This is why a company can actually have a crummy business and look ill-positioned for the future, yet have growing EPS and stock price. For example, McDonald’s has gone through rounds of store closures since 2005, sold major assets, now has more stores closing than opening and has its largest franchisees despondent over future prospects . Yet, the stock has tripled since 2005! Leadership has greatly weakened the company and put it into a growth stall (since 2012), and yet, its value has gone up! Microsoft (NASDAQ: MSFT ) has seen its “core” PC market shrink, had terrible new product launches of Vista and Windows 8, wholly failed to succeed with a successful mobile device, has written off billions in failed acquisitions, and consistently lost money in its gaming division. Yet, in the last 10 years, it has seen EPS grow and its share price double through the power of share buybacks from its enormous cash hoard and ability to grow debt. While it is undoubtedly true that 10 years ago Microsoft was far stronger as a PC monopolist than it is today, its value today is now higher. Share buybacks can go on for several years. Especially in big companies. But they add no value to a company, and if not exceeded by re-investments in growth markets, they weaken the company. Long term, a company’s value will relate to its ability to grow revenues and real profits. If a company does not have a viable, competitive business model with real revenue growth prospects, it cannot survive. Look no further than HP (NYSE: HPQ ), which has had massive buybacks, but is today worth only what it was worth 10 years ago as it prepares to split. Or Sears Holdings (NASDAQ: SHLD ), which is now worth 15% of its value a decade ago. Short-term manipulative actions can fool any investor and keep stock prices artificially high, so make sure you understand the long-term revenue trends and prospects of any investment, regardless of analyst recommendations.

The Problem With Leverage In A Portfolio

Barry Ritholtz has a new article on Bloomberg discussing San Diego County’s firing of a risk parity firm that used to manage part of its pension. Risk parity strategies often engage in using leverage. Cliff Asness, who runs AQR, a firm implementing risk parity approaches (among others), hated Barry’s piece and called it “facile” “innuendo”. He then referred to a piece explaining why he likes leverage in a portfolio at times. So, who’s right? Leverage is a bit like steroids. Steroids are neither good nor bad. They tend to magnify the effect of something and that can be good or bad depending on how it’s used. If you use steroids in specific targeted ways they can be an effective medical treatment. Likewise, if you abuse them they can be a destructive and unnecessary supplement.¹ Leverage is essentially the same thing. It will magnify the effect of a portfolio’s outcomes. There are very reckless ways to do this and very safe ways to use leverage. But one thing is almost always undeniable – leverage will cost you. And that’s the kicker. Borrowing money you don’t have is essentially a form of renting. And renters charge fees. The cost of leverage in a portfolio typically depends on the fee that brokers charge. This is usually a spread over LIBOR. This allows clients to fund their long positions and the broker pays some spread below LIBOR for cash deposited by the clients as collateral for short positions. The cost of the leverage will vary depending on who the borrower is.² The inherent difficulty in using leverage is that the fund manager is essentially passing on another cost to the end investor. That is, leverage reduces the real, real return of a portfolio by the cost of the leverage. In the aggregate we know that all managers are generating the market return minus their costs (taxes, fees, etc.) so if everyone started using leverage then our returns would be reduced by the cost of the leverage. And that’s the difficulty of using leverage in a portfolio. I like the concept of Risk Parity, but it’s hard to justify owning a lot of such a strategy simply because it’s an inherently expensive strategy to manage. And in a world that is likely to be a low return world that is potentially just adding another hurdle we don’t need. ¹ – I am not a doctor and I don’t even play one on TV. ² – This cost will vary on how the leverage is implemented. The cost of many risk parity approaches results from trading in more expensive underlying instruments such as reverse repurchase agreements, futures and swap transactions or certain other derivative instruments. In addition, many institutions are able to obtain this leverage inexpensively, but ultimately pass on the convenience of this exposure to clients in higher management fees. Share this article with a colleague

A Peek Under The Hood Of The New O’Leary Dividend ETF

Summary Kevin O’Leary, of Shark Tank fame, recently released his first U.S.-listed dividend ETF. The fund selects approximately 142 stocks based on factors that include quality, volatility, and yield. This passive index approach underscores a unique dividend oriented portfolio with solid fundamentals. Kevin O’Leary, of the Shark Tank fame, has morphed into one of the most polarizing investment figures on reality TV. Now he is taking his talents off-camera by releasing his first U.S.-listed exchange-traded fund focused on dividend paying stocks. The O’Shares FTSE U.S. Quality Dividend ETF (NYSEARCA: OUSA ) debuted this week to a great deal of intrigue by the financial media. Whether you love or hate O’Leary for his no-nonsense criticism and direct business style, this new ETF is certainly worth a look for serious income investors . According to the fund company’s website , “The Fund is designed to be a core investment holding that seeks to provide cost efficient access to a portfolio of large-cap and mid-cap high quality, low volatility, dividend paying companies in the U.S. selected based on certain fundamental metrics.” To achieve that end result, OUSA follows the FTSE U.S. Qual/Vol/Yield Factor 5% Capped Index. This fundamentally driven methodology selects stocks based on three core factors – quality, volatility and yield. The final portfolio is made up of 142 dividend paying companies with an average yield of 3.20%. Top holdings include well-known names such as Johnson & Johnson (NYSE: JNJ ) and Exxon Mobil (NYSE: XOM ). In addition, each of the underlying constituents is capped at a maximum 5% allocation so as not to significantly overweight a single position . I think it’s an important distinction to make that O’Leary is essentially the face of this company and not involved in any direct investment recommendations. This ETF is designed to follow a strict passively managed index without worrying over deviating into uncharted waters as some active funds can do. The current next expense ratio of OUSA is listed at 0.48%, which is on the high side for a passive ETF. Nevertheless, the fundamental selection criteria (read: smart beta) is one of the reasons that the fund company may feel justified to charge more for its ETF versus its peers. After analyzing the top 10 holdings of OUSA, my initial conclusion is that this ETF falls closest in nature to the iShares Core High Dividend ETF (NYSEARCA: HDV ). Both funds share 8 of their top 10 holdings and are dedicated to a more concentrated mix of high quality dividend stocks. HDV currently has $4.5 billion in assets, an expense ratio of 0.12%, and a 30-day SEC yield of 3.90%. It’s worth noting, however, that although there are similarities between the two funds, there are also significant differences too. HDV has very high asset concentrations in its top holdings, which currently make up 59% of the portfolio. The top 10 holdings in OUSA make up just 38% of its asset allocation. In addition, HDV has a great deal more energy and telecom exposure that is supplanted by technology and health care in OUSA. These portfolio weightings are likely to change over time as market factors and other conditions evolve. Vanguard investors can breathe easy that the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) shares 7 of the same top 10 holdings in OUSA as well. However, VYM covers a much broader spectrum of over 400 stocks. The Bottom Line Despite its higher expense ratio, OUSA appears to be constructed of a very solid mix of dividend paying stocks through a dependable index provider. Currently, this ETF does offer enough differentiating factors to make it worthy of your consideration when comparing equity income funds . It will be interesting to follow how much initial attention is generated in OUSA based on fund flow data, as well as how the portfolio adapts over time. The market for dividend ETFs is certainly filled with many beloved products and attracting attention may prove to be a difficult battle. According to prospectus filings, O’Shares is set to debut four additional international-focused dividend ETFs in the near future as well. That will help round out the fund family and offer strategies designed to excel under differentiating circumstances. Disclosure: I am/we are long VYM, HDV. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.