Tag Archives: seeking-alpha

Quarterly Financial Reporting Is Needed, Productive, And Good

The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer. The cause for this article is a piece from the Wall Street Journal, Time to End Quarterly Reports, Law Firm Says . Here’s the first two sentences: Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports. Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals. The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy. I disagree. There are at least four things that are false in the arguments made in the article, and in books like Saving Capitalism from Short-Termism : Quarterly earnings don’t produce value in and of themselves Quarterly earnings cause most corporations to ignore the long-term. Ending quarterly earnings will end activism, buybacks, and dividends. Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing. Why Quarterly Earnings are Valuable I’ve written a number of articles about quarterly earnings and estimates of those earnings: Earnings Estimates as a Control Mechanism, Flawed as they are , and Earnings Estimates as a Control Mechanism, Flawed as they are, Redux . The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not. As I wrote: Most of the value of a Corporation on a going concern basis stems from the future earnings of the company. Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate. Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof. The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not. Don’t think of the quarterly earnings in isolation. A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. A bad earnings number lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. Vice-versa for a good number. Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down. They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings. In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital. When the measurement periods get too long, discipline can be lost. Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. Even if the current period’s earnings meet the estimates, the job is not done. If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. The short-term is just the beginning of the long-term. It is not either/or but both/and. A company has to try to explain to investors how it is growing the value of the firm – if present targets aren’t being met, why should there be any confidence that the future will be good? Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal. The quarterly earnings measure whether the progress toward completing the goal is adequate or not. Now, the measure is not perfect, but who can think of a better one? Ending Quarterly Earnings Would Not End Activism, Buybacks, and Dividends I can think of an area in business where earnings estimates don’t play a role – private equity. Are the owners long-term oriented? Yes. Are they short-term oriented? Yes. Is capital managed tightly? Very tightly. All excess capital is dividended back – it as if activists run the firms permanently. If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders. Activists would still analyze companies to see if they are badly managed, and in need of change. If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe. Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings. On the Use of Excess Capital Investing, particularly for the long-term, is not risk-free. In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete. In such an environment, it can make a lot of sense to focus on shorter-term investments that are more certain as to the success of the project. It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently. Companies that shrink their balance sheets tend to outperform those that grow them. As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors. The same is true of large versus small investments for organic growth away from M&A. Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing. There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not. In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. That’s how biotech firms work, and it is why so many of them fail. The few winners are astounding. Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity. All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted returns, and not wasted on speculative projects with uncertain returns. The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive. Remember, bad investments are just expenses in fancy garb – it just takes the accounting longer to recognize the losses. Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company. Conclusion If quarterly earnings are abolished, intelligent corporations won’t change much. Investment won’t go up much, and the time horizon of most management teams will not rise much. If you need any proof of that, look at how private equity and large mutual insurers manage their firms – they still analyze quarterly results, and are conservative in how they deploy capital. The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors. Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies. Disclosure: None

The One Factor To Explain Them All

Yesterday’s post on hedge funds got me thinking again about how vague “risk factors” are. CAPM uses a one factor model showing that risk explained why certain assets performed better than others.¹ Basically, take more risk and you’ll generate a better return. That didn’t exactly explain things fully though. In fact, higher risk often correlates with worse returns.² Over the course of the last 25 years the idea of “factor investing” has really boomed. And investment companies loved this because they could market specific stylized facts that explained why the markets do certain things and why you should pay them high fees so they can take advantage of those things for you. Heck, even hardcore passive investors, who are notorious fee avoiders, will trip over themselves buying higher fee funds trying to guess the best factors to own at certain times. As a result, we got the small cap factor and the value factor and the momentum factor and all sorts of other factors. I think we’re up to 1,000+ factors now. There are so many I could just start making them up. And I will. Right now. For instance, companies whose founders are dog owners might outperform companies whose founders are cat owners. This is a perfectly logical assumption because dogs are better than cats so company founders who own dogs must be smarter than company founders who own cats. So, we now have the dog vs cat factor. If I tweak some data and find it’s statistically meaningful over long periods of time then I might even start a high fee fund to sell you. No cat owners allowed, obviously. Okay, okay. I am being stupid. I know. But you see my point, right? A lot of these “factors” could be nothing more than slick data mining by someone who found a pattern that doesn’t really exist. We want to understand and be able to predict things so badly that we often find stylized facts where they don’t even exist. But maybe we just can’t know. That doesn’t mean it’s not worth trying to find out or to try guessing about future outcomes. But we should start from one general factor: The We-Know-A-Lot-Less-Than-We-Think-We-Know Factor This doesn’t require some law of the financial markets that says anything has to outperform anything else over the long-term. Yes, we know that stocks will generally beat bonds because they’re a contract that gives the equity owner greater claim to profits than the bonds, but that doesn’t mean stocks have to outperform bonds or even that they’re more risky (whatever “risk” means in the context of this discussion to begin with, but that’s a whole other matter). The point is, you don’t necessarily earn a “risk premia” in stocks. You earn a contractual premia assuming the firm earns enough profit to pay it out (good luck predicting which firms will generate the highest profits in the future) and a bunch of apes with keyboards try to guess what the future value of those profits will be. Importantly, no one needs the efficient market hypothesis to understand why markets are really hard to beat. You just need the basic arithmetic of global asset allocation to understand that . This whole monetary system is something humans created from thin air. And we have, at best, an imprecise understanding of what financial assets are really worth at certain times and so the best we can do is try to understand the world for what it is, slap together some sound assumptions about the future, reduce our frictions, manage the known risks as best as possible and hope it doesn’t all fall apart at some point. Is it really much more complex than that? ¹ – Here’s the Three Factor Model. Here’s the Five Factor Model. Here’s a 100+ Factor model paper. Here’s a real model. 2 – See this paper titled ” High idiosyncratic volatility and low returns: International and further U.S. evidence “.

SPDR Gold Shares Closes A Gap As The Fed Maintains Its Churn On Rate Hikes

Summary The SPDR Gold Shares benefits from Federal Reserve minutes that further confirm the churn on hiking rates. The rally in SPDR Gold Shares appears to confirm an earlier case for a bottom but now the ETF sits right under important resistance. I examine the Fed’s latest churn by dividing the key parts of the minutes into the two different camps. Overall, the agreement on the need for more data makes a September hike seem even less likely than before and incrementally improves the (near-term) prospects for gold. The U.S. Federal Reserve released its minutes from its July 28 to 29, 2015 meeting . It was pretty much the same back and forth on monetary policy and the U.S. and global economies, but the words took on more significance than usual because of all the anticipation about the timing of the Fed’s first rate hike on the way to normalization. One net effect of the hemming and hawing was to send the U.S. dollar index down. The dollar’s downtrend from the March 12-year high remains well intact. Presumably, the continued lack of a definitive schedule for the first rate hike made market participants incrementally less interested in the U.S. dollar as a play on policy divergence against other major currencies. More importantly for me on this day, the SPDR Gold Trust ETF (NYSEARCA: GLD ) responded to the dollar weakness with a gain of 1.3%. This gain further confirms GLD’s bounce off recent lows and resumes the upward push from those levels. GLD has now filled the gap down from July 20th which at the time seemed to doom GLD to a quick trip to $100 and below. SPDR Gold Shares continues its bounce off the recent bottom but is now trading up against resistance from the downtrend defined by the 50-day moving average (DMA) The rally in GLD is notable and marks yet another validation of the use of Google trends to assess market sentiment in the face of extreme movements in gold’s price. In ” The Commodity Crash Accelerates: A New Juncture for Buying Gold ,” I made the case for a bottom in gold. GLD is up a modest 3.5% since then, but the accompanying rally has featured much stronger buying volume than selling volume. As more uncertainty looms over the timing of a Fed rate hike – including the possibility that the Fed is forced to punt on normalization – GLD looks more and more attractive, albeit tentatively. I now expect an “ah ha” moment to send gold soaring. Fed wavering on normalization would place the U.S. back in-line with the herd of central banks that are in retreat on monetary policy and make gold incrementally more attractive as an alternative currency. That potential upside confirms the attractive risk/reward of betting on July’s low on GLD as some kind of bottom. Once again, Fed-speak gave no definitive clues on the timing for a first rate hike. Those who expected more are experiencing the triumph of hope over experience. I divided the relevant components of the minutes into two camps: “yes, let’s hike” and “yes, well, but…” YES, LET’S HIKE For the most part, the committee members looking forward to a rate hike in the near future are assuming the economy will continue to improve. If forced to decide NOW whether to hike or not, current economic conditions would not facilitate a rate hike. Thus, time is ticking down to the wire for the accumulation of evidence that will push these members over the edge to a rate hike. Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point. Participants observed that the labor market had improved notably since early this year, but many saw scope for some further improvement. Many participants indicated that their outlook for sustained economic growth and further improvement in labor markets was key in supporting their expectation that inflation would move up to the Committee’s 2 percent objective, and that they would be looking for evidence that the economic outlook was evolving as they anticipated… Some participants…emphasized that the economy had made significant progress over the past few years and viewed the economic conditions for beginning to increase the target range for the federal funds rate as having been met or were confident that they would be met shortly. Those ready to hike rates step back and see a process of improvement inexorably moving the Fed toward a rate hike. Getting going on normalization will not only deliver the standard benefits for inflation and financial stability but also provide a good communication tool to assure market sentiment toward the economy. On the flip side of this sentiment-soother is the potential interpretation of a LACK of action: “the Fed knows something horrible that we do not yet understand or see…” A couple of others thought that an appreciable delay in beginning the process of normalization might result in an undesirable increase in inflation or have adverse consequences for financial stability. Some participants advised that progress toward the Committee’s objectives should be viewed in light of the cumulative gains made to date without overemphasizing month-to-month changes in incoming data. It was also noted that a prompt start to normalization would likely convey the Committee’s confidence in prospects for the economy. Labor markets are essentially healed and will continue to approach maximum employment with on-going improvement in the economy. In assessing whether economic conditions had improved sufficiently to initiate a firming in the stance of monetary policy, the Committee noted that, on balance, a range of labor market indicators suggested that underutilization of labor resources had diminished further. Most members saw room for some additional progress in reducing labor market slack, although several viewed current labor market conditions as at or very close to those consistent with maximum employment. Many members thought that labor market underutilization would be largely eliminated in the near term if economic activity evolved as they expected. The members who are ready to hike are reassured by the transitory impact of the deflationary pressures from falling energy prices and a strengthening U.S. dollar. In considering the Committee’s criteria with respect to inflation for beginning policy normalization, most members viewed the incoming data as reinforcing their earlier assessment that, although inflation continued to run below the Committee’s objective, the downward pressure on inflation from the previous decreases in energy prices and the effects of past dollar appreciation would abate. Someone at the Fed is already very itchy at the trigger… One member, however, indicated a readiness to take that step at this meeting but was willing to wait for additional data to confirm a judgment to raise the target range. YES, WELL, BUT…. The cautious members of the Fed look out nervously upon the horizon. For example, they take no assurance in a transitory impact on inflation. Add to the list of “international developments” the devaluation of the Chinese yuan. This (still on-going) event seems to underline economic troubles in China which in turn potentially translate to troubles in other economies. If so, the Fed has yet one more reason to proceed with extreme caution on normalization. …some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term and that the inflation outlook thus might not soon meet one of the conditions established by the Committee for initiating a firming of policy. Several of these participants cited evidence that the response of inflation to the elimination of resource slack might be attenuated and expressed concern about risks of further downward pressure on inflation from international developments. The cautious members are not yet convinced the labor market is healthy enough to begin normalization. …several were concerned that labor market conditions consistent with maximum employment could take longer to achieve, noting, for example, the lack of convincing signs of accelerating wages, which might be signaling that the natural rate of unemployment could currently be lower than they previously thought. The cautious members are much more nervous about the deflation-like pressures from the continuing collapse in commodity prices. The prospect of igniting the U.S. dollar again is also of concern. The two dynamics are correlated and even reinforcing. Policy normalization carries the prospect of tightening the linkage even further. …core inflation on a year-over-year basis also was still below 2 percent. Moreover, some members continued to see downside risks to inflation from the possibility of further dollar appreciation and declines in commodity prices. In addition, several members noted that higher rates of resource utilization appeared to have had only very limited effects to date on wages and prices, and underscored the uncertainty surrounding the inflation process as well as the role and dynamics of inflation expectations. EVERYBODY TOGETHER NOW Interestingly, the entire Committee appears to be in agreement that it needs yet MORE data to get comfortable with policy normalization. The Committee agreed to continue to monitor inflation developments closely, with almost all members indicating that they would need to see more evidence that economic growth was sufficiently strong and labor markets conditions had firmed enough for them to feel reasonably confident that inflation would return to the Committee’s longer-run objective over the medium term. This agreement notably dampens the prospect for a September hike. I suspect that given so many pundits and the like are sticking with September forecasts that the lack of one will cause some notable market disruptions that should incrementally pressure the dollar downward and thus help push gold higher. Be careful out there! Disclosure: I am/we are long GLD. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Long GLD shares and call options