How to Protect Your Portfolio From Earnings Surprises

Company reports are one of Wall Street's best kept bad secrets

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“Can’t anybody tell the truth anymore?” an exasperated Bob J. asked me at a recent cocktail reception. “Evidently not” I told him. Bob had seen me earlier that afternoon on Fox News.

I appeared on the show to respond to a new study on corporate earnings by Professors Ilia Dichev, Shiva Rajgopal of Emory University and John Graham of Duke.The study found that a full 20% of publicly traded companies lie about their earnings.

The shocking thing is that the figure wasn’t much higher. Twenty percent strikes me as abnormally low. Earnings manipulation is one of Wall Street’s greatest, best-kept secrets and has been for years.

In fact, CFOs I’ve met over the years have told me they could routinely swing things within 5-10% of the target earnings per share (EPS) if needed — a figure in line with the one cited in the study.But lie is a big word.

As I noted during my interview, there are all kinds of reasons why companies manipulate the numbers, beginning with the terribly flawed system itself.

As appalling as this thought may be, the system actually encourages this kind of behavior.

Under the current system, the law requires quarterly performance reports when many publicly traded companies actually operate in business cycles that are 1, 3, 5, or even 7 years long.

This creates a disincentive to report what’s actually happening and an incentive to “lie” about the numbers or at least “fudge” them, depending on your perspective. And, the longer the business cycle, the more a company must make estimates about quarterly results with the risk, of course, that things don’t turn out as management expects.

So while some companies may have lost their ethical and moral compasses, what they are doing is entirely legal.

Why Companies Lie About Earnings

Having spent more than 20 years in the markets, I believe the reason for this comes down to three biggies, for lack of a better term. Companies may “lie” to boost stock prices, smooth earnings and jack up compensation packages.

Virtually every publicly traded company draws on reserves and engages in all kinds of financial hocus-pocus in an effort smooth things out.

Take Boeing  (NYSE:BA), for instance.

 How to Protect Your Portfolio From Earnings SurprisesThe aircraft design, production and sales process is roughly 5-7 years long. For Boeing, quarterly earnings are nearly irrelevant. Investors would be better served if the company issued annual or even bi-annual data that better matched Boeing’s cash flows and product development cycles.

At the other end of the spectrum is Facebook (NASDAQ:FB).

Team Hoodie brings in revenue from a customer base that has the attention span of a New York cab driver focused on his next fare amid a sea of pedestrians. For Facebook, weekly earnings data might be best.

Under these circumstances, there’s immense pressure from inside and outside the company to “hit” the numbers, avoid debt covenant violations and influence shareholder, lender, and supplier expectations — all of which are carefully orchestrated to boost share prices over time.

These pressures are so great the gamesmanship uncovered by the study isn’t surprising at all.

It’s unpleasant. It’s unethical. And it’s disheartening.  But it’s not shocking.

How to Spot Earnings Gamesmanship

So how do you know if a company you own is cooking the books, and what do you do about it?

It’s not easy, but here are six things to watch for:

  1. Cash flow, cash flow, cash flow. Nobody ever went broke on accrual accounting and cash truly is king, especially now. That’s why I am especially interested in a company’s free cash flow. It’s tougher to fake. A quick and dirty method to calculate this is simply to subtract capital expenditures from operating cash flow.
  2. Big changes in accruals. These can come in many forms. Examples include capitalized expenditures, reserves, and accrued liabilities. Sometimes there’s an explanation, like pending litigation or a product recall, but CFOs don’t build these up for no reason.
  3. Big one time charges. Lately these are de rigeur and examples include write-downs, write-ups, trading losses, unusual transactions and, my personal favorite since the financial crisis began, gains or losses on asset sales, particularly toxic debt.
  4. Unrealistically smooth earnings. Business cycles vary tremendously, so it’s logical that earnings should too, perhaps not wildly, but they should show some variability under normal circumstances. Any business that doesn’t is immediately suspect in my book because either a) there are hidden accounting games being played or b) the company might really be run well in which case it’s worth an even closer look.
  5. Wide variations from their peer group. Not all companies are the same so don’t expect cookie cutter analysis to work. But if a company is way outside similar figures reported by its peers, chances are something’s “up.”
  6. The people. Admittedly, this is more art than science. It’s where you’ve either got to hone your instincts or study interpersonal behavior. I’ve actually had formal training on how to spot individuals who may not be entirely honest. So I listen carefully during analyst calls for voice tremors and watch televised interviews much more closely for physical tells than other people might. You may not be in the same boat, so I encourage you to use what I call the bar test…as in would you turn your back to this executive/politician/leader during a bar fight? If not, have faith in your instincts because chances are you don’t want to trust the person you’re observing.

Article printed from InvestorPlace Media, http://investorplace.com/2012/07/how-to-protect-your-portfolio-from-earnings-surprises-ba-fb/.

©2014 InvestorPlace Media, LLC

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