This post was originally published on TKer.co.
Warren Buffett thinks this whole discussion of whether or not a company beats expectations is problematic.
In his new annual letter to Berkshire Hathaway shareholders, the billionaire investor didn’t hold back his feelings (emphasis added):
"Finally, an important warning: Even the operating earnings figure that we favor can easily be manipulated by managers who wish to do so. Such tampering is often thought of as sophisticated by CEOs, directors and their advisors. Reporters and analysts embrace its existence as well. Beating 'expectations' is heralded as a managerial triumph.
That activity is disgusting. It requires no talent to manipulate numbers: Only a deep desire to deceive is required. 'Bold imaginative accounting,' as a CEO once described his deception to me, has become one of the shames of capitalism."
There are two types of reported earnings, and both have shortcomings 👎
Each quarter, every publicly traded company is required to report detailed quarterly financial results in accordance with generally accepted accounting principles (GAAP) as defined by the Financial Accounting Standards Board.
GAAP allows for some flexibility in how companies do their books including how revenue is recognized and how expenses are accrued. The more liberties a company takes in its accounting, the more it may be accused of committing accounting shenanigans or even outright accounting fraud.
But ultimately, GAAP is considered very rigid as it forces companies to incorporate items that are arguably non-recurring or have values that can be very volatile over short periods of time.
As a result, many companies will report a second set of numbers adjusted for these items at the discretion of management. This process gets you what are often referred to as operating earnings, adjusted earnings, pro-forma earnings, or non-GAAP earnings. Management will tell you these earnings better reflect the underlying, ongoing health of the company.
Buffett has issues with how earnings are reported under both GAAP standards and non-GAAP practices.
He has long been a vocal critic of GAAP, as it requires Berkshire Hathaway to report the unrealized gains and losses of its formidable stock portfolio every quarter.
“The GAAP earnings are 100% misleading when viewed quarterly or even annually,” Buffett wrote. “Capital gains, to be sure, have been hugely important to Berkshire over past decades, and we expect them to be meaningfully positive in future decades. But their quarter-by-quarter gyrations, regularly and mindlessly headlined by media, totally misinform investors.“
But as you can tell from his earlier quote, Buffett is also skeptical of how executives achieve their non-GAAP operating earnings. And it has everything to do with the fact that Wall Street analysts help set the market’s short-term expectations by providing quarterly earnings forecasts.
I went into this in the November 1, 2021 issue of TKer: 'Better-than-expected' has lost its meaning 🤷🏻♂️. From the piece:
Expectations can incentivize bad behavior
As you can imagine, no manager wants to be responsible for having to report worse-than-expected earnings, which could trigger a sell-off in the company’s stock. After all, many managers, as well as employees, are paid with some form of stock-based compensation.
So, there are a variety of things managers can do if business is on track to fall short of expectations:
Earnings management: While companies have to report financial results guided by Generally Accepted Accounting Principles, those principles allow for some flexibility. With some creative accounting, a company can make its short-term earnings look stronger than they actually are.
Expectations management: During the quarter, management can send out signals to analysts that cause those analysts to be extra conservative in their estimates. Consider recent history: Ahead of 2021’s Q2 earnings season, corporate America was crying bloody murder about how inflation was threatening profitability. Sure enough, 87% of S&P 500 companies went on to beat expectations in Q2. Not only that: Profit margins actually expanded to record levels during the period!
Working employees’ asses off: If you’ve ever worked for a big corporation, then you’ve probably seen your boss’s stress level tick up near the end of a quarter or end of a year. You start hearing things like “quarter-end sprint” or “expenses have been frozen.” Long-term projects get shelved as employees are moved to quick-turnaround items. Random bonuses in the forms of cash or food start getting thrown around for work no one wants to do.
Also, this isn’t just about getting numbers up by the end of a quarter.
Sometimes you’ll hear managers tell you to tap the brakes or save that brilliant project for next quarter or next year. Odds are your company’s financials are pacing ahead of expectations. Why raise the bar on yourself with a massive quarter today when you can “hit the ground running” tomorrow?
This whole game of corporations providing short-term financial guidance and analysts estimating short-term earnings certainly keeps things interesting for short-term traders.
And sure, guidance and quarterly updates can reveal to investors the degree to which corporations are on track to achieve longer term goals.
But as we’ve discussed, a lot of this short-termism can incentivize some unproductive behavior and it also risks destroying value in the long term. (Let’s not forget about the fact that whether a company beats or misses analysts’ estimate are just as much an indictment on the analyst as it is on the company. As Morgan Housel often says, “earnings don't miss estimates; estimates miss earnings.“)
The bottom line 😉
Whether or not a company beats analysts’ expectations for earnings usually tells you just how good executives and analysts are at precisely guessing the short-term behavior of customers, vendors, workers, and every other individual involved in the business. If the numbers are way off the mark, then there’s probably something going on. If they’re off by a little, maybe there’s not much to make a fuss about.
Beyond this headline generating phenomenon, companies provide lots of interesting detailed information about their business and the industry in which they operate. And their executives often share illuminating views on the economy from their unique perches. All of this can be quite useful for investors and anyone who cares about what’s going on in the business world. And so quarterly reporting isn’t all bad.
Investing isn’t easy and analyzing companies is very hard. And unfortunately, there’s no consensus on how to resolve the conflicts borne out of quarterly earnings reporting. For the time being, the best we can do is to stay educated and be mindful of the short-term pitfalls as we remain focused on achieving our long-term goals.
That’s interesting! 💡
J.M. Smucker sells more than half a billion dollars worth of Uncrustables every year. From the company’s CAGNY presentation (ht Brian Cheung):
Reviewing the macro crosscurrents 🔀
There were a few notable data points from last week to consider:
🎈 Inflation ticks up. The personal consumption expenditures (PCE) price index in January was up 5.4% from a year ago, which was unexpectedly higher than the 5.3% increase seen in December. The core PCE price index — the Federal Reserve’s preferred measure of inflation — was up 4.7% during the month after coming in up 4.6% the month prior.
On a month-over-month basis, the PCE price index and core PCE price index each accelerated to 0.6% in January.
The bottom line is that while inflation rates have been trending lower, they continue to be above the Federal Reserve’s target rate of 2%. For more on the implications of cooling inflation, read: The bullish 'goldilocks' soft landing scenario that everyone wants 😀.
🛍️ Consumer spending heats up. Personal consumption expenditures jumped 1.8% in January.
Adjusted for inflation, real spending was up an impressive 1.1%, the biggest gain since March 2021.
💼 Unemployment claims remain low. Initial claims for unemployment benefits fell to 192,000 during the week ending Feb. 18, down from 195,000 the week prior. While the number is up from its six-decade low of 166,000 in March 2022, it remains near levels seen during periods of economic expansion.
For more on low unemployment, read: That's a lot of hiring 🍾, You should not be surprised by the strength of the labor market 💪, and 9 reasons to be optimistic about the economy and markets 💪.
🏚 Home sales are cooling. Sales of previously owned homes fell 0.7% in January to an annualized rate of 4.0 million units. From NAR chief economist Lawrence Yun: "Home sales are bottoming out… Prices vary depending on a market’s affordability, with lower-priced regions witnessing modest growth and more expensive regions experiencing declines… Inventory remains low, but buyers are beginning to have better negotiating power… Homes sitting on the market for more than 60 days can be purchased for around 10% less than the original list price."
💸 Home prices are cooling. From the NAR: “The median existing-home price for all housing types in January was $359,000, an increase of 1.3% from January 2022 ($354,300), as prices climbed in three out of four U.S. regions while falling in the West. This marks 131 consecutive months of year-over-year increases, the longest-running streak on record.“
From Redfin: “The total value of U.S. homes was $45.3 trillion at the end of 2022, down 4.9% ($2.3 trillion) from a record high of $47.7 trillion in June. That’s the largest June-to-December drop in percentage terms since 2008. While the total value of U.S. homes was up 6.5% from a year earlier in December, that’s the smallest year-over-year increase during any month since August 2020.”
For more on the housing market, read: The U.S. housing market has gone cold 🥶
📈 New home sales are up. Sales of newly built homes jumped 7.2% in January to an annualized rate of 670,000 units.
🏢 Offices are still mostly empty. From Kastle Systems: “Office occupancy continues to hover just slightly below 50%. Last week, the 10-city Back to Work Barometer reached 49.8% occupancy. The increase was led by Dallas and Austin, Texas, which experienced 10- and eight-point gains to 53.2% and 65.3% occupancy, respectively. We expect those numbers to grow and return to their late January highs as both cities continue to recover from the recent weather disturbances.”
For more on office occupancy, read: This stat about offices reminds us things are far from normal 🏢
👍 Surveys suggest things aren’t so bad. According to the S&P Global Flash U.S. Composite PMI, private sector activity returned to growth in February as expansion in the service sector activity more than offset contraction in manufacturing activity. From S&P Global’s Chris Williamson: “Despite headwinds from higher interest rates and the cost of living squeeze, the business mood has brightened amid signs that inflation has peaked and recession risks have faded. At the same time, supply constraints have alleviated to the extent that delivery times for inputs into factories are improving at a rate not seen since 2009…”
With surveys, remember: What businesses do > what businesses say 🙊
Putting it all together 🤔
We’re getting a lot of evidence that we may get the bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
And the Federal Reserve has recently adopted a less hawkish tone, acknowledging on February 1 that “for the first time that the disinflationary process has started.“
Nevertheless, inflation still has to come down more before the Fed is comfortable with price levels. So we should expect the central bank to continue to tighten monetary policy, which means we should be prepared for tighter financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations). All of this means the market beatings may continue and the risk the economy sinks into a recession will relatively be elevated.
It’s important to remember that while recession risks are elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs. Those with jobs are getting raises. And many still have excess savings to tap into. Indeed, strong spending data confirms this financial resilience. So it’s too early to sound the alarm from a consumption perspective.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
As always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a terrible year, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the previous TKer macro crosscurrents »
For more on why this is an unusually unfavorable environment for the stock market, read: The market beatings will continue until inflation improves 🥊 »
For a closer look at where we are and how we got here, read: The complicated mess of the markets and economy, explained 🧩 »
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Sam Ro is the founder of Tker.co. You can follow him on Twitter at @SamRo
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