Tag Archives: Blaise Pascal

Q1-Earnings Review & The Risk To Estimates

With roughly 98% of the S&P 500 having reported earnings, as of mid-June, we can take a closer look at the results through the 1st quarter of the year. During the most recent reported period, 12-month operating earnings per share rose from $33.85 per share in Q4-2017 to $36.43 which translates into a quarterly increase of 7.62%. While operating earnings are widely discussed by analysts and the general media; there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”

Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. It is from this perspective the news improved markedly as 12-month reported earnings per share rose from $26.96 in Q4-2017 to $32.81, or a whopping 21.7% in Q1. This jump, of course, is directly related to the reduction in corporate tax rates following the passage of the “tax reform” bill in December of 2017.

However, as shown below, top-line revenue growth (sales) has also improved since the market bottom in early 2016. The issue is that while sales are indeed rising, the price investors are paying for each dollar of sales has grown exponentially since 2009. In other words, it is already well “priced in.”

Since the media focus on earnings per share (EPS), we see the same issue. Since the end of 2014, investors are paying twice the rate of earnings growth.

No matter how you look at the data, the point remains the same. Investors are currently overpaying today for a stream of future sales and/or earnings which may, or may not, occur in the future. The risk, as always, is disappointment.

Always Optimistic

But optimism is certainly one commodity that Wall Street always has in abundance. When it comes to earnings expectations, estimates are always higher regardless of the trends of economic data. The problem is that the difference between expectations and reality have been quite dramatic. 

As I wrote previously, 

“Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have ‘sharpened their pencils’ and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.”

“The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. ‘Optimism’ is, well, ‘exceedingly optimistic’ for the end of 2019.”

That was so a month-and-a-half ago.

Since then, analysts have gotten a bit of religion about the impact of higher rates, tighter monetary accommodation, and trade wars. As I wrote yesterday, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.

However, the onset of a “trade war” could reduce earnings growth by 11% which would effectively wipe out all of the benefits from the recent tax reform legislation.

As you can see, the erosion of forward estimates is quite clear and has gained momentum in the last month. 

There is no arguing corporate profitability improved in the last quarter as oil prices recovered. The recovery in oil prices specifically helped sectors tied to the commodity such as Energy, Basic Materials, and Industrials. However, such a recovery may be fleeting. There are signs currently that global economic growth is showing signs of weakening. As noted by Adem Tumerkan:

Taking the contrarian route – it’s not hard to see the market isn’t pricing in any potential global earnings issues. And this is troublesome because the risks keep adding up. The historically accurate South Korean Export Growth Indicator (SKEG) is signaling a looming global earnings recession.”

“[And] for the first time since the 2008 Great Recession, corporate bond yields have inverted.”

“…this inversion signals trouble ahead for the stock market. It means that ‘the cost of capital for corporates is now higher than the return on capital.’ Corporate Bond investors are clearly expecting a recession and deflation ahead – which will cause the prime rate to plunge…this will spill into the stock market and negatively send prices tumbling.”

Accounting Magic

Looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.

Of course, stock buybacks have been the “go to” method for boosting earnings. According to Greg Haendel from Wealth Management:

“The largest beneficiary of repatriation spending has been the stockholder with the most utilized tool being corporate stock buybacks. Share buybacks increased during Q12018 to a record $178 billion, up from $135 billion a year ago. Further, the 24 U.S. companies with the largest foreign cash holdings accounted for two-thirds of the increase in share buybacks. There has already been $324 billion of buyback announcements year-to-date with an expected total buyback amount of $800 billion for the year. ”

Furthermore, while the majority of buybacks have been done with “repatriated” cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs. 

Recently, compensation costs have been rising as the labor market has indeed grown tighter. Of course, this is what is normally seen at the end of economic cycle as rising compensation triggers a profit contraction.

While it would seem that sharply rising employee compensation would be a “good thing,” you will notice that sharply rising employee compensation, which impacts earnings growth, has historically coincided with weaker economic outcomes as higher costs erode profitability.

“It is worth noting that in both charts above, despite hopes of continued economic expansion, both employee compensation, and economic growth have continued to trend to lower since the 1980’s. This declining growth trend has been compensated for by soaring levels of debt to sustain the current standard of living.”

Economics Matter

The last chart below compares economic growth to earnings growth. Wall Street has always extrapolated earnings growth indefinitely into the future without taking into account the effects of the normal economic and business cycles. This was the same in 2000 and in 2007. Unfortunately, the economy neither forgets nor forgives.

With analysts once again hoping for a continued surge in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

The deterioration in earnings is something worth watching closely. While earnings have improved in the recent quarter, due to the benefit of tax cuts, it is likely transient given the late stage of the current economic cycle, continued strength in the dollar and potentially weaker commodity prices in the future.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

It is important to remember the bump in earnings growth will only last for one year at which point the analysis will return to more normalized year-over-year comparisons. While anything is certainly possible, the risk of disappointment is extremely high.

Pascal’s Wager Shows Why Stocks Get More “Risky” Over Time

Blaise Pascal, a brilliant 17th-century mathematician, famously argued that if God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn’t exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.

Pascal concluded, given that we can never prove whether or not God exists, it’s probably wiser to assume he exists because infinite damnation is much worse than a finite cost.

When it comes to investing, Pascal’s argument applies as well. Let’s start with an email I received this past week.

“The risk of buying and holding an index is only in the short-term. The longer you hold an index the less risky it becomes. Also, managing money is a fool’s errand anyway as 95% of money managers underperform their index from one year to the next.”

This is an interesting comment as it exposes two primary falsehoods.

Let’s start with the second comment “95% of money managers can’t beat their index from one year to the next.” 

One of the greatest con’s ever perpetrated on the average investor by Wall Street is the “you can’t beat the index game.” It is true that many mutual funds underperform their index from one year to the next, but this has nothing to do with their long-term performance. The reasons that many funds, and investors, underperform in the short-term are simple enough to understand if you think about what an index is versus a portfolio of invested capital.

  1. The index contains no cash
  2. It has no life expectancy requirements – but you do.
  3. It does not have to compensate for distributions to meet living requirements – but you do.
  4. It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  5. It has no taxes, costs or other expenses associated with it – but you do.
  6. It has the ability to substitute at no penalty – but you don’t.
  7. It benefits from share buybacks – but you don’t.
  8. It doesn’t have to deal with what “life” throws at you…but you do.

But as I have addressed previously, the myth of “active managers can’t beat their index” falls apart given time.

Larry Swedroe wrote a piece just recently admonishing active portfolio managers and suggesting that everyone should just passively invest. After all, the primary argument for passive investing is that active fund managers can’t beat their  indices over time which is clearly demonstrated in the following chart.”

“Oops. There are large numbers of active fund managers who have posted stellar returns over long-term time frames. No, they don’t beat their respective benchmarks every year, but beating some random benchmark index is not the goal of investing to begin with. The goal of investing is to grow your ‘savings’ over time to meet your future inflation-adjusted income needs without suffering large losses of capital along the way.”

It isn’t just mutual funds that regularly outperform their respective benchmarks but also hedge funds, private managers and numerous individual investors that put in the necessary time, work and effort.

But, I will admit that today, more than ever, the game is stacked against the average investor as high-speed trading takes advantage of retail investor online order flows. The proprietary trading desks, who have access to massive pools of capital, can push markets on an intra-day basis while computerized programs execute orders based on data flows. It has truly become the battle of “David and Goliath” with Wall Street armed with better technology, more resources, more information, teams of people dedicated solely to a single outcome versus – you and your computer. One can certainly understand why many individuals have given up trying to manage their investments.

But therein lies the huge conflict of interest between Wall Street and you. They need your money flowing into their products so they can charge fees. Wall Street is a business and, for them, business is good, and very profitable, as long as investors buy into the game that investing is the ONLY way to grow “rich.”

However, as investors, we must abandon the idea of chasing some random benchmark index, which really has very little to do with our own personal investing goals, and focus on the things that will make us wealth over time: spend less, save more, reduce debt (increase cash flow), grow our “human capital,” (earning power), invest and avoid major losses.

Investing and avoiding major losses brings us to the first point of the email which is “stocks become less ‘risky’ over time.”

Stocks Become Less “Risky” Over Time?

This idea suggests the “risk” of the loss of capital diminishes as time progresses.

First, risk does not equal reward. “Risk” is a function of how much money you will lose when things don’t go as planned. The problem with being wrong is the loss of capital creates a negative effect to compounding that can never be recovered. Let me give you an example.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.


The “power of compounding” ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe. 

The problem with following Wall Street’s advice to be “all in – all the time” is that eventually you are going to dealt a bad hand. By being aggressive, and chasing market returns on the way up, the higher the market goes the greater the risk that is being built into the portfolio. Most investors routinely take on more “risk” than they realize which exposes them to greater damage when markets go through a reversion process.

How do we know that risk increases over time? The cost of “insurance” tells us so. If the “risk” of ownership actually declines over time, then the cost of “insuring” the portfolio should decline as well. The chart below is the cost of “buying insurance (put options) on the S&P 500 exchange-traded fund ($SPY).

As you can see, the longer a period our “insurance” covers the more “costly” it becomes. This is because the risk of an unexpected event that creates a loss in value rises the longer an event doesn’t occur.

Furthermore, history shows that large drawdowns occur with regularity over time.

Byron Wien was asked the question of where we are in terms of the economy and the market to a group of high-end investors. To wit:

“The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion.

Importantly, it is not just the length of the market and economic expansion that is important to consider. As I explained just recently, the “full market cycle” will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology.

“There are two halves of every market cycle. 

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’ The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

With valuations currently pushing the 2nd highest level in history, it is only a function of time before the second-half of the full-market cycle ensues.

That is not a prediction of a crash.

It is just a fact.”

But as Mr. Pascal suggests, even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire. Rolling the investment dice while saving money by skimping on insurance may give us a shot at amassing more wealth, but with that chance of greater success, comes a risk of devastating failure.

Winning The Long Game

In golf, there is a saying that you “drive for show and putt for dough” meaning that it is not necessary to be able to drive a golf ball 300 yards down the center of the fairway – it is the short putting, measured in feet, which will win the game. In investing, it is much the same – being invested in the market is one thing, however, understanding the “short game” of investing is critically important to winning the “long game.”

When valuations rise to rarely seen levels, and the associated risks of a major drawdown increase exponentially, focus on managing the “risk” of the portfolio rather than chasing “returns.”

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

But it was Howard Marks who summed up our philosophy on “risk management” well when he stated:

“If you refuse to fall into line in carefree markets like today’s, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk.” 

Clients should not pay a fee to mimic markets. Fees should be paid to investment professionals to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Personally, I choose to “believe” as I really don’t like the sound of “eternal damnation.”