by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

 “Only time can heal what reason cannot.” – Lucius Annaeus Seneca

In response to the pandemic-driven economic downturn, both Congress and the Federal Reserve have intervened with fiscal and monetary support in the form of direct subsidies, loans, bailouts, tax rebates, supplemental unemployment benefits, ultra-low interest rates, support of capital markets, reduced regulatory constraints, and quantitative easing (QE). The Fed expanded its purchase program beyond Treasury bonds to also include municipal bonds, corporate bonds of both investment and speculative grade, as well as ETFs for the first time. While these policies can raise aggregate demand, employment, and investment in the short run, excess liquidity also supports inefficient firms that otherwise might not survive. The increased prevalence of these firms, as well as the valuation metrics at which their stocks trade can muddy the waters for analysts and thus contribute to a misallocation of capital. These firms also weigh on productivity growth going forward.

Because the downturn was spurred by the pandemic rather than the typical overheated economy and inflation, it has yielded several surprises for investors. For instance, despite unemployment reaching record levels, consumers spent more than expected on home repairs and remodeling which boosted sales at stores like Home Depot (HD) and Lowe’s Companies (LOW). Likewise, residential home sales have surged despite escalating unemployment. An intuitive expectation of an inverse relationship between the two would be incorrect, at least thus far. Outperformance of online retailers, like Amazon.com (AMZN), over some traditional recessionary picks, like Procter & Gamble (PG), has also been unexpected. Moreover, this was the first recession that drove people to spend more time outdoors, giving a boost to firms like sports vehicle maker Polaris (PII). However, the question to ask is:  Is this burst of COVID-driven growth anomalous and short-lived, or is it sustainable?

Another aspect to highlight is the conjectural nature of forward estimates and current valuations. The wild swings in near-term consensus estimates between earnings cycles seem to be highly speculative and largely based on the latest news headlines rather than analysis of underlying firms’ fundamental metrics. Similarly, it appears that some previously struggling firms are getting an unsustainable boost by pivoting to create products that help customers deal with COVID-19 impacts. In this article, I explore examples of two firms for which analysts anticipate rising near-term growth rates specifically driven by COVID-19 related tailwinds that we do not believe are sustainable longer-term. Read on....

  by Ryan Frederick
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In 2003, the SEC first officially adopted rules (following Sarbanes-Oxley in 2002) related to the reporting of non-GAAP financial metrics. The new regulations called for a reconciliation of GAAP versus non-GAAP results to be included in various investor resources and to refrain from excluding non-recurring items from non-GAAP metrics if they are reasonably likely to reoccur, which is subject to wide interpretation. Since then, it seems the perceived importance among investors of non-GAAP financial performance has been elevated above traditional GAAP measures. Between 2015 and 2017, less than 10.0% of companies in the S&P 500 did not report a non-GAAP income calculation. However, the ability for management to subjectively decide what is or is not relevant to a company’s core business leaves plenty of room for earnings manipulation.

On the one hand, companies tend to justify their exclusion of various transactions as necessary for “comparability” to historical results, given that GAAP rules have changed over time. Fair enough. However, when an investor chooses to rely upon non-GAAP results when comparing a given company’s results to another’s, the comparisons can be deeply misleading as management has great leeway for subjective (and sometimes ad-hoc) adjustments in their exclusions – i.e., what one company concludes should be excluded in a non-GAAP calculation may not be consistent with what another company may exclude.

In fact, in 2010 former SEC chief accountant Howard Scheck identified non-GAAP performance metrics as a “fraud risk factor.” The SEC even created a taskforce to analyze non-GAAP earnings metrics that could be misleading. Then, in an effort to provide more clarity, the commission provided Compliance and Disclosure Interpretations (C&DIs) which detailed ways in which the SEC may find non-GAAP disclosures to be misleading, but more on that later.

Here at Gradient Analytics, our focus on earnings quality analysis (for both short idea generation and vetting of long candidates) regularly includes an examination of non-GAAP adjustments to determine whether they are appropriate in helping represent the true performance of the firm, or whether they are misleading. There is a plethora of unique adjustments a company could make to a non-GAAP income calculation; however, some are more common than others. One of the more frequent adjustments to GAAP income is the exclusion of restructuring costs. Read on….

by Ryan Frederick
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Stock buybacks (or share repurchases – we will use the terms interchangeably) have garnered significant attention as publicly-traded companies have repurchased shares at record levels (in terms of dollars spent). In 2018, companies in the S&P 500 spent $806 billion on buybacks (about 3.8% of public float), shattering the previous record of $590 billion spent in 2007 (about 5.3% of public float) by 36.6%. Few topics provoke as intense of a response from those in the world of finance as to what role buybacks should play – whether in a given company’s cash management strategy or for the broader market as a whole. There are various viewpoints on the subject, but there’s a good chance you’ve primarily heard buybacks described in pejorative terms. The negative framing ranges from management using buybacks to manipulate EPS growth and share prices (with no underlying change in the company’s financial condition), to shortchanging long-term investments and employees, to cannibalization, to mis-spending tax cuts, to outright calls for the practice to be outlawed.

Indeed, it is easy to frame buyback programs in a negative light, and some of the connotations may be deserved. To be sure, corporate executives often focus so much on EPS performance that they might choose to engage in short-sighted and/or self-centered activities. (Whether they can get away with it is another matter.) However, the truth about buybacks is much more complicated than typically presented as there is a confluence of many factors and questions that must be considered, such as: What timeframe was used to analyze the effects? Was it the right timeframe? What are a company’s alternative investment opportunities before, during, and after a buyback program? Can an outsider refute with certainty what is/isn’t a good use of cash? What is the cost of capital and opportunity cost? What are the macroeconomic conditions, e.g., interest rates, fiscal policy, trade wars?

Moreover, do buybacks actually lift a given company’s share price and the value of an index that holds it? Is this practice such an epidemic and scourge on society that the federal government should step in to regulate what a private company (or by extension, its shareholders) can or cannot do with its cash? Should a buyback intended to reduce public float be made illegal once again (as it was until 1982)? We believe the answers to these questions are more nuanced than the media presents, so we will attempt to offer some additional insight. Read on….

Nothing seems to be strong enough to lift the market out of its doldrums.  Not the shiny corporate earnings announcements from Wal-Mart (WMT) and Home Depot (HD).  Not the exciting merger talks between BHP Billiton (BHP) & Potash (POT) or between Intel (INTC) & McAfee (MFE). Not the slightly improved global economic picture.