Warren Buffett blasts ‘one of the shames of capitalism’ 🤬
Plus a charted review of the macro crosscurrents 🔀
Stocks tumbled last week, with the S&P 500 falling 2.7%. The index is now up 3.4% year to date, up 11% from its October 12 closing low of 3,577.03, and down 17.2% from its January 3, 2022 closing high of 4,796.56.
This occurred during a period when retailing giants Walmart and Home Depot expressed caution on the outlook for consumer spending, a tone that seemed to be in conflict with the fact that both companies reported quarterly earnings that beat analysts’ expectations. (See here and here.)
In recent weeks, much has been made about how the share of companies beating analysts’ quarterly expectations has been low relative to history. According to FactSet, 68% of S&P 500 companies reported Q4 earnings that beat expectations. This is below the 5-year average of 77% and the 10-year average of 73%.
‘Disgusting’ activity 🤮
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.
For more investor wisdom:
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
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 🧩 »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
10 truths about the stock market 📈
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Stomach-churning stock market sell-offs are normal🎢
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
How stocks performed when the yield curve inverted ⚠️
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
How the stock market performed around recessions 📉📈
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
In the stock market, time pays ⏳
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
700+ reasons why S&P 500 index investing isn't very 'passive'💡
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks. From January 1995 through April 2022, 728 tickers have been added to the S&P 500, while 724 have been removed.
The key driver of stock prices: Earnings💰
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
When the Fed-sponsored market beatings could end 📈
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
What a strong dollar means for stocks 👑
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
Economy ≠ Stock Market 🤷♂️
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
Stanley Druckenmiller's No. 1 piece of advice for novice investors 🧐
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Peter Lynch made a remarkably prescient market observation in 1994 🎯
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Warren Buffett's 'fourth law of motion' 📉
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
'Past performance is no guarantee of future results,' charted 📊
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. According to their research, 29% of 791 large-cap equity funds that beat the S&P 500 in 2019. Of those funds, 75% beat the benchmark again in 2020. But only 9.1%, or 21 funds, were able to extend that outperformance streak into 2021.
One stat shows how hard it is to pick market-beating stocks 🎲
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 22% of the stocks in the S&P 500 outperformed the index itself from 2000 to 2020. Over that period, the S&P 500 gained 322%, while the median stock rose by just 63%.
“Operating earnings” is unfortunately a bit ambiguous. It can be used to describe net income adjusted for certain items, which is a non-GAAP metric. But it is also used to describe sales less cost of goods sold and operating expenses but before interest expenses and taxes, which is a GAAP metric.