NEWS
9 Apr 2021 - Making up the numbers
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Making up the numbers Adam Chandler, Evans & Partners 26 March 2021 By the measure of whether companies "beat" estimates, the most recent U.S. reporting season was outstanding. At our last count, 79 per cent of S&P500 companies had exceeded consensus estimates. With the S&P500 at record highs, easy monetary conditions, another fiscal stimulus package and reopening ahead, perhaps that's all equity investors need to know. But, as we look more closely at earnings trends in the U.S. market, what becomes clear is that companies are increasingly making adjustments that boost official earnings numbers - and at times, mask the underlying business reality. So, exactly what earnings are beating estimates? In this article we will look at how some companies are using adjustments to inflate earnings, the escalating use of adjustments, and lay out why all this matters for investors.
A brief historical context In short, adjusted earnings are financial metrics that don't meet the relevant U.S. accounting standards for inclusion in financial statements. For those that don't spend their time digging through listed company financials, adjusted earnings are often provided in company's earnings press releases, and in investor presentations and calls, which are less heavily regulated than the standardised, Generally Accepted Accounting Principles (or GAAP) earnings found in financial statements[1]. We will refer to adjusted (or non-GAAP) earnings and GAAP earnings throughout this article. Adjusted earnings should help improve the visibility of the core business' performance and sustainability. A one-off event involving a large legal settlement, may blur the picture of a company's underlying health. For example, when rating agencies Moody's Corporation and S&P Global added back settlements following the Financial Crisis and subsequent industry reform, it provided a clearer view of core businesses that remained incredibly profitable. However, adjustments are nuanced and may be misleading. Unsurprisingly, some management teams have, at times, gamed the system, making questionable adjustments to earnings to give the appearance of higher profitability. A former Chief Accountant at the Securities and Exchange Commission, Lynn Turner, succinctly described non-GAAP earnings as reporting "everything but the bad stuff". One of our favourite examples in recent years was the adjusted earnings manufactured by WeWork, the provider of shared office space. The company's 2018 offering document caught our attention with the very creatively titled "Community adjusted EBITDA". This inflated earnings by adding back almost every imaginable expense including stock compensation, rent adjustments, sales and marketing costs, growth and new market development expenses, as well as general and administrative expenses, magically transforming 2017's EBITDA loss of $769 million into a profit of $233 million. In the long run, of course, trouble awaits managements that paper over operating problems with accounting manoeuvres. Eventually, managements of this kind achieve the same result as the seriously-ill patient who tells his doctor: "I can't afford the operation, but would you accept a small payment to touch up the x-rays?" Berkshire Hathaway 1991 shareholder letter WeWork's 2018 disclosure was a harbinger of a failed 2019 IPO. The valuation halved, before the IPO was pulled, and subsequently WeWork was acquired by its largest investor, Softbank, to help the company avert bankruptcy. As The Guardian noted in December 2019 this was "facilitated by the public exposure of long known information: WeWork was losing a ton of money ..."[2]. Recent data on adjusted earnings confirmed our suspicions about the increasing frequency and magnitude of adjustments. The data also lends support to the claims that overall, adjustments rarely reduce reported earnings. It seems once on the adjusted earnings treadmill, getting off can be difficult.
Median adjusted EPS boost (to GAAP EPS) for the Dow Jones Industrial Average Source: FactSet and Evans and Partners International Fund
While COVID-19 may have resulted in genuine one-offs, the trend for greater use of adjusted earnings is clear. Management adjustments are becoming more prolific. In 1996, 59 per cent of S&P 500 companies used non-GAAP metrics by 2016 that had increased to 96 per cent[3]. Recent advances in augmented reality Two categories of adjustments that we monitor closely are restructuring and stock compensation add backs. Restructuring charges are a common adjustment. From time to time we see justifiable earnings adjustments by the management of our portfolio companies as they navigate one-off events. Conversely, repeated restructuring charges are a red flag; flattering adjusted earnings and potentially masking significant and very real, day-to-day expenses. Stock compensation add backs are another frequent adjustment, particularly in the tech sector. Ironically, while the early 2000's accounting requirement that companies expense stock options has been complied with to the letter in financial statements, many management teams now add back all stock compensation to adjusted earnings. In our view, this provides a misleading view of profitability. Take for example SNAP Inc (SNAP), the social media company. We have no gripe with SNAP, the company has excellent traction with products, users and increasingly advertisers, however their large equity compensation plan does highlight an existential expense question. In 2020, SNAP's stock-based compensation was $770 million, or 30 per cent of revenue. In comparison, adjusted EBITDA was only $45 million, and that was after adding back over three quarters of a billion dollars in stock expense. One single adjustment shifted a lot of red into the black (at least on an EBITDA basis). Does adding back recurring stock compensation really provide a better indication of SNAP's true underlying performance? Stock awards are key to attracting and retaining SNAP's talent. As at the end of 2020, SNAP had almost 4,000 full time employees, with over half in engineering roles. Good luck competing against Facebook[4] after cutting $770 million from your yearly compensation bill, in the intensely competitive, Silicon Valley labour market. In fact, in SNAP's 10K disclosure the risk factors indicate that even a share price decline poses a risk to both staff motivation and retention. Fortunately for SNAP, most analysts covering it focus on revenue multiples! While various adjustments from Uber, Tesla and Alibaba have at times caught our attention, it would be a mistake to tar all tech companies with the same brush. Alphabet and Microsoft are two companies within our portfolio that heavily utilise stock compensation, yet always account for this as an expense. Neither of these companies embellish GAAP earnings with adjustments, they're already highly profitable businesses.
Perverse incentives and outcomes So, does it really matter that some companies are including more aggressive earnings adjustments and subtly shifting attention to non-GAAP earnings? We think it does. Firstly, earnings measures preferred by management may obscure key business trends and comparability across periods (when adjustments are conveniently applied inconsistently) and across companies. Diligent investors and analysts may be expected to see through such dubious adjustments. However, it's a fast paced, headline driven, and currently credulous market, where momentum and all-time highs cover a multitude of sins. Details just get in the way of making money in the short-term. Perhaps more concerningly, many senior management teams are highly incentivised to touch up their own x-rays, through performance-based compensation linked to adjusted earnings metrics (and comparison to other companies who also utilise adjusted earnings). Management compensation plans, disclosed in U.S. proxy statements, highlight the breadth of companies paying CEO's based on one form or another of adjusted earnings[5]. This risk was highlighted by a 2018 study that found "CEO pay is excessive for the S&P 500 firms that report non-GAAP earnings that are much higher than their GAAP earnings"[6].
The long game As the frequency and magnitude of earnings adjustments continue to grow, so does the risk of tipping points for companies whose adjusted earnings no longer even vaguely approximate the financial reality. This may happen either through tougher regulation, or perhaps more likely, through a dawning realisation in a less buoyant market, with a subsequent loss of investor confidence and capital. "One day the market woke up and said, yeah but these numbers don't make any sense." Andy Fastow Former CEO of Enron It is exceptionally difficult to precisely time dramatic shifts in market perception. So, dancing until the music stops is a waltz we'll leave to others[7]. But there is an upside. Questionable adjustments may signal underlying business operations that are struggling to meet expectations and a management culture that encourages half-truths or denial, that we're happy to avoid. All of which is invaluable information to fundamental investors with a long-term horizon. At the Evans and Partners International Fund, we construct our portfolio on four key pillars: business quality; management quality; robust balance sheets; and a keen focus on valuation. Earnings quality, backed by strong cash flow, is key to our investment process, as it affects each of these four pillars. We will continue to pore over adjustments (as well as less obvious accounting manipulation) as we evaluate businesses, valuations and management teams. Unlike some boards, we don't rate management highly for consistently achieving targets through fanciful financial adjustments. Rather, we expect management teams at our portfolio companies to be focused on taking steps today (and tomorrow, and the next day...) to improve the core business and compound returns over the long-term. In a concentrated portfolio of 12 to 15 securities, no company is there to make up the numbers. [1] A key purpose of accounting principles is to have a standardised approach to financial reporting. All public companies in the U.S. are required to report earnings according to Generally Accepted Accounting Principles (or GAAP), as set out by the Financial Accounting Standards Board (FASB). When adjustments are included in company earnings releases a reconciliation between GAAP and adjusted earnings is required. [2] Interestingly, WeWork is reportedly making a renewed attempt to go public through a (SPAC).The Financial Times reported on 23 March 2021, that despite losing $3.5bn in 2019 and $3.2bn in 2020, WeWork is aiming to go public through a merger with a special purpose acquisition company (SPAC), which would have financial disclosure requirements that are lighter than for an IPO, albeit at a much reduced valuation from the abortive IPO two years ago. [3] Academic Literature Review: Accounting Reporting Complexity and Non-GAAP Earnings Disclosure, Audit Analytics, May 2019. [4] By comparison, Facebook expensed $6.5bn in stock compensation in 2020, however, did not add this back to provide adjusted earnings. [5] For the curious reader, SNAP compensates the management team on adjusted earnings, although this isn't disclosed in their Proxy Statement as they don't lodge one - it isn't a requirement as their publicly listed shares are non-voting. [6] High Non-GAAP Earnings Predict Abnormally High CEO Pay, Kothari and Pozen, May 2018. [7] Including former Citigroup CEO, Chuck Prince, whose infamous 2007 quote in an interview with the Financial Times on the cusp of the financial crisis, "When the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you've got to get up and dance", haunted both him and Citigroup throughout the Financial Crisis and beyond.
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8 Apr 2021 - New Funds on Fundmonitors.com
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Wunala Capital Emerging Opportunities Fund |
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Warakirri Concentrated Australian Equities Fund
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Warakirri Ethical Australian Equities Fund
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Warakirri Ethical Global Equities Fund
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Warakirri Global Emerging Markets Fund
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Trineta Emerging Markets Growth Trust
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Pzena Emerging Markets Value Fund
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Pzena Global Focused Value Fund (Wholesale)
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Apostle Dundas Global Equity Fund
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Coaster Capital Horizon Fund
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7 Apr 2021 - Gold's mid-cycle pullback leaves miners historically undervalued and poised for recovery
6 Apr 2021 - Green hydrogen: a European case study
1 Apr 2021 - Hedge Clippings | 01 April 2021
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1 Apr 2021 - Managers Insights | Montgomery Investment Management
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Damen Purcell, COO of Australian Fund Monitors, speaks with Gary Rollo, Portfolio Manager of the Montgomery Small Companies Fund. The Montgomery Small Companies Fund was started in September 2019 and has come through a pretty volatile period, outperforming the ASX Small Ordinaries and broader ASX 200 Total Return Index by significant amounts. Since inception the fund has returned 20.39% with a standard deviation of just 2.74%.
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1 Apr 2021 - From the desk of Amit Lodha
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From the desk of Amit Lodha Amit Lodha, Portfolio Managers, Fidelity International February 2021
Funds operated by this manager: Fidelity Asia Fund, Fidelity Australian Equities Fund, Fidelity China Fund, Fidelity Future Leaders Fund, Fidelity Global Emerging Markets Fund, Fidelity India Fund |
1 Apr 2021 - The 4 Bubbly Pockets of markets showing heightened risk for investors
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The 4 Bubbly Pockets of markets showing heightened risk for investors Andrew Mitchell, Senior Portfolio Manager, Ophir Asset Management 10 March 2021 The ongoing surge in stock prices -- including the NASDAQ, now up almost 100% from its March 2020 low - has many investors fretting that stock markets are now in bubble territory and at risk of a crash. Indeed, according to one survey, the majority of investors now believe the US market is in bubble territory. It has become increasingly clear over the last few weeks that, whilst we don't believe the markets we invest in, Australian and global small and mid-caps, are in a bubble, some parts of investment markets are frothy, with stretched investor sentiment. Below, we also look at four pockets of exuberance in the market (Bitcoin, US IPOs, call options and growth-stock trading volumes) that -- while not being the 'four horsemen of the apocalypse' portending a major bear market -- are indicators that clearly suggest investors do need to be managing risk. At Ophir we are remaining focused on investing in quality companies at reasonable valuations, but also stress testing those companies' likely performance during a savage sell off, and in this environment, we are urging other investors to begin taking similar risk management measures. Exuberance Exhibit 1: Bitcoin The first bubbly pocket is Bitcoin. We can't help but notice the amount of noise surrounding the digital currency. We are constantly asked about its valuation. Even Uber drivers ask for our thoughts. And ads for Bitcoin trading courses and transacting platforms are becoming ubiquitous. This is not unexpected given the rise in price of Bitcoin over the last few years, putting other financial market bubbles in the shade (see chart). The Bitcoin ascent
Importantly, though, Bitcoin is somewhere between a collectible and a currency (and not a particularly good one yet). So, in our view, it doesn't qualify as an asset because it doesn't generate cash flows from which to value it. This makes it ripe for speculation and a good barometer for when financial market sentiment is high. Exuberance Exhibit 2: SPAC IPOs Another measure of market exuberance is IPO issuance, which has ramped up in the US, particularly through what are called Special Purpose Acquisition Companies, or SPACs for short. These vehicles, often called 'blank cheque' companies have a two-year window to find a private company target which they merge with to effectively list it, or else hand back the capital to investors. Private office leasing company WeWork is the latest in a long line said to be in talks with a SPAC to go public. IPO issuance tends to increase when company owners think they can raise capital, or sell out, at heightened valuations in the market, and generally not when it represents good value for buyers. SPACs have been around for a number of years, but they raised six times the amount of money in 2020 than they did in 2019. SPACs have emerged from a relative backwater to become the dominant form of listing for US companies, now currently comprising over 50% of IPO activity in the US. Their boom has come with SPACs bringing early-stage higher-growth businesses, particularly technology businesses, to market. There is huge demand for these stocks from retail traders with more time on their hands and less aversion to volatility. The demand has been fuelled by interest rates near 0%, which means the opportunity cost for investors of having their cash tied up in a SPAC waiting for an acquisition is low. The 2020 SPAC IPO boom has continued into early 2021 (as of 21 January 2021)
Exuberance Exhibit 3: retail call options This next measure of exuberance is tied to the democratisation of investing that has given retail investors cheap access to trading platforms and financial information. When combined with government stimulus cheques and extra time on their hands, small retail traders have been investing heavily in call options on individual listed companies. These options essentially give the buyer the right to buy a share in a company at a certain price (strike price) and the trader executes the option if the share price rises above the strike price. They are generally bought if the investor is bullish on the company and its price is rising higher; but they are popular with retail traders because options are a cheaper way to get exposure to that potential price rise. As can be seen in the chart below, call option volumes for small parcels (less than 10 contracts) that retail traders tend to buy, have gone through the roof over the last year, and particularly the last few weeks. Call Option Buy Minus Sell at Open for investors with less than 10 contracts for options on individual US equities (In million contracts. Last observation is for the week ending 29th Jan 2021)
Such betting by often value agnostic retail traders should give long term investors pause as this may not be a particularly sustainable source of demand behind price rises of companies. Exuberance Exhibit 4: growth stock volume And, finally, trading volumes in the most expensive growth-orientated companies has exploded recently (see chart). Whilst not at the dot.com levels from 2000 at present, those companies trading at greater than 20 times Enterprise Value-to-Sales ratios (an historically expensive level) are making up a much bigger part of the market and account for around a quarter of all trading activity. There are some rational reasons for this, including some large high-growth (and high valuation) technology companies further entrenching their dominate positions during COVID, but it does suggest caution is warranted. Trading in stocks with extremely high EV/sales ratios has surged (as of 21 January 2021: LTM EV/sales ratios of stocks with LTM revenues > $50 million)
A buying opportunity In the short term, we would not be surprised to see a 5-10% pull back in the major share markets given the extended level of investor optimism we see in some corners at present. Timing, though, for any pullbacks is always difficult to judge when it is sentiment based. We would see such a pull back as a buying opportunity in our funds and a healthy occurrence for markets. We think it less likely that a major bear market is around the bend given the supporting backdrop to corporate earnings as the vaccines bring the virus under control, and central banks' willingness to keep short-term and long-term interest rates lower for even longer in the absence of signs of inflation. This should support the attractiveness of equities relative to bonds for some time yet. Our risk management plan to deal with bubbly markets So whilst we don't see the markets we invest in at 'bubble' valuation territory, some measures of investor sentiment described above do argue for caution in company selection. Beyond being well diversified by company, sector and geography and not overexposed to any particular investing style, our risk-management plan ensures the companies we hold in our funds have a high probability of upgrading earnings at their next results announcement and are trading on reasonable valuations compared to fundamentals (cash flow and earnings) and peers. Moreover, we track how the company is likely to fair in an economic and market 'meltdown'. This includes tracking measures related to liquidity, dividend yield, gearing and how opaque the company's business model is. We aggregate these measures at a portfolio level to understand how we are faring across each metric, ensuring the exposures are calibrated appropriately for where we are at in the market cycle. In conjunction these measures help provide downside protection in the event of any market sell off. At present whilst largely being fully invested within our funds, we are paying particular attention to not overpaying for growth and have become more conservatively positioned across our meltdown risk metrics at a fund level. Funds operated by this manager: Ophir Global Opportunities Fund, Ophir High Conviction Fund (ASX: OPH) |
31 Mar 2021 - Performance Report: Quay Global Real Estate Fund
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| Fund Overview | The Fund will invest in a number of global listed real estate companies, groups or funds. The investment strategy is to make investments in real estate securities at a price that will deliver a real, after inflation, total return of 5% per annum (before costs and fees), inclusive of distributions over a longer-term period. The Investment Strategy is indifferent to the constraints of any index benchmarks and is relatively concentrated in its number of investments. The Fund is expected to own between 20 and 40 securities, and from time to time up to 20% of the portfolio maybe invested in cash. The Fund is $A un-hedged. |
| Manager Comments | Underlying constant current stock returns were up +5.3% reflecting the ongoing recovery in real estate values. During the month, the so called 're-open trade' played a meaningful part of in the fund's performance. Strong gains in retail (Brixmor Property, Scentre Group, Wharf REIC) and healthcare (Ventas) underwrote a pretty solid month for investors. At the other end of the spectrum, the main drag on performance were the pandemic 'superstars' including European storage, German residential and data storage. Quay still believe these sectors have very bright long-term prospects and they remain happy holders across their preferred names. |
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