How to crack Wall Street’s earnings code

How to crack Wall Street’s earnings code
7 terms to listen for when CEOs and CFOs talk business
Matt Andrejczak, MarketWatch

SAN FRANCISCO (MarketWatch) — Executives at Research In Motion Ltd. were “extremely excited” in March 2011 about prospects for the Blackberry smartphone and PlayBook tablet, according to the company’s quarterly earnings release.

Their tone changed over the short course of a year. In subsequent earnings releases, RIM used phrases like “challenging start,” “slightly below our forecast,” and “market challenges” to describe the pace of its business.

As its struggles mounted, RIM (US:RIMM) eventually stopped providing financial targets to the investment community.

By now, investors know RIM’s predicament. The Canadian company is selling fewer Blackberrys and losses are piling up. Its shares have plunged 72% over the past 12 months.

And recently, RIM delayed its much-anticipated Blackberry 10 — again.

Let RIM be a lesson for decoding corporate earnings-speak as investors gear up for this year’s second-quarter earnings updates, which are slated to kick-off July 9 with aluminum maker Alcoa Inc. (US:AA)

Alcoa faces low bar after Street cuts profit views.

This time, more companies are likely to dispense disappointing news, or worse, reveal dim second-half prospects. Blue-chip companies such as Ford Motor Co. (US:F) , Procter & Gamble Co. (US:PG) and United Technologies Corp. (US:UTX) have already issued financial warnings.

So far, 94 of the companies in the Standard & Poor’s 500-stock index (US:SPX) have made negative earnings announcements for the second quarter. That compares with 26 positive announcements, according to Thomson Reuters data as of June 29.

Word play

With growth for the rest of 2012 looking suspect, investors need to be mindful of corporate management trying to sugarcoat business conditions. To help, MarketWatch asked money managers and market analysts which key phrases perk their antennae when reading an earnings statement or listening to a conference call.

“We get suspicious when corporations talk about a ‘strong’ or ‘solid’ quarter but revenues disappoint,” said Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund (US:MPDAX).

Here’s a sampling of what management might say — and what they really mean:

1) Conditions were challenging
Translation: We’re getting killed by the competition is another way to interpret this statement, according to Dallas-based money-manager Charles Sizemore, who pens the Sizemore Investment Newsletter.

2) Sales and earnings are poised to reaccelerate
Translation: Forget the bad quarter we just announced and maybe even our current business period, said Brian Sozzi, chief equities analyst at New York’s NBG Productions, which runs the website decodingwallst.com.

3) Weather affected sales
Translation: The company sells a product or service no one really wants or they are losing market share, said Tim Gramatovich, chief investment officer at Santa Barbara, Calif.-based Peritus Asset Management, which runs AdvisorShares Peritus High Yield ETF (US:HYLD)

4) Right-sizing inventory
Translation: Sales are slipping or falling off a cliff, said Sandy Villere III, a portfolio manager for New Orleans-based Villere & Co., which runs Villere Balanced Fund (US:VILLX) .

5) Macro-environment was weak
Translation: Our market share is under pressure.
Blaming the economy could obscure market share losses or the company’s decision to step up discounts, NBG’s Sozzi said. This is often heard when profits are less than a company’s internal projections.

6) We face uncertainty
Translation: We lost sales this quarter. In this case, companies are certain business is slowing, Gramatovich said.

7) Seasonality affected sales
Translation: Business is weaker than usual.
Companies are prone to doing more business at certain times of the year. But if a company’s sales typically slip 10% in the fourth quarter and the company reports a 25% decline, then beware if management tries to spin this as nothing out of the ordinary, said Dan Mahoney, head of CFRA Research, which does forensic accounting and quality of earnings research.

Anatomy of a conference call

In “Detecting Deceptive Discussions in Conference Calls” published in May’s Journal of Accounting Research, Stanford University business professors David Larcker and Anastasia Zakolyukina found that when it comes to language, deceptive CEOs and CFOs use more references to general knowledge and fewer references to shareholder value.

In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words, their research concluded. Watch for excessive use of words like “strong” and “great.”

Quarterly conference calls are a highly planned event, in which top executives read from a script of carefully chosen words. CEOs usually start with an executive overview, followed by the CFO summarizing the company’s profit or loss, sales, and performance by business unit.

Then they offer an outlook before opening the call to analyst questions.

During the call, it’s important to listen to how executives are communicating their message, said Chris Terry, a senior analyst at Hodges Capital Management in Dallas. For instance, is management emphasizing something different than three or six months ago?

Moreover, listen closely to detect if management’s tone has changed about sales growth or product pricing. This could impact profit margins. Do they sound less aggressive? Better yet: Match their comments against a rival company. If there’s a disconnect, there might be a problem.

Also, determine if management ducks questions.

“At the end of the day, it’s about managing expectations and the best teams provide as much information and explanation as possible to assist analysis,” Terry said. “Others lose credibility fast and the stock suffers as a result.”

Take luxury goods retailer Tiffany & Co (US:TIF) , whose shares are trading near a 52-week low after its guidance seesawed in a span of six months. Tiffany on Nov. 29 raised its 2011 outlook, only to cut its forecast Jan. 10.

Then on March 20, the retailer said demand had picked up. In late May, Tiffany brought down those expectations. Shares have stumbled 19% year-to-date.

“We and everyone else like companies which under-promise and over-deliver,” said investment chief Bill Smead of Smead Value Fund (US:SMVLX)  in Seattle. His fund doesn’t own Tiffany shares.

Earnings meets, beats or misses

An earnings miss may be a prelude of things to come.

“A miss usually leads to another miss,” said John Del Vecchio, co-portfolio manager of the AdvisorShares Active Bear ETF (US:HDGE) , which bets on company share prices to decline.

“Very rarely does a business have a one-quarter bump in the road,” he added.

Research in Motion is a good example. Dating back to June 2011, the company missed the consensus profit estimate of analysts in four of those quarters, FactSet data shows. Another example was Juniper Networks Inc. (US:JNPR) , according to Del Vecchio, who profited from shorting the stock last year.

Juniper, a maker of telecommunications networking equipment, missed sales expectations from the second quarter of 2011 through the fourth quarter. Juniper later cut its quarterly financial projections and also issued a below consensus sales outlook for its 2012 first quarter.

Watch inventory — especially at consumer-products makers. In the past, companies have been known to speak optimistically about future sales even as current inventories are growing much faster than revenue.

Inventory tripped up Deckers Outdoor Corp. (US:DECK) , maker of Ugg boots and Teva sandals.

The company’s fourth-quarter report Feb. 23 showed sales up 40% while inventories had ballooned 103%. Yet Deckers’s brass spoke of “compelling growth prospects across our entire business.” Come April 26, the company cut its outlook after missing first-quarter estimates. 

During the quarter, sales growth had slowed to 20% while inventories rose 95%.
No surprise, Deckers shares have been squashed. The stock is down 63% from its November 2011 52-week high of $118.90.

A string of profit or sales misses is never good. To money-manager Sizemore, it can mean “management has underestimated how bad the company’s situation is. Industry or market conditions are changing faster than management believed and their firm is getting left behind.”

Where the Power Really Lies

If you really want to know where the power (and the truth) is in American, ask yourself how in the middle of the "Great Recession" when mega-millions are unemployed, when 2 million people a year declare personal bankruptcy, when two million people a year have their homes foreclosed on them, when most personal bankruptcies include unaffordable medical expenses,

… when all these things are hammering away at our middle class, … with all this going on, … American's largest corporations are producing record profits, all-time records: Caterpillar, Apple, Microsoft, MacDonald’s ... Read on  

Corporate Profits Were the Highest on Record Last Quarter. By CATHERINE RAMPELL

The nation’s workers may be struggling, but American companies just had their best quarter ever. The New York Times Economix Blog: Visualizing Booming Profits (November 23, 2010)

American businesses earned profits at an annual rate of $1.659 trillion in the third quarter, according to a Commerce Department report released Tuesday. That is the highest figure recorded since the government began keeping track over 60 years ago, at least in nominal or noninflation-adjusted terms.

Top companies: Most profitable

Rank    Company    2010   $ (millions)

1          Exxon Mobil

            30,460.0

2          AT&T

            19,864.0

3          Chevron

            19,024.0

4          Microsoft

            18,760.0

5          J.P. Morgan Chase & Co.

            17,370.0

6          Wal-Mart Stores

            16,389.0

7          International Business Machines

            14,833.0

8          Apple

            14,013.0

9          Johnson & Johnson

            13,334.0

10        Berkshire Hathaway

            12,967.0

11        Procter & Gamble

            12,736.0

12        Wells Fargo

            12,362.0

13        Coca-Cola

            11,809.0

14        General Electric

            11,644.0

15        Intel

            11,464.0

16        ConocoPhillips

            11,358.0

17        Citigroup

            10,602.0

18        Hewlett-Packard

            8,761.0

19        Google

            8,505.0

20        Goldman Sachs Group

            8,354.0

21        Pfizer

            8,257.0

22        American International Group

            7,786.0

23        Cisco Systems

            7,767.0

24        Philip Morris International

            7,259.0

25        Ford Motor

            6,561.0

26        PepsiCo

            6,320.0

27        General Motors

            6,172.0

28        Oracle

            6,135.0

29        Eli Lilly

            5,069.5

30        McDonald's

            4,946.3

31        Morgan Stanley

            4,703.0

32        UnitedHealth Group

            4,634.0

33        Amgen

            4,627.0

34        Abbott Laboratories

            4,626.2

35        Devon Energy

            4,550.0

36        Occidental Petroleum

            4,530.0

37        United Technologies

            4,373.0

38        Freeport-McMoRan Copper & Gold

            4,336.0

39        Kraft Foods

            4,114.0

40        3M

            4,085.0

41        American Express

            4,057.0

42        Walt Disney

            3,963.0

43        Altria Group

            3,905.0

44        Comcast

            3,635.0

45        Corning

            3,558.0

46        United Parcel Service

            3,488.0

47        CVS Caremark

            3,427.0

48        PNC Financial Services Group

            3,412.0

49        Home Depot

            3,338.0

50        U.S. Bancorp

            3,317.0

Investing guru Doug Casey on the morality of selfishness and money

Sunday February 12. I just ran into this (and I am a great lover of philosophy, logic, semantics and word games!) Investing guru Doug Casey on the morality of selfishness and money:

“Let me say one more thing about the issue of selfishness – the virtue of selfishness – and the vice of altruism. Ayn Rand might never forgive me for saying this, but if you take the two concepts – ethical self-interest and concern for others – to their logical conclusions, they actually are the same. It's in your selfish best interest to provide the maximum amount of value to the maximum number of people – that's how Apple became the giant company it is. Conversely, it is not altruistic to help other people. I want all the people around me to be strong and successful. It makes life better and easier for me if they're all doing well. So it's selfish, not altruistic, when I help them.”

I think there’s some truth to that, and yet selfishness and altruism are not the same, nor are dark and light, good and bad, up and down. It’s quite possibly not in my self-interest to give up my life for another, unless you redefine “self-interest”, is it? “Self-interest” is very close to “self-preservation”, and I can hardly be said to be “preserving myself” by giving up my life, without redefining “self”. If we consider self to be my human life, then it is not. We would need to say “self” is my eternal self. Then we could argue that it might be possible to “serve myself” by “denying myself.” But then we are dealt a paradox that it required Jesus to rectify for us.

May you enjoy your boredom!

I remember once I heard that there is an old Chinese saying that is said intending to be a curse on the person: MAY YOU LIVE IN INTERESTING TIMES. Ooo. I guess the implication is that we should enjoy our boredom. Haha..

Wikipedia expands on the concept this way:

"May you live in interesting times", often referred to as the Chinese curse, is reputed to be the English translation of an ancient Chinese proverb and curse, although it may have originated among the English themselves. It is reported that it was the first of three curses of increasing severity, the other two being:

"May you come to the attention of those in authority" (sometimes rendered "May the government be aware of you"). This is sometimes quoted as "May you come to the attention of powerful people." (Alternately, "important people".)

"May you find what you are looking for." This is sometimes quoted as "May your wishes be granted."

Creating a Climate of Health, Wellness and Safety in the Workplace.

Since it widely believed, and many studies support, the idea that unhealthy workers cost more than it would have cost to keep them well, why are so many people opposed to universal health care in the United States?

I personally believe that universal health care would pay for itself in prevention and worker productivity and also by enlarging the middle class and its purchasing and spending capability in the economy.

"A stitch in time saves nine." Right now we are continually paying nine and gasping, "It's too expensive!" It's too expensive, that's right, but it's too expensive NOT to do it!

And just to show you what I mean about the worker productivity issue, I will attach below something written not to address universal health care, but which, inadvertently perhaps, gives the issue away upon perusal of its content.

The article says obesity costs American businesses $153 billion a year. If that is the case, or anywhere close, imagine what all employee health problems cost!

How Much Are Unhealthy Workers Costing You, and What Can You Do About it?

It's reported that unhealthy workers cost employers billions every year. NIOSH has some ideas for developing programs and policies that can improve worker health and cut costs.

Full-time workers in the United States who are overweight or obese and have other chronic health conditions miss about 450 million more days per year than healthy workers. According to a Gallup poll, this results in an annual productivity loss of $153 billion.

The Gallup-Healthways Well-Being Index finds that full-time workers of normal weight without chronic health conditions make up 13.9 percent of the U.S workforce and average about 4 days a year of absence. Workers of above normal weight with three or more chronic conditions average about 42 days of absence per year.

Another report, the "Thomson Reuters Workforce Wellness Index" finds that a decline in overall population health is contributing to rising healthcare costs and lost productivity for U.S. employers. The report cites an annual cost of unhealthy behavior of $623 per employee.

The index uses six behavioral risk factors to tract collective health of workers who have employer-sponsored health care. The risks are:

•          Body mass index
•          Blood pressure
•          Cholesterol
•          Blood glucose
•          Tobacco use
•          Alcohol use

In 2010, about 14 percent of direct healthcare costs for these employers was directed linked to the six factors. The single biggest factor was body mass index, which is used to measure obesity.

NIOSH Identifies Strategies

In a report entitled "Essential Elements of Effective Workplace Programs and Policies for Improving Worker Health and Wellbeing," NIOSH identifies four key areas employers need to address to improve worker health. We'll present two today, and two tomorrow.

1. Organizational Culture and Leadership

•          Develop a "human centered culture." Effective programs thrive in organizations with policies and programs that promote respect throughout the organization and encourage active worker participation, input, and involvement.

•          Demonstrate leadership. Commitment to worker health and safety, reflected in words and actions, is critical. The connection of workforce health and safety to the core products, services and values of the company should be acknowledged by leaders and communicated widely.

•          Engage mid-level management. Supervisors and managers at all levels should be involved in promoting health-supportive programs. They are the direct links between the workers and upper management and will determine if the program succeeds or fails. Mid-level supervisors are the key to integrating, motivating and communicating with employees.

2. Program Design

•          Establish clear principles. Effective programs have clear principles to focus priorities, guide program design, and direct resource allocation. Prevention of disease and injury supports worker health and well being.

•          Integrate relevant systems. Program design involves an initial inventory and evaluation of existing programs and policies relevant to health and well-being and a determination of their potential connections. Programs should reflect a comprehensive view of health: behavioral health/mental health/physical health are all part of total health. Integration of diverse data systems can be particularly important and challenging.

•          Eliminate recognized occupational hazards. Changes in the work environment (such as reduction in toxic exposures or improvement in work station design and flexibility) benefit all workers.

•          Be consistent. Workers' willingness to engage in worksite health-directed programs may depend on perceptions of whether the work environment is truly health supportive. Individual interventions can be linked to specific work experience. For example, NIOSH says that industrial workers who smoke are more likely to quit and stay quit after a worksite tobacco cessation program if workplace dusts, fumes, and vapors are controlled and workplace smoking policies are in place.

•          Promote employee participation. Ensure that employees are not just recipients of services but are engaged actively to identify relevant health and safety issues and contribute to program design and implementation. Barriers are often best overcome through involving the participants in coming up with solutions.

•          Tailor programs to the specific workplace and the diverse needs of workers. Effective programs are responsive and attractive to a diverse workforce. One size does not fit all—flexibility is necessary.

•          Consider incentives and rewards. Incentives and rewards, such as financial rewards, time off, and recognition, for individual program participation may encourage engagement, although poorly designed incentives may create a sense of "winners" and "losers" and have unintended adverse consequences.

•          Find and use the right tools. Measure risk from the work environment and baseline health in order to track progress. For example, a Health Risk Appraisal instrument that assesses both individual and work-environment health risk factors can help establish baseline workforce health information, direct environmental and individual interventions, and measure progress over time.

•          Adjust the program as needed. Programs must be evaluated to detect unanticipated effects and adjusted based on analysis of experience.

•          Make sure the program lasts. Design programs with a long-term outlook to assure sustainability. Short-term approaches have short-term value. There should be sufficient flexibility to assure responsiveness to changing workforce and market conditions.

•          Ensure confidentiality. Be sure that the program meets regulatory requirements (e.g., HIPAA, state laws, ADA) and that the communication to employees is clear on this issue. If workers believe their information is not kept confidential, the program is less likely to succeed.

Econ 101: Comparative Advantage versus Absolute Advantage

In economics, comparative advantage means you can produce something for the lowest cost. Absolute advantage means you produce the best product. It helps to know that what it costs someone to produce something is the opportunity cost—the value of what is given up.

But basically what you have here is a good example of the economists taking two incredibly simple concepts and messing them up so badly that nobody (in their right mind) can understand what they are talking about. I sometimes nowadays find help on You Tube.

In this case, I think any one of the following will do quite nicely:

http://www.youtube.com/watch?v=VVp8UGjECt4

http://www.youtube.com/watch?v=Z3xd8bXlzeU

http://www.youtube.com/watch?v=qSk-ugSizY4

Forecasting 101

We all make investment decisions based on some kind of forecast of the economy. We might look to certain professionals or rely on our gut instincts. But one way of the other, we require some kind of forecast of the future in order to invest in it.

“Therefore … , why not go after it and make it the best I can?” was my thinking. And test it by recording it and sharing it with others.

A year ago, we tried to forecast the Dow. I "surmised" it would end 2011 and start 2012 at 12,700. It turned out to have been amazingly accurate, the index closing at 12,723 today (February 1, 2012.

Actually, it closed the year at 12,217, and I had said it would test 13,000 the first of the year, which it hasn’t done (yet), although it is close.

But getting the forecast fairly close indicates to me that the market does follow certain fundamentals after all, those being:

·         corporate earnings (the tangible) together with revenues and perhaps market share plus cash position - which is considered relative to the competition in same industry,

·         corporate leadership (the intangible) in terms of personnel and corporate structure and operations, and

·         multiple of earnings, which is what investors are willing to pay to own that stock and be entitled to receive, through dividends plus increase in the value/ price of the stock, based on the corporation's reinvestment of those earnings in itself.

Perhaps the "most fundamental fundamentals" then are 1) earnings, 2) the company's ability to sustain or grown those earnings in the mid-term future (2-6 years) based on micro-economic (internal to the company) and macro-economic (external to the company) factors.

It is said that investors buy the market six months in the future, that is, they invest based on about as far as they think they can see into the future and what the company's situation would seem to them to be at that point in time.

So putting this all together, we can pose and illustration: my target investment earns $2 per share. My assessment tells me that this company can continue at this pace and earn the same in six months.

I am willing to pay 12 times earnings for those shares, that is, $24 per share, based on my assessment of the risk. If I do in fact, purchase shares at 12 times earnings, I am investing in something based on my personal Price/ Earnings ratio of 12.

Flip that fraction over, that is put the denominator on top and the numerator on the bottom, and it gives Earnings/ Price = 1/12. 1/12 in decimal notation = 8.33%. 8.33% is my expected Yield from my investment.

Now I have a basic or FUNDAMENTAL piece of information, which I can now use to compare my investment with other (and competing for my capital) investments that are available.

Finance teaches us that risk and return are inversely related, that is the greater the prospective return, the greater the risk that will be associated with that investment. And conversely, the lower the expected return, the lower the expected risk.

My investment has an expected return of 8.33%, but I could have invested in say, for example, a piece of real estate with an expected return of 15%, but I thought it was too risky for me. Or I could have invested in an oil well drilling consortium that "expected" a 23% return, but that one was way too risky for my taste.

On the other end of the risk/ return spectrum I have a choice of bank CD's yielding between .5% and 2.5% based on the term, the .5% CD having a six months term and the 2.5% CD being a ten-year term. But I chose my investment because I felt I needed to at least try to earn a higher rate of return than that, especially considering that it is probably not going to keep with inflation.

But after analyzing my investment options and choosing the one I did, I was willing to pay 12 times earnings for my stock, which gave it a price of $24 in the market.

Throughout the investment world, millions of decisions are being made, very similar to mine, and the Market will be determined, IN TERMS OF FUNDAMENTALS, by the aggregate of these decisions.

All these investment decisions combined will price my stock at $24 a share, unless of course, the market is not reacting to FUNDAMENTALS, like when there is a major event that inspires either "unwarranted" optimism or the same "unwarranted" pessimism among us investors.

An event like that could be almost anything, but recently we have seen political gridlock in Washington really throw the market for a loop. These events, when combined with computer-generated trading has led to the markets having greater volatility and greater up and down swings that ever in its history.

As investors, we must ask ourselves, when it seems that the market is "in the grip" of excessive optimism or pessimism, "What are the FUNDAMENTALS?" that is, what are corporations earning, what are their expected earnings, what are the micro-economic and real macro-economic risks that apply.

As investors, we can see wild market swings almost daily, but what guides the market in the long term? I would say THE FUNDAMENTALS do; they SHOULD, and most of the time they do.

So going back to our little game of trying to predict the DJIA one year into the future, we would want to disregard all the temporarily unsettling events that throw the market for days or even weeks at a time and focus on the things that we feel determine the value of the market long term.

That is why I predicted the DJIA at 12,700. The DJIA was around 11,700, but I felt there was an excessive degree of pessimism acting on it: all the news was bad, and investors were discouraged.

But the world is seldom all bad or all good. When we feel it is all good, it is probably actually worse than we think. And when we think the world is all bad, it is most likely better.

The prediction was based on my feeling that the Fundamentals were actually not that bad and that the DJIA should really be around 12,300. Then it seemed that we were not out of the woods in the recession, so any real growth that the economy had, which would eventually be reflected in the equity markets, would be slow, probably in the range of 3% GDP.

So applying this 3% growth to the 12,300 figure gives a figure of around 12,700. Now a year later, that is just about where the DJIA is today.

So all this is not meant to really be an inane game or an irrelevant hypothetical, or worst an exercise in gambling or gamesmanship. It is intended to be a minimal effort at creating a "backdrop” for making my investment decisions.

I have, in fact, acted upon this prediction over the past 12 months, not because I felt it was certain, but only because it was the best I could do. And I felt it was necessary for me to at least make the effort.

My investments have done OK, but measured against what? Measured against complete disaster, they have done great. Against any one of a number of POSSIBLE investment scenarios, they have done perhaps poorly.

One of the things that this forecast led me to, because it portrayed an extended period of such slow growth in the economy, was to consider buying bonds instead of stocks. And this has turned out to have been an immensely popular alternative for many investors during 2011.

I have tried to invest conservatively and based on my best projections, and then live with the consequences and, perhaps learn from them.

I am encouraged to at least have some sort of primitive methodology. I can at least now work with this method in the future, looking, of course to indications that it could be improved or altered in any way.

That brings me up to the present. Looking forward to 2012, the “experts” are forecasting another year of perhaps 3% growth in GDP. If corporate performance follows this figure, all things remaining constant, our DJIA of 12,700 should also increase by 3%, taking it to around 13,100 by year end 2012.

Now I try to stand back and look at that, and I just simply feel in my gut that we have had too much bad news for too long. “Been down so long, it looks like up to me.” And guessing a little about the chartist in us all, I just felt that the DJIA would go up to just short of 13,500.

That seems like a nice number that we will not be too frightened of. Then, just short of 13,500 is 13,450. So 13,450 is my forecast for the DJIA for 12/31/2012.

Now I can settle down and see what, in fact happens. Hmmm, that’s it for now, I think. I guess I will not be accused of having been laconic.