Earnings Don’t Matter! December 6, 2017 by The Knowledge Leaders Team in Knowledge Leaders Our long-time readers are familiar with the work of Professor Baruch Lev of the NYU Stern School of Business, whose research forms the basis for the Knowledge Leaders investment strategy. In his decades-long study of financial records, Lev first discovered a link between a firm’s knowledge capital and its subsequent stock performance, ultimately identifying a market inefficiency that leads highly innovative companies to deliver excess returns. We call this market anomaly the Knowledge Effect. In a new article in Financial Analysts Journal, Lev and co-author Feng Gu continue to advance the findings on intangibles. The article, “Time to Change Your Investment Model,” identifies that earnings prediction has lost “much of its relevance in recent years.” As a form of predicting corporate results, “earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis.” The basis for this shift, the authors explain, occurred after the emergence of the semiconductor. “Starting in the early 1980s, investment in traditional, tangible assets (structures, factories, machinery, inventory) – considered assets by accountants and reported accordingly on the balance sheet – dropped precipitously from 15% of gross added value in 1977 to 9% in 2014, a 40% drop. In contrast, the investment rate in intangible capital (R&D, patents, information systems, brands, media content, business processes) – mostly expensed in corporate income statements – increased continuously from 9% to 14% of added value, a 56% increase. This radical business model transformation came to be known as the knowledge – or information revolution, an irreversible trend in developed economies.” As a result, for companies, “the only way to survive and prosper in such a competitive environment (is) through constant product and process innovation, achieved primarily by investing in intangible assets.” Therefore, “earnings’ usefulness to investors declines sharply for companies that increasingly rely on intangible value-creating assets.” For these reasons, “GAAP-based reported earnings no longer reflect the periodic value changes (growth) of most business enterprises, and thus conventional earnings-based security analysis has lost much of its usefulness for investors in recent years.” In summary, the authors observe: “The disappointing returns on managed funds in recent years should raise doubts about the continued usefulness of conventional security analysis. Our extensive empirical evidence on the loss of relevance of GAAP numbers, in both this article and our recent book, confirms these doubts. Certain major investors have already departed from the status quo. … We propose a different course: Rather than replace analysts with robots, substitute an improved investment methodology for an outdated one.” If you’re interested in reading Lev and Gu’s article, download it here. Stay tuned for more on Professor Lev’s research in early 2018 and an in-depth Q&A on his latest research on intangible capital. All quotes within are pulled from the article “Time to Change Your Investment Model,” by Feng Gu and Baruch Lev, Financial Analysts Journal, Q4 2017, a publication of the CFA Institute. Chart credit: the featured chart is pulled from the same article. http://blog.knowledgeleaderscapital.com/?p=13778
I don't know that I would call this shift "recent". As one can see from the chart, the shift occurred at around '94, when the internet age dawned, at least as far as the consumer was concerned. And by the late 90s, companies were being priced based on "vision" (the VSR: vision to sales ratio). Which is yet another reason why prices reflect not what the company is "worth" (whatever that may mean) but rather what people are willing to pay.
It is no surprise to me that "earnings no longer matter" when you consider: *Publicly-traded companies within indices now have a never-ending stream of free capital due to the millions of Americans now participating in 401K and other defined-contribution plans rather than company sponsored pension plans of old. *Cost of capital has been in a perpetual bear market due to the 30-year bull market in petro-dollar backed US treasuries. 3% cost of capital is a far easier hurdle than 8% rates of old. *Electronic, highly liquid markets give investors more confidence that they will be able to always find a "greater fool" to buy shares from them at higher prices. *Government digital fiat money creation/debt explosion since the 1980s. If the government's balance sheet doesn't matter and prosperity can be created out of thin air, why should corporate balance sheets matter that much? *M&A/LBO explosion since 1980s - story stocks seem much less risky if there is a fertile environment where companies are constantly getting acquired. Just my opinion.
You remember that movie "Limitless"? There was a quote, not to be found in public( i checked web ), where Bradley Cooper's character soon sours on the massive amount of time/brainwork spent on devouring the business press and financial data, and he goes (i don't know exact wording) "Who wants to spend all that time and energy on the numbers only to get a 5% uptick? [Scene shows him reading press like Financial Times etc] "No....i started digging into the more strategic information....") I think Baruch Lev and Feng Gu are right, the numbers are heavily gamed-out and have little value left other than confirmation. Case in point: go to www.cpajournal.com, find the "search" lupe, in upper right corner and search them for "Earnings smoothing"....watch the plethora of results that pop up...! I'm shocked i tell you, shocked!