Building Wealth Doc's note: Earnings season is underway... Every quarter, Wall Street analysts and average investors alike follow the news to decide what stocks to sell and buy next.
But today, Stansberry Venture Value editor Bryan Beach explains what everyone gets wrong about earnings seasons and the data you should actually follow...
It's the most pointless exercise in the modern markets...
I'm talking about the perceived importance of Wall Street analysts' estimates and the "earnings season" saga that plays out every three months.
The entire song and dance wastes everyone's time. And as I'll help you learn today... it's based on one of the world's greatest investment fallacies. I'll also point out what you should be paying attention to instead.
But before we get into all the details, let's start at the top...
This whole charade began when investment banks decided to offer a service to large trading clients...
Decades ago, these banks started hiring analysts to cover large public companies. Over the years, the analysts' roles expanded. They eventually began publishing detailed reports... issuing buy, hold, and (on rare occasions) sell ratings... and even setting 12-month price targets for the stocks.
As a result, the CEOs of the public companies soon realized that they should cooperate with these Wall Street analysts... These analysts had established relationships with big-money investors and worked for the same banks that would be able to raise money for their companies when needed.
So the CEOs and the Wall Street analysts started getting friendly with one another.
As it turns out, the big-money clients didn't care much about the analysts' price targets or write-ups... However, they did like that the analysts offered direct access to CEOs. Once they were in the room with the CEOs, the analysts' big-money clients could do their own due diligence. And so, a virtuous cycle formed...
Analysts write nice things, so CEOs like to work with them... Then, the analysts provide their big-money clients with access to their CEO buddies.
In exchange for saying nice things, the analysts' banks earned investment-banking fees when the CEOs needed to raise money or buy companies. And in exchange for access to the CEOs, the big-money clients would use the analysts' banks for their trading needs – allowing the banks to earn fees that way.
Everyday individual investors like us are not the ones benefiting from this game... The analysts serve as matchmakers between the CEOs and the big-money clients. The financial analysis often takes a backseat.
Over the decades, a ritual has developed out of this symbiotic little ecosystem...
And that ritual – the quarterly earnings song and dance – has spun out of control.
As part of the back-and-forth relationship, companies provide Wall Street analysts with "earnings guidance." That's just a fancy way of saying, "This is how much we'll probably make next quarter."
Of course, management providing information about the future isn't completely worthless. But some CEOs – like legendary investor and Berkshire Hathaway founder Warren Buffett, for example – consider this whole process to be nonsense and refuse to play along. (By the way, if Buffett believes something is a stupid idea, you should pay attention.)
And the game doesn't stop there...
With management's earnings guidance in hand, the Wall Street analysts decide to make their own estimates. Eventually, media outlets and data aggregators begin consolidating the various analysts' estimates into a "consensus"...
So now, during "earnings season," these media outlets compare the reported results from companies with the consensus estimates. And then, they use dramatic headlines to report their findings to the investing public.
This rigmarole has evolved for decades. But things really kicked into high gear in the early 2000s, when the current financial-disclosure regulations came out and financial TV became ubiquitous...
Now, Yahoo Finance robo-journalists and TV networks like CNBC get free content for two straight weeks as they talk about which companies "beat" and "missed" analysts' estimates with the urgency once reserved for weathermen during hurricane season.
All of this noise builds up and leaves everyday investors with the false impression that something important just happened.
The thing is... Almost nothing important happens with quarterly earnings.
Imagine asking your friend how the football game went last night...
And he simply responds, "We were outscored 14-10 in the second quarter."
That would be worthless, right? You wouldn't know who won the whole game just from that response. In sports, quarterly results don't mean anything. It's about the entire game.
Yet somehow, we're convinced that the financial world is different... that it's bad news when well-educated 20-somethings fail to accurately pinpoint the quarterly earnings of a global operation with tens of thousands of employees and a long-term strategy that could span a decade or more.
All this nonsense can cause substantial moves in the market. But that's not the worst part...
Some of the so-called experts focus on one of my least-favorite accounting metrics in the world...
That metric is earnings per share ("EPS").
I'm a certified public accountant who started my career auditing public companies for a "Big Four" firm. I then served as the accounting director and controller for a publicly traded company before starting my own accounting consultancy.
I used to audit financial statements for a living. Then, I helped build them. Now, I analyze and write about them. I meticulously analyze hundreds of financial statements. And yet...
I hardly ever look at a company's EPS.
EPS is simply a company's net income – its revenue minus its expenses – divided by the number of shares outstanding. Net income is the "bottom line" on the income statement.
Because of that, most folks assume it's pretty important. If you know what you're doing, you can use it as part of your analysis. But I'm not alone in my EPS skepticism...
In 2018, Buffett told his shareholders that net income "is not representative of the business at all." Seth Klarman, an investing legend in his own right, called net income "an accounting fiction." (Net income is the basis for EPS).
Why is there so much skepticism around the income statement?
The issue is that particular financial statement is rife with gray areas and estimates. Companies have many levers to pull – including dozens of "estimate" levers on the expense side of the income statement – to carefully land their net-income number right on top of the earnings estimate. And, obviously, even the most well-intentioned estimates could end up being inaccurate... possibly materially so.
Value investors get this, and they turn their attention elsewhere...
There's an old value investing adage: "Net income is an opinion. But cash flow is a fact." To find a company's cash flows, simply turn a couple pages past the income statement in most U.S. Securities and Exchange Commission ("SEC") filings. That's the financial statement that most of the world's best investors, including Buffett and Klarman, focus on.
But even with cash flows, one quarter's numbers won't be helpful. You need to look at a few years of information in totality. The statement of cash flows comes with its own shortcomings, but I still consider it the most useful financial statement that a company puts out. By making a couple of minor adjustments and, again, looking at two to three years' worth of cash flows, you can get an incredibly accurate view of a company's performance and prospects.
So where does this leave everyday investors like us?
I want to make a couple suggestions today...
First, unless you're a technical trader trying to skim profits off of erratic short-term price moves, you can usually completely ignore earnings headlines. Remember, it's the most pointless exercise in the modern markets. It's fine to listen to the company's quarterly call with management teams – we do that to glean some useful operational insights – but you don't need to sweat the EPS numbers that will be slathered across mainstream financial media.
Second, if you like to roll up your sleeves and get into the financial statements... remember that the income statement is often an "accounting fiction," to quote Klarman.
Other than studying revenue growth, I generally don't spend any time at all looking at the income statement. Turn the page and check out a few years of the statement of cash flows instead... That's where Buffett, Klarman, and other legendary value investors will be.
If it feels daunting to dive deep into companies' earnings reports, it doesn't mean you have to sit out the stock market. Stansberry Research hires experts like me to do that heavy lifting and provide you with our best advice.
My Venture Value newsletter is one of our elite publications, with rare analyses of small companies that even Wall Street has failed to notice or fully understand. But you can get started with Stansberry's Investment Advisory – which I also contribute to – for as little as $49 a year. Click here to learn more.
Regards,
Bryan Beach