Summary
- Unusual gains/losses distorted earnings per share by an average of $1.16/share (22%) for firms in the S&P 500 in 2018.
- The popular measures of “core” earnings do not properly account for unusual items and are subject to significant bias according to new research from Harvard Business School & MIT Sloan.
- Our research shows that Linde, PLC is a stock investors should avoid ahead of its Q3 earnings report on Nov. 12.
- Looking for more stock ideas like this one? Get them exclusively at Value Investing 2.0 . Get started today »
Unusual gains/losses distorted earnings per share by an average of $1.16/share (22%) for firms in the S&P 500 in 2018. The popular measures of “core” earnings – i.e. street earnings[1], Compustat[2] or non-GAAP metrics – do not properly account for unusual items and are subject to significant bias according to new research from Harvard Business School (HBS) and MIT Sloan.
Why is earnings data wrong?
In “Core Earnings: New Data and Evidence,” Ethan Rouen and Charles Wang from HBS and Eric So from MIT Sloan show that traditional data providers and analysts are missing or mis-categorizing a very material and growing amount of unusual gains/losses.
“…many of the …(unusual gains/losses) collected by New Constructs do not appear to be easily identifiable in Compustat…” – page 13
The authors show the market is inefficiently assessing earnings because too few people read financial footnotes.
Earnings Data Is Getting Worse
The average per share impact of unusual items has increased 170% from $0.43/share in 1998 to $1.16 at the end of 2018. Figure 1 plots the total impact of unusual items or “Total Adjustments.”
Figure 1: Total Adjustments Per Share for the S&P 500
Sources: New Constructs, LLC and company filings
Excludes Berkshire Hathaway (BRK.A) (NYSE:BRK.B), which represents a significant outlier in all years
Total Adjustments captures the after-tax value of all the unusual items that we collect from the income statement and the footnotes. Though our numbers bear a close resemblance, the HBS & MIT paper is circumspect about exactly which of our adjustment are used to provide the superior measure of “core earnings” featured in the paper. To bring as much value as possible to investors, we share details on all of our adjustments.
For a full description of the adjustments used here and in the HBS paper, please see the final section of this report and the Appendix.
How You Can Protect Your Portfolio
“Trading strategies that exploit (adjustments provided by New Constructs) produce abnormal returns of 7-to-10% per year.” – Abstract, 4th sentence
The paper presents a long/short strategy that holds the stocks with the most understated EPS and shorts the stocks with the most overstated earnings. Positions are opened in the month each 10-K is filed and held until the next 10-K is filed, or about a year.
This simple, low turnover strategy produced abnormal returns of 7%-to-10% a year. These abnormal returns show that the market misses important data in the footnotes and that investors who adjust for unusual items can better protect their portfolios.
Here’s a Short/Sell Idea Based on our Proprietary Data
Our research shows that Linde, PLC (LIN) is a stock investors should avoid ahead of its Q3 earnings report on Nov. 12. LIN had some of the largest income adjustments, or most overstated earnings, of all companies in the S&P 500 in 2018. LIN had nearly $2.2 billion in net non-recurring income reported on the income statement and hidden in the footnotes. Our largest adjustment was removing the company’s $2.9 billion after-tax gain on sale of assets divested as part of its merger with Praxair, disclosed on the cash flow statement.
We identified $6.48/share in non-recurring income that artificially increased reported earnings. This income was offset by $0.82/share in non-recurring expenses. In total, we identified $5.67/share in net non-recurring income.
Without our adjustments, LIN’s reported EPS more than tripled, from $4.31/share in 2017 to $13.11/share in 2018. However, after removing non-recurring items, we find that LIN’s core earnings grew much more modestly, from $5.14/share in 2017 to $7.44/share in 2018. Furthermore, core earnings were well above reported EPS in 2017, and were nearly half reported EPS in 2018.
Although the HBS paper did not focus on our quarterly data, our models do incorporate data from 10-Q’s in order to create trailing twelve months (TTM) models for companies. On a TTM basis, LIN’s core earnings of $5.26/share are significantly below reported earnings of $9.96/share.
LIN’s overstated earnings make it more likely to miss expectations when it reports third quarter earnings.
Investors who rely on reported earnings might think that LIN’s P/E ratio of 20 (below the S&P 500 at 22) is cheap. Using core earnings per share, on the other hand, LIN has a P/E ratio of 36, which is a much better reflection of the high growth expectations implied by the stock price.
The combination of overstated earnings and an expensive valuation earns LIN our Very Unattractive rating. The stock is also in our Most Dangerous Stocks Model Portfolio.
More Stocks to Sell: Most Hidden Gains and Overstated Earnings
Figure 2 shows the firms in the S&P 500 with the largest after-tax income adjustments in 2018. These items artificially increase reported earnings and must be removed to calculate a firm’s true recurring profitability.
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