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At the conference last weekend in Omaha, Charlie Dreifus, portfolio manager and managing director of the small-cap firm Royce & Associates, advised on the proliferation of financial massaging in a talk titled “Accountants and Accountability.”
Dreifus began by demonstrating the expensiveness of the market by comparing it to its only historical parallels — in the Great Depression of 1929, the tech bubble of 1999-2000 and financial crisis of summer 2007 — and giving its price-earnings, price-GDP and Schiller PE numbers. Yet one metric resists giving the same result, the “Fed model” or yield on the 10-year and inverse of the market’s price-earning ratio for an earnings yield. The openness to interpretation of employing various data segued into this discussion on accounting.
“We don't need more accounting principles,” Dreifus said. “We need more accountants with principles.”
To make his point, Dreifus pointed out several misleading practices, like an increase in non-GAAP earnings (85-90% of earnings reports include reconciliations of GAAP to non-GAAP), and what he called “EBBS” or “Earnings Before Bad Stuff.”
That “bad stuff” can equal recurring items like stock options. And it can exclude the amortization of intangibles.
Non-GAAP numbers also tend to be higher because management has often toyed with the numbers to beat expectations. Therefore, the market is more expensive than it may seem.
“We’re amazed when we ask sell-side analysts, give us a model on a GAAP basis, and they say, “we’ll get back to you,” Dreifus said. “What does that mean? They don’t have it, because they’ve been fed the Kool Aid of the company’s non-GAAP guidance.”
Dreifus recommended scanning SEC documents, particularly proxy statements, where companies explain whether incentive compensation for executives it tied to non-GAAP results.
Last, Dreifus warned of the possibility that such discrepancies would expand as companies increasingly veered toward online shareholder meetings with minimum outsider questions.Ă‚
See the Royce Funds’ portfolio here. Also see photos of the conference here.
