How Corporate America Cheats Investors Every Day

This perfectly legal scam is robbing us all blind…

An underwhelming earnings season is winding down while stocks struggle. The sell-siders are, bluntly, panicking.

I wouldn't be surprised in the least to find many of you have heard from your advisors over the past few days - advisors with a vested interest in keeping you long the markets (and ensnared in their asset-based fee models).

I'd also bet you're being told "not to worry." I bet you're hearing a lot about companies "flush with cash" and "beating their earnings expectations."

I bet you're being told, despite the obvious signs all around us, that this market is "uniquely solid" and that "the numbers confirm it."

Have I pretty much nailed it word for word?

That's because I'm a hedge fund guy. I know the legal tricks and accounting stunts that keep CEOs and, well, hedge fund guys "well-remunerated."

I'll let you in on another secret: They're lying to you. The market is lying to you, and it's costing you plenty...

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Today's CEOs Aren't Smarter - Just Better at Fooling You

Jeremy Grantham, who I've allocated to, is a legendary value investor and co-founder of Boston-based asset management firm Grantham, Mayo, & van Otterloo. Earlier this year, he effectively acknowledged that, since about 2000, markets have lost any sense of reality. Mean reversion, price discovery, honest reporting, and dependable cycles of cheap and expensive stock determinants are history.

What we have instead is what David Stockman calls a casino - not a market. Since 2000, price/earnings (P/E) ratios have averaged 60% percent higher than in the prior 50 years, and profit margins are averaging 30% higher.

IMPORTANT: More than 10 years after the housing collapse, Americans have the potential to regain their stake of a $72 billion pool.

Grantham called that a "double whammy." I call it ridiculous.

So how have earnings skewed to such nosebleed extremes? Has nearly every publicly traded company since the dot-com era suddenly become A+ material? Are CEOs and CFOs that much sharper than before?

Nope.

In fact, what we have are a lot of D+ and C- companies masquerading as phi beta kappas. They pull this off by legally hiding behind a safe harbor of bogus accounting, stock buybacks, and a little-known, extremely dubious parlor trick called ex-items accounting.

In short, today's companies aren't smarter than our dads' generation. They're not more profitable.

They're just less ethical.

What's happened between then and now? Values have changed. We've lost a sense of commonwealth, or what the Romans might've called "res publica."

Of course, the causes of this are infinitely debatable, and that debate is better left to sociologists or ethicists. But it's enough to say that, in place of the old, a new kind of Darwinism and a much sexier greed has taken root.

Again, it's complicated, but for our purposes today, it comes down to this: Stock-based compensation in the C-suite has seduced executives into thinking more about second homes and third cars than, say, the Eighth Commandment or the sixth deadly sin.

Profit from the Initiative Senior Treasury Official Craig Phillips Calls "Core" to U.S. Housing Policy

Today - more than ever before in American history - executive compensation is largely tied to stock performance. An executive might receive, relative to his or her overall compensation, a modest paycheck every two weeks; maybe it comes to the low seven figures for the year.

But in too many cases, that same executive is allotted, as part of their compensation package, tens or even hundreds of millions of dollars' worth of company stock.

A miss on earnings means a miss on an entire swath of executives' American Dream.

This system fosters corruption and trickery like a petri dish fosters nasty bacteria.

In such a twisted setting of executive incentives and temptations, the well-funded finance officers behind the stocks you are buying will do almost anything to manipulate earnings and distort reality.

Your financial advisor probably forgot to mention this when they called last week, but an Associated Press report recently concluded 72% of the companies it reviewed had adjusted profits that were higher than net income. From 2010 to 2014, the S&P 500 as a whole showed adjusted profits that came in $583 billion higher than net income.

Perhaps one of the best examples of this legalized fraud is Klaus Kleinfeld's Alcoa Corp. (NYSE: AA), traditionally the first company to report in "official" earnings season.

In the last seven years, this creative CEO has generated just under $11 billion in cash flow while simultaneously spending the same amount on capital expenditures (capex), and another $3 billion in dividends. Yet Kleinfeld managed, despite $2 billion in cumulative losses, to report positive earnings.

Alcoa's not alone. In fact, Kleinfeld and his ilk... Noel R. Wallace's Colgate-Palmolive Co. (NYSE: CL), Robert H. Swan's Intel Corp. (NASDAQ: INTC), Kenichiro Yoshida's Sony Corp. (NYSE: SNE), H. Lawrence Culp, Jr.'s General Electric Co. (NYSE: GE), and Dennis Muilenburg's Boeing Co. (NYSE: BA)... are the norm, not the exception.

It would be one thing if this kind of manipulation and institutionalized fraud were the desperate act of some gang of criminals, but - I'm here to tell you - this scam is 100% legal. It has the full, enthusiastic support of the U.S. Securities and Exchange Commission (SEC).

Yes, folks, today, we're at the point where just 13% of the total revenue growth reported since the financial crisis of 2008 is coming from actual earnings.

The rest is just accounting tricks.

So how do they do it?

How Wall Street's Favorite Game Is Played

A lot of it comes down to clever bookkeeping called "ex-items."

Think of it as a parallel little accounting universe, where CEOs are allowed to carry two sets of books... you know, kind of like Al Capone's accountant did.

In 2008, American taxpayers were forced to bail out incompetent businessmen. Now, thanks to Public Law 110-289, it's time they pay it back.

One set of books uses generally accepted accounting principles (GAAP) as stipulated by the Sarbanes-Oxley Act. Play fast and loose with those books, and you can expect the SEC to set you up with an all-expenses-paid vacation to one of the East Coast's finer low-security prisons, like FCI Allenwood, where elite crooks rub elbows with the likes of Martin Shkreli.

The other set of books uses non-GAAP accounting. That's what gets reported to sell-side types and retail investors (i.e., suckers).

The repeal of Financial Accounting Standards Board Rule 157, which eliminated "mark to market" accounting, has opened the door for gaming earnings season, which means you're the one getting "played."

Non-GAAP accounting allows CEOs to write off millions and billions in goodwill, plant closing losses, severance and health benefits, lease cancellations, investment banking fees, or new operations costs as a "non-recurring expense."

In short, this "second book" basically allows companies to skip past (i.e., ignore) overhead and report mostly cash flow. That's a bit like a lemonade stand that reports only lemonade sales but not the cost of lemons and plywood...

These legalized write-offs allow executives to sweeten their valuations going into bad merger and acquisition deals or "beat earnings expectations" at nearly every earnings season. (That's another Wall Street trick. Analysts set expectations artificially low, the easier to pull off a beat. That's a bit like your kid's teacher telling you, "Junior's report card beat expectations: He got a C- when we only expected a D+.")

When I was a hedge fund guy, we ate this up. We looked at (many, many) bad companies with uncorrelated earnings and cash flows, sudden changes in reserves, suspiciously consistent earnings growth, and other red flags. We took the monotonous time to look at GAAP reality rather than ex-items fiction.

We'd buy these dolled-up turkeys - prior to what we knew was a bogus earnings season - for cheap. Then we'd dump 'em for a profit after they "beat expectations."

It pays to know who's cheating...

But then again, if you trust the pundits and CEOs on CNBC, the only one getting cheated is you.

For example, those reduced P/E ratios they peddle are mostly fiction, because the earnings against that price are legally doctored.

And when you add stock buybacks (which are at record levels since 2008) to this distortive and largely unknown witch's brew, you get even more dishonesty, because the buybacks shrink the share pool and distort the P/E ratios one more turn... or two... or three...

I wouldn't blame you if you didn't want to believe me. It's ugly, and it flies in the face of everything we're told from a very young age about the American Dream.

But there's no denying this: As of today, the S&P 500 is up over 40% from its 2007 peak. But when you get into the boring math (which hedge fund guys do) and measure GAAP- and inflation-adjusted earnings calculations against more than $4 trillion in stock buybacks, you'll discover that today's S&P 500 earnings are lower than they were before the last crisis.

In other words, today's stocks are trading more than 1/3 higher than they were during the last bubble... with altogether much lower earnings.

This S&P 500 peak is ridiculously, comically overvalued - or, at least, it would be ridiculous and comical if millions of regular investors weren't trapped inside.

Be careful out there.

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About the Author

25-year run as a hedge fund portfolio manager, family office chief investment officer, managing director and general counsel. Internationally recognized expert in credit and equity markets as well as macro risk management.

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