You Won't Believe What Wall Street Gets Away with During Earnings Season

Editor's Note: Robust Q4 2017 earnings reports have helped the Dow crack 26,000, but it pays to take a closer look at those numbers. As Shah first revealed a couple years back, Wall Street's playing a manipulative game here. You can't miss his breakdown of this scheme...

Every day you're in the market - whether you own shares of your favorite company in an individual account, have a thick IRA, or you've got a portfolio through a pension plan - you're being lied to.

That's because everyone on Wall Street - the analysts, the investment banks, the media, the data compilers, and the companies themselves - are all playing a game with your money.

It's called "hide the earnings."

Today, I'm going to tell you everything you don't know about analysts' earnings reports, consensus estimates, actual reported earnings - and how we're all openly lied to.

It's going to make you very uncomfortable, scared even.

But don't worry - I'll tell you the truth about the recent earnings numbers.

Two - Very Different - Ways to Calculate Earnings

wall street

The game that everyone on Wall Street is playing is legal because there are two ways to calculate earnings.

One way is by using Generally Accepted Accounting Principles (the GAAP way). As you might guess, GAAP earnings are dictated by a common set of accounting principles, standards, and procedures. The combination of authoritative standards and commonly accepted methods give investors a level of consistency in the financial statements they use to analyze companies and make their buy/sell decisions.

But the preferred way analysts, data compilers, the media, and companies talk up earnings is by talking up non-GAAP earnings. These are sometimes called "pro-forma" earnings, or "Street" earnings, or "earnings before the bad stuff happens."

All companies are required to report GAAP earnings, but to get to them you have to be proactive - you have to get ahold of the company's quarterly reports and analyze them.

But here's the thing...

Everyone else is focused on non-GAAP earnings, which companies also include in their quarterly and annual company reports - and may even highlight at the expense of their actual GAAP earnings.

What's crazy about non-GAAP earnings is they can be calculated in all kinds of different ways - there's no industry standard of what can be done on a non-GAAP accounting basis and nothing stopping reporting companies from being "creative."

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Companies use non-GAAP accounting because they say it gives a "more accurate picture of earnings from day-to-day operations."

They say their earnings shouldn't include "non-recurring" one-time charges or write-offs for things like restructurings, asset write-downs, writing off goodwill charges or other merger, acquisition, or company divestiture related charges, and certain kinds of compensation schemes.

In short, if a company thinks their earnings are going to be negatively affected by something  that's deemed to be non-recurring, that doesn't relate to day-to-day operations of the business - which is what they say investors really care about - they simply side-pocket those items, which makes their earnings look a heck of a lot better.

Whether those non-recurring items recur and keep recurring is another story. Of course, a lot of the time they do.

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Analysts Are in on the Shakedown

As far as analysts, they're all over non-GAAP numbers.

Most "Street" analysts don't bother with GAAP because the companies they cover want them to focus on non-GAAP numbers. That's the game.

And of course, not all analysts come to the same conclusions about what will be included or not included in a company's non-GAAP numbers. But they, meaning the principal analysts that make up the consensus of analysts whose consensus estimates are used, are pretty well informed by the companies themselves about what they're doing for the most part - about what they're accounting for... or not accounting for.

Do company executives tell analysts what they're doing to guide analysts' estimates in line with what management wants the analysts' estimates to be?

You bet they do.

It's not legal, but there are ways around that, for sure. I'll get to that in a minute.

But first...

Here's how a consensus of analysts gets convened, according to Michael Patton, director of earnings estimates at S&P Capital IQ: "Let's say 20 analysts cover a stock, and 13 do it one way and seven do it another way. Which are in the consensus? We go by the majority rule. We go with the 13."

In other words, if the minority use GAAP to arrive at their earnings estimates, they'll never be in the consensus. That would be way too messy.

The other data compilers of analysts' earnings estimates, Thomson Reuters, Zack's, and FactSet (FactSet is starting to come around to GAAP realities and may in the future be the only data compiler worth following) have their own ways of convening the "right" analysts, which mostly means they're in the game.

It usually happens that the mainstream sell-side analysts, those who work for banks and investment banks who want to help land all kinds of business from the companies they cover for their employers (we know how that works in spite of the rules and regulations and fines paid in the past for doing exactly that), have a good relations with executives at the companies they cover.

It's absolutely in a company's best interest to help guide analysts' estimates. They almost always want to guide them below what they're actually going to report because they want to beat consensus estimates to try and boost their share prices.

It's a thin line, guiding analysts.

According to law firm Skadden, Arps, Slate, Meagher & Flom LLP's September 2012 Corporate Finance Alert in its section on Regulation FD Considerations (emphasis mine)...

Regulation FD (Fair Disclosure), which addresses selective disclosure of information by SEC- reporting companies, provides that when an issuer discloses material nonpublic information to certain individuals or entities - generally, securities market professionals, such as stock analysts, or holders of the issuer's securities who may trade on the basis of the information - the issuer must make public disclosure of that information simultaneously, in the case of intentional disclosures, and promptly, in the case of unintentional disclosures. Regulation FD prohibits "selective disclosure" of material nonpublic information. Violators of Regulation FD are subject to SEC enforcement actions, but there is no liability under Rule 10b-5 for failure to make a public disclosure required by Regulation FD. The SEC has issued guidance stating that Regulation FD does not change existing law with respect to any duty to update.13 In other words, Regulation FD does not create a duty to update forward-looking guidance information, but it does create important considerations for companies that issue earnings guidance. Any decisions to provide guidance or to update earnings guidance (or to respond to direct or indirect inquiries that address future earnings results) must be made with sensitive consideration to Regulation FD. In addition, companies must be careful not to selectively share any material information that affects previously issued guidance, which may create a duty to update where there was no prior duty.

So what does that all mean?

It means under Regulation FD, analysts aren't supposed to be privately guided by company managers or executives, but they can get the information executives want them to get if they all get it and they all change their estimates, which can be viewed as "informing the public."

Now you know companies use non-GAAP methods to spruce up their earnings. And now you know analysts use the same methods to come up with their estimates, how they can be guided by company executives, and how they're convened into a consensus that companies can beat when they come out with their quarterly earnings.

That's the game.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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