October, 2018
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

As a youngster, I enjoyed reading books that featured the brilliantly logical boy detective named Encyclopedia Brown. This was a series of books written by Donald J. Sobol where the son of the local police chief would use his intellect and observational powers to solve things like “The Case of the Sleeping Dog,” “The Case of the Midnight Visitor,” and “The Case of the Treasure Hunt.

encyclopedia brown

I recently read a Wall Street Journal article that made me wonder what Encyclopedia Brown would make of this situation. Facts of the case will be forthcoming, but first some context:

Publicly traded companies are required to report their profitability every quarter as a sort of business report card. Investors regularly judge the value of a company’s stock on, among other things, the amount a company has earned, based on the metric of earnings per share (EPS). Calculating a company’s EPS is really no more complicated than middle-school math. Take the amount of income earned and divide by the number of common shares of stock. Missing or exceeding analysts EPS expectations by even a penny can be the catalyst for significant swings in the price of the stock.

In Apple’s (AAPL) last quarter, they reported $11.519 billion of income and 4,926,609,000 shares of stock; performing the calculation we see that Apple earned $2.33811938394 per share. Obviously that kind of number doesn’t sound great over the airways so, all reports will round to the nearest cent and state that Apple’s EPS for the quarter was $2.34. Every earnings report from every company is going to involve this type of rounding so I’d like to draw your attention to the third number after the decimal point (the thousandths place) in our calculation – in this case an 8. Remember that if a number in that location is 5 or above, rounding rules allow us to round up to the next cent while if that digit is a 4 or less, we round down; hence in Apple’s case the reported earnings are $2.34 and not $2.33.

Most of us have played enough board games to know that when rolling a die, over time, each of the numbers 1-6 occurs approximately the same number of times. Similarly, with thousands of companies reporting several times a year, intuitively one would expect the actual number (0-9) that appears in the thousandths place in the EPS calculation to be completely random, with each numerical digit 0-9 approximately the same number of times, very close to 10% of the time.

Here is where we need Encyclopedia Brown to solve “The Case of the Missing Four.”

Some enterprising analysts* looked at nearly a million of these reports and found something surprising; one specific number appeared in that third spot significantly fewer times than the others; the number 4. What is going on here? Why would the number 4 be under-represented in this way? Is it randomness (unlikely due to the sample size) or the sign of something nefarious?

If you are a company executive whose job is being judged by how profitable the company is and your EPS calculation turned out to be $1.264; you might be incentivized to adjust a few accounting entries so that the calculation becomes $1.265 which would allow you to report your EPS as $1.27. These accounting adjustments might be technically legal, but might also be a sign that your firm has a culture of playing fast and loose with the rules – if you are willing to bend these rules, what other corners are being cut? On the other hand, it would be hard to argue that the investing public is being deceived if a company postpones its office supply order from September 30 to October 1, lowering expenses for Q3 and having the same effect on EPS.

So the missing 4 is probably not widespread corruption, but something that reminds us that when making investment choices, attention must be paid. It does indicate that certain companies do act unethically. In fact, one company, Dell, didn’t report a 4 in the thousandths place once from the time of its IPO in 1988 to 2006; consequently, the SEC sniffed this out and levied a $100 million fine against Dell for misleading investors. The SEC is also investigating at least 10 other companies in connection with “The Case of the Missing Four.” When investing in specific companies, identifying those that seem to have a culture of fluffing their numbers can help reduce the risk of making an investing mistake.

The potential that exists for management to massage earnings numbers is one reason why we at Castle use EPS as only 1 of many data points when we are evaluating if we want to invest in a company’s stock. Not only do we utilize other metrics of profitability, but we also examine trends that make sure earnings, revenues, and cash flow are all increasing at similar rates.

The Third Quarter Reviewed

As the economy maintained its good health and the impact of tax cuts have kicked in, companies have been producing excellent earnings numbers. The chart below shows the annual EPS percentage change for the S&P 500 since 2000 as well as the sources of the change. Then on the right it breaks down the past 2 quarters where you can see that we are on pace for an impressive 25%+ growth for 2018.

SP 500 year over year

This performance has allowed the equity markets to post solid gains for the third quarter. Most indexes were able to wipe out the losses that were experienced in the winter and eclipse all-time highs.

Index      1st Qtr 2018      
Return
1 Year
      Return        
3 Year
     Annualized      
Return
5 Year
     Annualized      
Return
S&P 500 7.7% 14.4% 11.9% 13.4%
Nasdaq Composite 6.6% 23.6% 16% 18.5%
Russell 2000 – Smaller Companies 7.8% 17.6% 11% 12.5%
MSCI EAFE – International -1.2% 6.8% 4.9% 6.4%
Barclays US Aggregate Bond -0.2% -0.4% 1.7% 2.3%
  • Growth stocks continued to outperform Value stocks
  • Health Care and Industrials were the leading sectors
  • Apple and Amazon became the first trillion-dollar companies
  • The Federal Reserve increased short-term interest rates by another .25%
  • The unemployment rate dropped to 3.7%
  • Worldwide growth has been slower, but steady

Even though the stock market has continued to climb, valuations have stayed in a reasonable range.

SP 500 Index

Looking Ahead

As we enjoy an economic expansion that is nearly the longest ever, it is natural to wonder how long it will last. An economist likened the investor’s predicament to 2 old maxims:

“Fix the roof while the sun is shining.”
“Make hay while the sun shines.”

The first implies taking defensive action to prepare for the worst, the second suggests continuing to make the most of the good times while they last.

We are of the mindset that the economy is in a late portion of the cycle and not the end of the cycle, so you should be making hay. But, at the same time, if you have not rebalanced your portfolio in the past several years (something we do regularly for our clients) it is likely that your equity exposure has grown and should probably be trimmed (fixing your roof).

We look at recession indicators from various sources and none of them have yet ascribed a very high probability to a near term recession. Below is a chart that shows PIMCO’s view.

US ChartSource: PIMCO, September 2018

Certainly, a recession will come at some point, but the slow & steady journey of this expansion combined with a lack of over-consumption and over-building, as well as enhancements like “just-in-time inventories” lead us to believe that when the next recession does come, it is unlikely to be as deep or painful as the previous one was.

Meanwhile we are watching for gray clouds in the following places:

  • Mid-Term Elections
              ο   Keeping in mind that divided government is the norm in America, but a shrinking center increases the probability of irrational policies.
  • What will the consequences of increased tariffs on Chinese goods be?
              ο    What will a renegotiated NAFTA look like?
  • Geopolitics
              ο    Will the difficulties in Argentina, Italy, and Turkey become widespread?
  • Profit Margins 
              ο    Can record high margins be maintained?
  • Age of the recovery
              ο    Good returns are typically found late in cycles.
  • Income
              ο    Will low unemployment lead to inflation-triggering higher wages?

Thanks for reading. We’ve got several new faces in the Castle offices as our team and service expands. Please join me in welcoming Kim Koepfer (admin), Michael O’Hara (investments), and Jonathan Kreilein (valuations). Thanks for letting us be a part of your financial journey. Have a great fall.

 DarrenSignature

* Nadya Malenko and Joseph Grundfest in a research paper titled: Quadrophobia: Strategic Rounding of EPS Data

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.

Index 1st Qtr 2018 Return 1 Year Return 3 Year
 Annualized
 Return 5 Year 
Annualized Return
S&P 500 -0.8% 14% 10.8% 13.3%
Nasdaq Composite 2.6% 20.8% 14.3% 18.1%
Russell 2000 – Smaller Companies -0.1% 11.8% 8.4% 11.5%
MSCI EAFE – International -1.5% 14.8% 5.6% 6.5%
Barclays US Aggregate Bond -1.5% 1.2% 1.2% 1.8%
 
While market gyrations and the accompanying headlines can increase investor anxiety, stepping back and remembering that the goal of most investors is having an investment portfolio that thrives over decades, not days, helps put things in perspective. Don’t confuse mass media market commentary with financial advice – the former provides contextual information and entertainment; the latter should be personalized to your individual situation and goals.
Along these lines I recommend a recent blog by Josh Brown titled “Some Alternatives to Evidence Based Investing” where he lists some of your options if you don’t use a systematic approach to construct a durable portfolio.
http://thereformedbroker.com/2018/03/20/some-alternatives-to-evidence-based-investing/
Meanwhile, the economy continues its trend of slow growth. Responding to the recent tax cuts and more government spending, growth is expected to increase, at least in the short-term. 
Unemployment has fallen to 4.1%, a dramatic difference from the 10% we were experiencing in 2009. This is one of the lowest rates we have seen in my lifetime (since 1969).
                                    
Of course, this is great news for those of us who like to have jobs, but there is another side to this coin. We mentioned the economy’s slow growth, it has been averaging about 2.2% annual growth during the current expansion. The drop of the unemployment rate from 10% to 4.1% has accounted for about one-third of the growth we have experienced. Most economists agree that an unemployment rate of 3.5% is about as low as possible. Without the stimulus provided by putting more people to work, overall economic growth will be harder to come by in the years ahead.
It is also logical to expect that along with a tighter labor market, the growth of wages paid should continue to increase. 
The rise in Corporate profits was very solid in 2017 and with the benefit of significant tax cuts, 2018 should be excellent as well. The chart on the next page shows the combined annual Earnings Per Share (EPS) for the companies in the S&P 500 as well as estimates for the future. This will create quite a high bar for earnings comparisons in 2019 and beyond. Especially in an economic environment that is likely to see higher wages, higher interest rates and slower growth.
 
 
 
 
 
 
 
In addition to the U.S., nearly all countries in the world are growing, but none are booming. This should provide a certain stability to the condition of the global financial markets, at least for now.
Because of the economic growth and stability, the Federal Reserve has been comfortable continuing to move interest rates back toward a more normalized level. The Fed did raise rates in March and is expected to do so again another 2 or 3 times this year.
 
          
 
 
 
 
 
 
 
 
                              
Rising interest rates often present some challenges to bond investors. Most Castle clients will see among their bond investments things like Floating Rate Bonds, Convertible Bonds, and High Yield Bonds which have tended to do a little better as interest rates rise.
As expectations for 2018 earnings have increased, this has brought down the market’s valuation to a near normal level. Nerdy math alert: Forward P/E = stock market price divided by estimates of the next 12 months earnings; thus, a lower price or a higher earnings projection makes a lower P/E. This makes it more comfortable to be a stock investor this year, as there continues to be no signs of an imminent recession. But attention must be paid (and performance expectations adjusted) to the years following 2018 as continued earnings growth at this level will be challenging to maintain. As always you are encouraged to remain diversified and long-term focused.
I’d like to conclude this quarter’s letter with a personal note. My dad passed away earlier this year. Though he was not the kind of father to pull me aside and dispense quips of wisdom, he did teach me many important lessons most often through his actions. So as a tribute to him, I pass a few of these lessons along:
Protect your family, love your spouse
Hard work is good
You reap what you sow
Experiences are often more valuable than things
Cereals should be combined
Steak should be pink
Don’t strike out looking
Read the Bible
Live adventurously
Live up to the legacy you have received – leave a legacy to follow
Pay attention to the weather
Great things come from little beginnings - an entire stalk of wheat was once contained in a tiny seed
There are a variety of ways to be smart
Be someone’s mentor
Life is sometimes rough; comebacks will be needed
Thanks for reading, let your family know that you love them. Have a great spring.