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Why EPS And Share Price Don’t Predict Future Performance

Most analysts, and especially “chartists,” put a lot of emphasis on earnings per share (EPS) and stock price movements when determining whether to buy a stock. Unfortunately, these are not good predictors of company performance, and investors should beware. Most analysts are focused on short-term – meaning quarter-to-quarter – performance. Their idea of long term is looking back 1 year, comparing this quarter to the same quarter last year. As a result, they fixate on how EPS has done and will talk about whether improvements in EPS will cause the “multiple” (meaning stock price divided by EPS) to “expand.” They forecast stock price based upon future EPS times the industry multiple. If EPS is growing, they expect the stock to trade at the industry multiple, or possibly somewhat better. Grow EPS, hope to grow the multiple, and project a higher valuation. Analysts will also discuss the “momentum” (meaning direction and volume) of a stock. They look at charts, usually less than one year, and if price is going up, they will say the momentum is good for a higher price. They determine the “strength of momentum” by looking at trading volume. Movements up or down on high volume are considered more meaningful than those on low volume. But unfortunately, these indicators are purely short-term, and are easily manipulated so that they do not reflect the actual performance of the company. At any given time, a CEO can decide to sell assets and use that cash to buy shares. For example, McDonald’s (NYSE: MCD ) sold Chipotle and Boston Market. Then, the leadership took a big chunk of that money and repurchased company shares. That meant McDonald’s took its two fastest-growing and highest-value assets and sold them for short-term cash. They traded growth for cash. Then leadership spent that cash to buy shares, rather than invest in another growth vehicle. This is where short-term manipulation happens. Say a company is earning $1,000 and has 1,000 shares outstanding – so its EPS is $1. The industry multiple is 10, so the share price is $10. The company sells assets for $1,000 (for the purpose of this exercise, let’s assume the book value on those assets is $1,000 – so there is no gain, no earnings impact and no tax impact.) Company leadership says its shares are undervalued, so to help out shareholders it will “return the money to shareholders via a share repurchase” (Note, it is not giving money to shareholders, just buying shares.) $1,000 buys 100 shares. The number of shares outstanding now falls to 900. Earnings are still $1,000 (flat, no gain), but dividing $1,000 by 900 now creates an EPS of $1.11 – a greater than 10% gain! Using the same industry multiple, analysts now say the stock is worth $1.11 x 10 = $11.10! Even though the company is smaller has weaker growth prospects, somehow this “refocusing” of the company on its “core” business and cutting extraneous noise (and growth opportunities) has led to a price increase. Worse, the company hires a very good investment banker to manage this share repurchase. The investment banker watches stock buys and sells, and any time he sees the stock starting to soften, he jumps in and buys some shares so that momentum remains strong. As time goes by and the repurchase program is not completed, he will selectively make large purchases on light trading days, thus adding to the stock’s price momentum. The analysts look at these momentum indicators, now driven by the share repurchase program, and deem the momentum to be strong. “Investors love the stock”, the analysts say (even though the marginal investors making the momentum strong are really company management), and start recommending to investors that they should anticipate this company achieving a multiple of 11 based on earnings and stock momentum. The price now goes to $1.11 x 11 = $12.21. Yet, the underlying company is no stronger. In fact, one could make the case it is weaker. But due to the higher EPS, better multiples and higher share price, the CEO and her team are rewarded with outsized multi-million dollar bonuses. But over the last several years companies did not even have to sell assets to undertake this kind of manipulation. They could just spend cash from earnings. Earnings have been at record highs – and growing – for several years. Yet, most company leaders have not reinvested those earnings in plant, equipment or even people to drive further growth. Instead, they have built huge cash hoards , and then spent that cash on share buybacks, creating the EPS/multiple expansion – and higher valuations – described above. This has been so successful that in the last quarter, untethered corporations have spent $238B on buybacks, while earning only $228B . The short-term benefits are like corporate crack, and companies are spending all the money they have on buybacks rather than reinvesting in growth. Where does the extra money originate? Many companies have borrowed money to undertake buybacks. Corporate interest rates have been at generational (if not multi-generational) lows for several years. Interest rates were kept low by the Federal Reserve hoping to spur borrowing and reinvestment in new products, plant, etc. to drive economic growth, more jobs and higher wages. The goal was to encourage companies to take on more debt, and its associated risk, in order to generate higher future revenues. Many companies have chosen to borrow money, but rather than investing in growth projects, they have bought shares. They borrow money at 2-3%, then buy shares – which can have a much higher immediate impact on valuation – and drive up executive compensation. This has been wildly prevalent. Since the Fed started its low-interest policy, it has added $2.37 trillion in cash to the economy. Corporate buybacks have totaled $2.41 trillion. This is why a company can actually have a crummy business and look ill-positioned for the future, yet have growing EPS and stock price. For example, McDonald’s has gone through rounds of store closures since 2005, sold major assets, now has more stores closing than opening and has its largest franchisees despondent over future prospects . Yet, the stock has tripled since 2005! Leadership has greatly weakened the company and put it into a growth stall (since 2012), and yet, its value has gone up! Microsoft (NASDAQ: MSFT ) has seen its “core” PC market shrink, had terrible new product launches of Vista and Windows 8, wholly failed to succeed with a successful mobile device, has written off billions in failed acquisitions, and consistently lost money in its gaming division. Yet, in the last 10 years, it has seen EPS grow and its share price double through the power of share buybacks from its enormous cash hoard and ability to grow debt. While it is undoubtedly true that 10 years ago Microsoft was far stronger as a PC monopolist than it is today, its value today is now higher. Share buybacks can go on for several years. Especially in big companies. But they add no value to a company, and if not exceeded by re-investments in growth markets, they weaken the company. Long term, a company’s value will relate to its ability to grow revenues and real profits. If a company does not have a viable, competitive business model with real revenue growth prospects, it cannot survive. Look no further than HP (NYSE: HPQ ), which has had massive buybacks, but is today worth only what it was worth 10 years ago as it prepares to split. Or Sears Holdings (NASDAQ: SHLD ), which is now worth 15% of its value a decade ago. Short-term manipulative actions can fool any investor and keep stock prices artificially high, so make sure you understand the long-term revenue trends and prospects of any investment, regardless of analyst recommendations.

The Problem With Leverage In A Portfolio

Barry Ritholtz has a new article on Bloomberg discussing San Diego County’s firing of a risk parity firm that used to manage part of its pension. Risk parity strategies often engage in using leverage. Cliff Asness, who runs AQR, a firm implementing risk parity approaches (among others), hated Barry’s piece and called it “facile” “innuendo”. He then referred to a piece explaining why he likes leverage in a portfolio at times. So, who’s right? Leverage is a bit like steroids. Steroids are neither good nor bad. They tend to magnify the effect of something and that can be good or bad depending on how it’s used. If you use steroids in specific targeted ways they can be an effective medical treatment. Likewise, if you abuse them they can be a destructive and unnecessary supplement.¹ Leverage is essentially the same thing. It will magnify the effect of a portfolio’s outcomes. There are very reckless ways to do this and very safe ways to use leverage. But one thing is almost always undeniable – leverage will cost you. And that’s the kicker. Borrowing money you don’t have is essentially a form of renting. And renters charge fees. The cost of leverage in a portfolio typically depends on the fee that brokers charge. This is usually a spread over LIBOR. This allows clients to fund their long positions and the broker pays some spread below LIBOR for cash deposited by the clients as collateral for short positions. The cost of the leverage will vary depending on who the borrower is.² The inherent difficulty in using leverage is that the fund manager is essentially passing on another cost to the end investor. That is, leverage reduces the real, real return of a portfolio by the cost of the leverage. In the aggregate we know that all managers are generating the market return minus their costs (taxes, fees, etc.) so if everyone started using leverage then our returns would be reduced by the cost of the leverage. And that’s the difficulty of using leverage in a portfolio. I like the concept of Risk Parity, but it’s hard to justify owning a lot of such a strategy simply because it’s an inherently expensive strategy to manage. And in a world that is likely to be a low return world that is potentially just adding another hurdle we don’t need. ¹ – I am not a doctor and I don’t even play one on TV. ² – This cost will vary on how the leverage is implemented. The cost of many risk parity approaches results from trading in more expensive underlying instruments such as reverse repurchase agreements, futures and swap transactions or certain other derivative instruments. In addition, many institutions are able to obtain this leverage inexpensively, but ultimately pass on the convenience of this exposure to clients in higher management fees. Share this article with a colleague

GLD: Capitulation Time?

Summary Given what’s occurring in the gold stocks, it seems only a matter of time before GLD breaks down. When it’s all said and done, the 2011-? bear in gold stocks might be the worst on record, one that will most likely never be beaten. For the first time, I see the finality of this bear market in GLD. The reason I’m bullish on GLD for the long-term is continued strong money supply growth, flat to declining gold production, increasing interest payments on US debt, and low valuations. Most gold companies will be able to survive a lower price environment. It’s been a few weeks since I gave an update on the SPDR Gold Trust ETF (NYSEARCA: GLD ). In my previous article, I discussed the move in GLD after the Federal Reserve meeting concluded: GLD has risen to the 115 level, as it rocketed higher after the Fed meeting this past Wednesday. So just more of the same indecisiveness; however, the gold stocks aren’t really following GLD’s move to the upside. From the beginning of this bear market, it’s the gold stocks that have been leading the way lower. GLD’s strength might just be temporary due to a knee jerk reaction to the Fed statement. In the past, these initial moves turn out to be incorrect in terms of which way GLD is ultimately going to go. Since that time, GLD has weakened considerably and actually temporarily moved below the 110 level today (Wednesday), which is major support that held in November 2014 and March 2015. If this is the final sell-off of this bear market, then that 90-100 target that I have been talking about since last year comes into play – and fast too. The weekly MACD also shows another negative crossover, which could portend new lows are ahead. (Source: Schwab) Given what’s occurring in the gold stocks, it seems only a matter of time before GLD breaks hard to the downside. The NYSE ARCA Gold Bugs Index ($HUI) is comprised of 16 gold companies and it includes the biggest names in the sector. The index has been incredibly weak as of late, and when you see the gold producers selling off like this, usually GLD isn’t too far behind. This looks like capitulation, which I have been waiting many months for. So without question, if GLD breaks aggressively lower, this will be the final sell-off for this bear market. I wasn’t sure if it was going to happen but now the likelihood grows everyday the more gold stocks collapse. This would be a most welcome turn of events as this bear market is very long in the tooth. When it’s all said and done, the 2011-? bear in gold stocks might be the worst on record, one that will most likely never be beaten. The HUI hit an all-time high of 630 in late Summer of 2011, which means it has declined 78% from that point to today’s levels. If GLD enters that final leg lower, you could get some major panic selling in the shares of these precious metal companies. It’s not out of the question for the Gold Bugs Index to be cut in half if GLD hits 90 (or about $950 for gold). That would put the HUI at 70 and change, which is an 89% sell-off from peak to trough. We have to go back to the Great Depression to see that kind of carnage in a U.S. stock index, as the Dow declined from 381 in 1929, all the way to 41 by 1932. An 89% sell-off as well. But it only took a few months for the Dow to double off of the lows, and a year later it had tripled from the bottom. I expect a similar rebound in terms of percentage and swiftness should the HUI move substantially lower over the coming weeks/months. (click to enlarge) (Source: StockCharts.com) No market index is going to lose 80%-90% of its value and just remain at those levels for years. These size percentage losses only occur in major oversold events where investors misprice assets to the extreme. At bubble tops, peak prices last for just a few days/weeks, the same goes for bear market bottoms. The lows in the Nasdaq during 2002 (after the tech/internet bubble burst) only lasted a few days. 2-3 months later the index was up 50%, a year later the Nasdaq was up 100% from the lows. If we go back and look at the previous bear market in the HUI (which ended in late 2000), the bottom was very short-lived. History will repeat here as well. These gold stocks are already at deep deep discounts to their fair values. The further they move to the downside from current levels, the tighter the rubber band is pulled, and the faster and harder it will snap back. I’m Still On The Sidelines With GLD and the gold producers acting very weak over the last few months, I have been in mostly cash. For the first time though, I see the finality of this bear market. During previous lows that have occurred over the last few years, it was questionable. While gold and precious metal share prices were cheap, they weren’t at extremes levels that would mark a final bottom. This would be more definitive now, as gold anywhere under $1,000 is simply unsustainable. I still believe that GLD is in its bottoming stage while the stock market is in its topping stage. I don’t see a market crash occurring in the next few months, rather I expect this chopping action to continue. Marginally higher highs could be hit in the major US indices, or we could just see a series of lower highs. Next year though (and maybe towards the end of this year) will not be pretty for the market. Many investors look for reasons why GLD has been performing so poorly since 2011-2012. This has nothing to do with the strength of the USD, as so many people believe. It’s simply the result of the huge bull market in stocks that has occurred. But the stock market is not attractive at the moment as valuations are extremely stretched. And with the Fed about to embark on raising rates probably sooner rather than later, it’s time to be booking profits. Why Am I A Long-term Gold Bull? I’m currently bearish on GLD’s short-term outlook, long-term though I’m pounding the table. I know for a lot of investors it’s hard to see this sector ever returning to its former glory of 2011. But this is going to be the best performing asset class over the next several years. Gold will continually move higher in price as long as we have a non-gold backed fiat currency system. You have M2 surpassing the $12 trillion level in the last few weeks. With the money supply constantly expanding at a very brisk pace, it’s only a matter of time before the gold price catches up. (Source: Federal Reserve) You also have the major gold producers showing a flat to declining production profile over the next several years. This is in stark contrast to what the landscape looked like in 2011, when many gold projects were being developed and growth in output for most gold companies was very strong. Some might worry about the Fed raising rates, which investors believe would put further downward pressure on the price of gold. But we are in a negative interest rate environment, and the Fed Funds rate would have to hit 2% for that to change. I doubt the Fed gets past 1.0-1.5% before this economy starts to buckle. That figure could move higher if inflation and GDP growth pick up in the short-term. But it’s not just the economy that will feel the pressure of rising rates, it’s the U.S. Government’s debt position that will be impacted the most. The Government is a huge beneficiary of this low interest rate environment, as it means lower interests. The second rates increase, so will interest payments. If rates “normalize” to the 4% level, interest will skyrocket. From the Congressional Budget Office’s updated projections for 2015-2025: Interest Payments. CBO expects the government’s interest payments to rise sharply during the coming decade , largely as a result of two conditions. The first is the anticipated increase in interest rates as the economy strengthens. Between 2015 and 2025, CBO projects, the average interest rate on 3-month Treasury bills will rise from 0.1 percent to 3.4 percent and the average rate on 10-year Treasury notes will rise from 2.6 percent to 4.6 percent. Second, debt held by the public is projected to increase significantly under current law….Together, the rising interest rates and federal debt are projected to more than triple net interest costs-from $229 billion in 2015 to $808 billion in 2025. So as confirmed by the CBO, should rates normalize, the interest that the U.S. will be paying on the debt will go from $229 billion to $808 billion over the next decade (this doesn’t include interest credited to Social Security and other government trust funds). The faster the Fed raises rates, the faster these payments balloon. The simple fact is the U.S. will be running $1+ trillion deficits again in the not too distant future. Of course GDP is projected to increase as well over the next decade, so a $1 trillion deficit won’t be the same in terms of “percent of GDP” as it was say 5 years ago. But that’s also a reflection of the amount of inflation/growth in the system, so gold will respond positively to this. The U.S. is still dealing with a ever increasing debt obligation that simply can’t be repaid. This stealth inflation that has been in place since the 2008 financial crisis will remain. Gold will have its turn as it must adjust for higher levels of money supply growth. The biggest reason though to be a long-term gold bull is simply because of the extremely compelling valuations in the sector. Sure, they will get even cheaper if GLD takes one last plunge. It wouldn’t be out of the realm of possibility to have many producers/developers/explorers selling at or below cash values soon, as their businesses will be worth nothing to investors. This is exactly what occurred in tech/internet stocks in 2002, the general stock market in 2008, and housing in 2009-2010. At a certain price point, an asset becomes as close to a “sure thing” as it will ever be. What’s The Timing Of This? Should GLD break down decisively, I’m expecting this bottom/capitulation process to last 2-4 months for GLD and the gold stocks. That would mean investors should be looking to be buy sometime in the September-November timeframe. The window to acquire GLD and precious metal shares at or near the absolute lows will be small and will not hold for many days. Timing though isn’t extremely important providing investors are purchasing somewhere near the bottom. Once the bottom is reached, I expect a V-shaped recovery with GLD moving back swiftly to the 115 level. Will There Be A Mass Wave Of Bankruptcies In The Gold Stocks? Given a possible low of $950 for gold, and the debt loads for many of these companies in the sector, investors might assume that we will see a wave of bankruptcies come this Fall. But that is unlikely for a few reasons. 1. While net debt levels are high for some gold producers, much of this debt is long-term in nature. Barrick Gold (NYSE: ABX ) for instance, the most indebted company in the sector, has plenty of cash on hand to cover its debt obligations (including interest) for the next several years. The majority of companies will be able to survive a trip down below $1,000. Most of the weak ones have already perished (Allied Nevada for example), the rest have adapted to this low gold price environment and can withstand more downside. Unfortunately their stock prices will suffer. 2. As I mentioned earlier in this article, as well as in previous articles on the sector, gold under $1,000 isn’t sustainable. The simple reason is cash costs will never be able to get down to that level across the industry without a serious supply disruption. And we haven’t had a big enough increase in total gold output worldwide over the last 15 years that would warrant/necessitate a decrease in production. Gold producers have done a tremendous job with reducing their costs structures since the precious metal started to decline in 2011, but to ask them for more is too much. Everything that could be done (to reduce All-in Sustaining costs), has been done. The only other avenue would be to take offline some of this lower margin supply. I just don’t see that happening though because of the disruption this would cause to the industry. In Summary This feels like the start of capitulation in GLD, and in typical fashion it’s the gold stocks leading the way lower. Should GLD break down hard (and we don’t have some last gasp stick save event), I’m expecting the ETF to bottom out around the 90-100 region (probably closer to 90). The gold stocks have much further downside than GLD, and we could see the HUI fall as much as 90% from the 2011 peak when it’s all said and done. There is much to be bullish about when looking at the long-term for GLD. Production growth is flat to declining, M2 is still rising at a very strong pace, net interest for the U.S. will skyrocket which will cause the deficit to hit $1 trillion again, and valuations in the gold sector are extremely compelling already. If “this is it” then I expect the bottoming process to last for 2-4 months. We won’t see a mass wave of bankruptcies in the sector either during that time. Net debt levels are high for some gold producers, but much of this debt is long-term in nature. I also don’t expect gold to remain under $1,000 for long, so it won’t be an issue for most companies. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.