By Matthew Kliber
On a recent quarterly earnings call, the chief executive of one of our short positions stated, “As we look at the economic and corporate growth environment around us, we continue to see weak economic growth trends globally and uncertainty and tight business spending patterns for the near term. Despite the record highs being experienced by equity markets, the real world continues to struggle with corporations using more of their cash to repurchase shares than in making clear commitments to invest in growth.”
Given the substantial increase in large companies exhibiting evidence of demand strain and earnings risk, we could not agree with him more. Regardless, year to date, multiples have expanded, indices seemingly set new highs daily, and, most concerning, investors are at greater risk of loss.
As the first quarter earnings season comes to an end, we continue to observe large companies report revenue below the consensus estimate while reporting in-line or narrow earnings beats, many of which were the product of aggressive earnings management and financial engineering.
Today, we observe several parallels to the period that preceded the last recession. Similar to 2006-2007, we note an increase in companies financing their own sales through on-balance-sheet means (such as extended financing arrangements) and/or the use of off-balance-sheet mechanisms (such as the provision of loan guarantees to third-party financial institutions on behalf of customers) to offset demand weakness. We also note multi-year high inventory levels across sectors, and an increased pervasiveness of discretionary changes in accounting practices that have led to unsustainable earnings benefits. Finally, we note an increased reliance upon non-cash, accrual-sourced earnings which, in our experience, increases future period earnings risk.
We also note an increase in expectations management as dozens of companies in our large capitalization universe have conditioned investors to expect that significant economic recovery, and earnings growth, will occur in the second half of 2013. Consequently, second half earnings estimates have been buoyed and multiples have expanded. We view this dynamic as another parallel to the period that preceded the last recession wherein we observed companies engaging in non-nefarious earnings management with the expectation (and guidance) that the economy -- and earnings growth -- would strengthen in the second half of 2007. However, as the economy weakened, companies missed revenue estimates, companies depleted non-cash sources of earnings, and investors lost money.
In addition, we have witnessed a spike in abnormal insider selling behavior this year, in particular, the early exercise of deep-in-the-money stock options not set to expire until 2016-2019. While the up-tick in insider selling that occurred in late 2012 may be rationalized by the uncertainty regarding the pending tax law changes, the frequency and materiality of abnormal insider divestitures in 2013 -- coincident with increased reliance upon unsustainable, non-cash sources of earnings -- exacerbate our concerns about earnings sustainability. This year we have also seen a proliferation of recently-public companies engaging in aggressive financial engineering to mask earnings weakness to enable beneficially-priced liquidity events for insiders and private equity sponsors.
Finally, we note an absence of sell-side analyst scrutiny of companies' back-end weighted earnings guidance, and we note a proliferation of increases in sell-side analyst price targets once previously-set price targets had been achieved, yet without corresponding increases in earnings estimates. Multiple expansion of this sort increases the risk of (i) adverse investor reaction to adverse earnings events, and (ii) significant investor loss.
In sum, we are seeing what we believe is a repeat of the pattern that preceded the last recession with two key differences: (i) Today, unlike then, companies are at peak operating margins as cost structures have been rationalized (hence, there is little room for incremental expense savings); and (ii) Today, multiple expansion has occurred due to a Fed-induced, liquidity-driven rally (and not due to evidence that earnings growth is sustainable and/or that it will accelerate).
Matthew Kliber is the founder of Gracian Capital, a San Diego-based, short-biased hedge fund manager that shorts liquid, large cap, uncrowded equity securities.