($422 billion were redeemed during past five years from actively managed funds, going to passive vehicles)
The stock market is doing fine, but investors are losing faith in active portfolio managers. How come? Simply, poor performance. “Only 9.5 percent of actively managed large-cap domestic equity funds beat the S&P 500 Index in the five years ending August 31. That’s the worst five-year performance since 1999 …” (Bloomberg, September 15, 2016). Given recent years’ volatility of stocks, you would expect smart, active managers, moving securities quickly across sectors and deploying alternative investments, to beat the averages. But they evidently don’t. I, for one, am not surprised.
Having watched carefully over the years the investment models of fund managers, and having examined the questions analysts ask in quarterly conference calls, the major reason for the poor performance is clear to me: fixation with companies’ earnings. Most investment models revolve around the prediction of corporate earnings, and many of the questions asked in the conference calls concern earnings guidance, and expected cost items. “Earnings move markets” was, and still is, the mantra on Wall Street. The only problem: Reported (GAAP) earnings no longer indicate corporate value changes, hence the poor performance of earnings-based investment models.
The following figure, from The End of Accounting …, shows the gains over the past quarter century from a perfect prediction of corporate earnings and cash flows. While earnings easily beat cash flows until this century, in recent years’ cash flows have a slight edge.
The major reason for earnings’ fall from grace, as I have indicated in past blogs, is accounting regulations (GAAP). The indiscriminate income statement expensing of value-creating investments (customer acquisition cost, content creation, R&D, IT systems, etc.), the mark-to-market valuations of non-traded assets/liabilities (an oxymoron), and the write-offs of assets and goodwill, contaminate reported earnings with charges, mostly one-time, which are unrelated to corporate future performance and value creation. At the same time, important business events, like clinical trials results of pharma and biotech companies, or failure of oil & gas companies to replace depleted reserves, are ignored by the accounting system. No wonder then, that an earnings-focused investment analysis generates such poor results. But cash flows aren’t the solution: they too provide a myopic view of performance.
The solution, as we demonstrate in The End of Accounting, is a shift to an investment analysis which focuses on the real value-creators of businesses: the “strategic assets” of the enterprise which confer competitive advantage (the customer franchise, revenue-generating patents and brands, unique oil & gas properties, or an upward trending policy renewals of insurance companies), as well as the successful deployment of these assets to create value (strategies to retain customers, patent protection from infringement). Much more on such strategic investment analysis in future blogs. Finally, focus on a single indicator (earnings) to evaluate a business is as valid as a sole focus of your doctor on the cholesterol count to reflect your health. Time to change the doctor as well as your investment model.
Note: Please leave the comments in the space below. Shout out to an investment fund – Gavekal Capital, who published an extended interview with Baruch Lev. More of the information could be found at —http://blog.gavekalcapital.com/