Investing is simple. Whether it's the equity or bond market, public or private, cash flows drive asset prices. Life, however, isn't simple. And investing is also incredibly difficult given the nonlinear nature of the world. When cash flows fail to live up to expectations, asset prices can go awry. Leading up to the global financial crisis, for example, investors thought home prices couldn't fall. Investors therefore thought the hundreds of billions of securitized debt instruments backed by monthly mortgage payments were money good. We now know they weren't.
Fast forward to 2020. The current global economic expansion has been remarkably long but has produced a lower-than-average rate of growth. Despite a combined 768 rate cuts and $11+trn (and counting) of quantitative easing, inflation remains elusive. To me, what's most notable about this environment is the historic strength of corporate profits against a backdrop of mediocre economic growth, uniquely low productivity and well-below-average revenue growth. In this regard, the United States stands apart from other major markets. Despite this being the longest, yet weakest, economic expansion since the Civil War, earnings power has expanded at a remarkable 13.3% annualized, as shown in Exhibit 1 below.
As I wrote in October's Strategist's Corner, Here's What Keeps Me Up at Night, corporate chieftains have for years aggressively engineered financial results. If we channel Artemus Ward, I think we're supposed to ask, "What do we think we know about this profit cycle that perhaps ‘ain't so'"?
Consider earnings quality Comparing GAAP (Generally Accepted Accounting Principles) and non-GAAP earnings, as we do in Exhibit 2 below, may help us discern what is, and what ain't, so.
Wall Street anchors to non-GAAP operating earnings (dark blue line) because they are believed to be a better reflection of the profitability of regular business operations. They typically exclude noncash charges or expenses that flow through the income statement. Examples include the depreciation of an asset, such as a factory, or goodwill from an acquisition.
The GAAP guidelines, issued by the Financial Accounting Standards Board, are standardized general rules. GAAP earnings reflect "extraordinary" noncash charges, such as amortization or the write-off of a bad investment.
Logically, there is typically a difference between non-GAAP and GAAP earnings. No surprise there.
However, as shown in Exhibit 2, as this cycle aged and earnings strengthened, the differential, represented by the blue bars, expanded, on average. In fact, the levels shown above are about one-third higher than those of the late 1990s. This implies that earnings during the second half of this cycle were of lower quality as investors largely ignored an increasing number of "extraordinary" noncash hits to earnings.
To be fair, some of the gap can likely be explained by technology and the secular shift from physical to nonphysical investments such as intellectual property.
Why active management matters
There are companies that are making sound investment choices behind the scenes, and the difference between reported earnings and GAAP earnings is appropriate. Conversely, there are companies whose value proposition has eroded, and their below-average management teams make poor resource allocation decisions. This helps explain why the essence of active management is understanding industry and company fundamentals, determining who ha pricing power and who doesn't and channel-checking companies' products and service to assess their viability.
With today's lofty valuation levels and the unusual length of this market cycle — almost 12 years — it's more important than ever to be able to distinguish between what is and what isn't a noncash charge that should be excluded from reported earnings. That's why we believe active management may offer more value in the future than it has at any point so far in this unusually homogenous cycle. And it starts with distinguishing between the ordinary and the extraordinary.
Rob Almeida is global investment strategist for MFS Investment Management