For the week of 1/6/20-1/10/20, we focus on the Earnings Distortion scores for three companies.
We measure earnings distortion using a proprietary human-assisted ML methodology featured in a recent paper from Harvard Business School (HBS) and MIT Sloan. This paper empirically shows that street earnings estimates are incomplete and less accurate since they do not consistently and accurately adjust for unusual gains/losses buried in footnotes.
As corporate managers bury key data in footnotes to manipulate earnings, and investors miss them, investment opportunities arise because stock prices tend to be driven by core earnings power.
Our Earnings Distortion Scores[1] empower investors to combat management efforts to obfuscate financial performance. The aggregate level of distortion recently reached levels not seen since right before the tech bubble and the financial crisis.
Weekly Earnings Distortion Insights
Figure 1 contains the S&P 500 companies, plus those with market caps greater than $10 billion, that report earnings the week of January 6, 2020.
Figure 1: Earnings Distortion Scorecard: Week of 1/6/20-1/10/20
Image Source: New Constructs, LLC
Details: WBA’s Earnings Distortion
In fiscal 2019, WBA had $601 million in net earnings distortion that cause earnings to be understated. Notable unusual expenses found in the firm’s 2019 10-K include:
- $477 million in transformational cost management expenses primarily recorded in SG&A – Page 47
- $303 million in acquisition-related costs – Page 47
- $196 million in store optimization costs primarily recorded in SG&A – Page 47
- $73 million in impairment charges on its pharmacy licenses primarily recorded in SG&A – Page 80
The transformational cost management expenses are part of WBA’s Transformational Cost Management Program, which aims to deliver over $1.8 billion in costs savings by fiscal 2022. Similarly, the store optimization costs are part of WBA’s Store Optimization Program, which aims to close around 750 stores in the company’s Retail Pharmacy USA segment.
In total, we identified $0.65/share in net unusual expenses in WBA’s 2019 results. After removing this earnings distortion from GAAP net income, we see that WBA’s 2019 core earnings of $4.96/share are down just 8% year-over-year (YoY). Meanwhile, GAAP net income paints a much worse picture, as it is down almost double, or 15% YoY.
How to Make Money with Earnings Distortion Data
“Trading strategies that exploit {adjustments provided by New Constructs} produce abnormal returns of 7-to-10% per year.” – Page 1 in Core Earnings: New Data & Evidence
In Section 4.3 of Core Earnings: New Data and Evidence, professors from HBS & MIT Sloan present a long/short strategy that holds the stocks with the most understated EPS and shorts the stocks with the most overstated earnings. Positions are opened in the month each 10-K is filed and held until the next 10-K is filed, or about a year.
This simple, low turnover strategy produced abnormal returns of 7-to-10% a year. These abnormal returns show that the market misses important data in the footnotes and that investors who adjust for unusual items can make more money.
This article originally published on December 30, 2019.
Disclosure: David Trainer, Kyle Guske II, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.
[1] Note that Earnings Distortion scores will be added to our website via a new column on the Screeners and Portfolios page in January 2020.
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