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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Show Me the Earnings!

In the popular 1996 movie "Jerry Maguire", about an aggressive sports-agent who wakes up and questions the loose ethics of his profession, one incredibly memorable line was uttered that has become firmly entrenched in the popular American lexicon.

After his crisis of conscience, sports-agent Jerry Maguire, played by Tom Cruise, is fired from his firm for writing an inflammatory essay suggesting that his large sports management company could do a better job with fewer clients and less money. As Maguire is leaving, he tries to persuade his professional athlete clients to jump ship with him. Only one professional football player agrees to stay with Maguire, an unremarkable Arizona Cardinals wide receiver played by Cuba Gooding Jr., Rod Tidwell.

Tidwell is willing to go the distance with Maguire, but only under one condition. He says, in a movie line that has become famous, "Show me the money!"

This simple phrase has grown so ubiquitous and powerful in our capitalist American culture because it cuts to the chase in any conceivable business deal. Any potential mutually beneficial economic transaction can be distilled down into these four hard-hitting words. Whether a nation-state is negotiating to buy a dozen jumbo jets from Boeing or an average American kid is going into the corner convenience store to buy a snack, "Show me the money!" slices away all the non-essential elements to reveal the core of capitalism.

If the asking price for anything can be voluntarily met by a willing buyer, if the buyer can "show the money", a deal can be consummated.

In the chaotic stock-investing arena, this great Jerry Maguire phrase could be pirated and modified to state, "Show me the earnings!" Just as "Show me the Money!" cuts to the quick in voluntary and mutually beneficial capitalist economic transactions, "Show me the earnings!" slices away all the pervasive stock market hype and exposes the ultimate core issue.

For equity investors there is nothing more important than earnings. Investor psychology, popular opinion, hopes and dreams, and other warring factors can wax very influential for equity prices over the short-term, but over the long-term the only thing that matters is the ability of companies that stock investors own to earn profits in their business operations. Without long-term earnings, no company can survive. A business in a capitalist economy must earn money or else face certain doom over the long run.

Ultimately, when everything else is stripped away to leave only the core fundamental heart of equity investment remaining, all that truly matters is the ability of a public company to consistently earn profits on its operations. The only reason that stock investors will even consider placing their scarce and valuable capital at risk in the volatile stock markets is because they expect that the companies they buy will earn enough money to provide a reasonable return on their investment. These returns, even though they come in the two primary flavors of capital gains and dividends, are always ultimately dependent on earnings.

If a company begins consistently growing its earnings, it will attract other investors which will bid-up its stock price, providing healthy capital gains for earlier investors. If a company has steadily increasing earnings, it may begin paying some of its profits out in dividends, providing a direct cash income stream to its equity owners. Both types of equity returns, capital gains and dividends, are totally, completely, and utterly dependent on the ultimate ability of the underlying company to earn profits. If there are no profits or no near-future prospects of profits there is simply no rational reason left to own a specific stock.

For example, one of my favorite Internet companies is Amazon.com. As a relentless and insatiable reader, I think Amazon is just a wonderful service for folks like me who lust after knowledge and understanding. Although I love buying books from Amazon, I wouldn't invest in Amazon if it was the last publicly-traded company on earth. Amazon, now eight years since it was founded, continues to hemorrhage money at a frightening rate on almost every book it sells.

Being in business is all about earning money, making profits, not selling at a loss. The long-suffering shareholders of Amazon, bless their charitable hearts, are effectively sending me a small portion of their precious capital with each below-cost book I buy from Amazon. Thanks for generously subsidizing my reading and research Amazon shareholders! No profits for Amazon? Then there is no reason for it to be in business!

Another example of elusive profits is the recent zero percent auto-financing craze. A lot of the profits that US auto companies make are earned through their captive finance programs. As General Motors and Ford constantly appeal to the infinite vanity of Americans to seduce them into buying shiny new cars to parade in front of their friends, the car giants well know that the vast majority of US consumers can't afford to write a check to buy a car outright and will have to "buy" their car on time. As car buyers spend many years working to pay-off their debt which can sometimes almost double the cost of a car, car manufacturers that finance these debts earn profits on the interest charged.

Zero percent financing was a great promotion from a marketing perspective, but what is the point of selling a vast amount of goods if a company is not making money? Sales by themselves are ultimately meaningless. Profits are the golden ring of capitalism, not sales.

For example, anyone reading this essay could easily become the largest seller of gold on the entire planet if they really wanted to. All they would have to do to achieve this goal is to start selling gold for $200 per ounce, far below the market price and their cost. Never mind that they would be slammed with a big loss on each ounce of gold sold. If one desperately wants sales, craves market-share, but couldn't care less about profits, it is quite possible to sell any quantity of goods imaginable at a loss.

Of course, selling at a loss over time always leads to bankruptcy, but this simple truth never seems to enter the minds of the goofy corporate managers who sell-out their shareholders' best interests (earning profits) in order to temporarily "increase market share" by selling goods below total costs. Capitalism is about earning profits. Business is about earning profits. Stock investing is about buying shares in companies' profits. Period.

In this surreal bubble-era in which we curiously find ourselves still languishing in the United States, the average stock investor seems to have totally forgotten that the only ultimate reason to own a given company is earnings!

While earnings are absolutely crucial for every publicly-traded company in existence, the amount of profits earned relative to a company's stock price are also hyper-critical.

If I was to tell you that I know of this great company that earned $1b last year that you have to consider buying, you should just laugh at me. Earnings information is only useful in the crucial context of the total valuation of a particular company, its stock market capitalization. The attractiveness of a particular earnings level is always dependent on what it costs to buy an ownership share in that earnings stream.

If, after you laugh at me, I tell you that the company I have in mind is only worth $5b on the stock market right now, you may grow far more interested. A market-capitalization of $5b and earnings of $1b create a very low and attractive price earnings ratio of 5.0, implying that the company, assuming flat growth, will earn back the total price investors paid for it within 5 years, a 20% return. Because the centuries-old average US equity return is around 7.4% or a P/E of 13.5 (see "Century of the Dow"), you will probably be excited to learn more about my potential investment play.

If, on the other hand, I tell you that the sweet company I know about with $1b of earnings is currently trading in the stock market at a valuation of $200b, I sure hope you start really laughing at me. A market-cap of $200b and earnings of $1b yield a stellar and exceedingly ugly P/E ratio of 200.0! All things being equal, this means an average investor can expect to wait 200 years for the company to re-earn the price they paid for it, an implied return of a dismal 1/2%.

Waiting 200 years for a return would be fine if we were all immortals, but since the average investor has exactly zero hope of being around 200 years from now and because 1/2% is far below even the watered-down official inflation rate, you should take your scarce capital and run for the hills if I or anyone else ever suggests that owning a mere $1b of earnings is worth paying a whopping $200b. Perish the thought!

For stock investing, the ability of a company you buy to earn money for you is everything! However, not only the ability of a company to earn profits is important, but also absolutely crucial is how much the market is asking you to pay for a particular earnings stream. If you want to consistently make money in the markets year after year, decade after decade, you simply have to buy low and sell high. The only way to buy low is to know how much companies are worth. In stocks, long-term worth is ultimately exclusively determined by the earning power of publicly-traded companies. These are many of the timeless truths of long-term equity investing wrapped-up in a nutshell!

Since the September 21st US stock market lows, American investors have been mercilessly subjected to one of the most brazen and aggressive financial propaganda campaigns that I have observed in my entire life. Adolf Hitler's notorious Minister of Propaganda, the incredibly evil Josef Goebbels, would be quite proud of the mainstream US financial media's aggressively manipulative behavior in the last few months. Rather than simply reporting somewhat objectively on market events, the mainstream financial media is desperately trying to rekindle a new bull market in investor psychology.

Sure, this perma-bullish bias for equity markets has always existed in the mainstream financial media, but before the 9/11 attacks in the US there was an occasional token contrary opinion offered, even if the person espousing the non-conformist market viewpoint was just used as cannon-fodder for the financial media to ridicule. Since 9/11 however, the appearance of even a whiff of contrary opinion in the mainstream financial media has become more elusive than a central banker who has the slightest clue how free markets operate.

In this new spectacular bear market rally that apparently must be coddled and protected at all costs by the mainstream financial media, honor and integrity be damned, the prices at which the markets are offering stocks for investors to purchase have catapulted far beyond overvalued into the just-plain-silly realm that we should have left behind for decades in early 2000. At the end of December as documented in the new January 2002 issue of our private Zeal Intelligence newsletter, major US index P/E ratios were just obnoxiously high at hyper-dangerous levels.

In market-capitalization weighted average (MCWA) price earnings ratio terms, the current broad equity valuation levels are downright terrifying.

The market-darlings of the Great American Casino known as the NASDAQ 100 were trading at 55.9 times earnings even after the violent purging of hopeless tech losers in NASDAQ's annual portfolio rebalancing. NASDAQ investors apparently haven't lost enough money or born enough pain yet, as they should have learned their lesson in March 2000 that buying companies that will take 56 years to earn back the price paid for them is not the wisest of ways to deploy precious capital!

I sincerely wish that the scourge of hyper-valuations only infected the greed-ridden NASDAQ casino, but unfortunately the life's work of tens of millions of unsuspecting Americans is at stake as their retirement funds are invested in popular big companies trading at valuations only seen in the past at the very apex of great market bubbles. The elite Dow 30 was trading at a MCWA P/E of 43.0 at the end of December, a staggering number. Even the 500 grand companies of the S&P 500, the flagship American equity index in terms of importance and total market-capitalization, were collectively trading at an unreal 35.5 times earnings as we rang in the New Year.

The whole fantastic rally of the last four months or so which pushed stock valuations to such heady extremes was based on the elusive promise of much higher corporate earnings in 2002. Without these prophesied vast increases in earnings, the current rally is doomed and there will be much wailing and gnashing of teeth. If US corporate profits don't explode upward with unprecedented decisiveness and fury, and very soon, stock prices in the US will turn south to continue their long painful spiral down to fundamental reality.

Stock prices are up, but where are the fabled profits to support the new prices? Show me the earnings!

I fear that today's zealous US equity investors being sucked back into the bubble-valued US equity markets by endless Wall Street propaganda are so consumed by naked greed and focused on the short-term that they have completely divorced themselves from long-term earnings realities. As history teaches over and over again, a fool and his money are soon parted. Without extraordinary positive earnings growth soon, in the first half of 2002, the current great bear market rally will collapse leading to the brutal destruction of vast amounts of valuable capital.

If stock prices are to remain high or run even higher, real earnings must start accruing fast to validate the popular and widespread bullish thesis on 2002!

As earnings remain mysteriously elusive, new accounting standards, the bitter fruits of past deceitful earnings reporting, and besieged American consumers will all coalesce into a massive headwind retarding the absolutely crucial earnings growth in 2002 on which so many Wall Street analysts have desperately placed their last remaining hopes.

Ominously, new accounting standards are already placing US corporate earnings in the unenviable position of having to fight a huge uphill battle. When one company buys another, it often pays far more than the actual assets of the acquired company are worth. This is known as "goodwill" in accountant-speak. New FASB standards effective January 1st force acquiring companies to quickly recognize when they have paid too much for purchased companies. The acquirer will now have to flush the excess goodwill off its balance sheet, running it through earnings as a loss.

On January 10th stories were already emerging suggesting that US companies may have to write-off $1 TRILLION due to foolish acquisitions paying far too much for companies at the height of the late 1990s/early 2000 bubble mania. One key example, the giant Wall Street darling AOL Time Warner, is expected to write-off $60b. This means that Time Warner's shareholders lost the equivalent of $60b due to management's horrible decision to buy AOL right at the height of a speculative mania! Viacom has $72b of goodwill on its books, Qwest has $34b, AT&T has $25b, and the dismal list goes on and on.

Remember the appropriately big stink made about Enron's stunning implosion wiping out tens of billions of dollars of capital? Unlike the Enron managers who destroyed their shareholders' capital, it is most unfortunate that the corporate managers running these mega-US companies that will suffer through tens of billions of dollars worth of goodwill write-offs in 2002 will probably not even be fired, let alone strung-up or sent to jail for violating their sacred fiduciary duty to their shareholders by paying grossly inflated prices for companies.

Although goodwill write-offs are accounting entries and do not represent cash expenses, they are still very real and devastating economic losses to shareholders of the companies who vastly overpaid for acquisitions. These companies will have to earn back enough real profits from operations in future years to make up for these mammoth losses. In many cases, the goodwill write-offs could utterly wipe-out the entire amount of earnings ever retained by companies in their entire multi-decade corporate histories! Bubbles do have consequences!

Another looming problem for US corporate earnings going forward are the sister plagues of rank deception in the way earnings are reported and projected. Because earnings have been so vastly and improperly overstated for so long, any 2002 earnings recovery will have to first reckon with past deceptions.

Wall Street analysts, fully realizing that current price earnings ratios are very dangerous, have unacceptably resorted to the widespread use of "forward earnings", mere estimates of future earnings, to compute P/Es. Any guess about the future is simply a flight of fancy and does not deserve to be a core component in the general analysis of a company's current valuation. Stock analysts in 1999 vastly over-estimated 2000 earnings. Stock analysts in 2000 vastly over-estimated 2001 earnings. And stock analysts in 2001 have almost certainly vastly over-estimated 2002 earnings.

Until American investors suffer enough to learn the hard lesson that Wall Street exists solely to make Wall Street money by hyping stocks, that it is always bullish regardless of whether it should or shouldn't be based on fundamentals, much more capital will yet be annihilated by Wall Street perma-bullish propaganda.

A second and related blight on earnings is the deceitful, dishonorable, and fraudulent horror of widespread reporting of pro-forma earnings for official headline quarterly results rather than solid GAAP earnings (see Pro Forma Madness). The SEC strictly requires certain time-tested accounting standards for earnings reporting. Publicly-traded US companies must report their operating results to the SEC by adhering to these standards or they face serious legal consequences. These same companies that must report their proper set of books to the SEC, however, arbitrarily create numbers out of thin air based on total fantasy to report to investors in headline earnings press releases.

In pro forma earnings, as I wrote in my earlier essay "Pro Forma Madness", any expense that a company doesn't want to report for any reason is simply magically erased. Pro forma means "as if", it is a "guess" or "hypothetical earnings". Any non-operating losses are typically prime candidates for magical exclusion from pro-forma earnings.

A loss is a loss is a loss, regardless of whether it is from operations or from some foolish side adventure that management has embarked upon, like paying too much for buying other companies. Pro forma financial modeling is fine for private reports to very sophisticated accredited investors who thoroughly understand accounting and finance, but is absolutely unacceptable and downright deceptive when used in place of SEC-required GAAP earnings for general distribution. If straight-up GAAP earnings are good enough for the SEC, they are good enough for investors!

Corporate managers who knowingly release these fantasy pro-forma numbers as their official headline quarterly earnings press releases to the general investing public are dishonorable liars who are foolishly attempting to manipulate investor psychology through deception rather than face hard realities. When all the dust settles, these thieves and liars are going to be shredded by hungry lawyers working for investors who were deceived by and lost money because of pro forma fantasy headline earnings reporting.

Any 2002 earnings recovery has to be in real, solid, SEC-approved GAAP earnings, not pro forma flights of fancy which selectively delete any expenses of which corporate managers are ashamed!

The bottom line for stock prices is they ultimately depend 100% on corporate earnings in the long run. Corporate earnings depend almost entirely on the US economy, the financial health of its participants, and their willingness to spend money. If the American consumers, which ultimately drive 2/3 of the US economy directly and indirectly, decide to begin saving a little again or stop taking on ever more crushing debt for current consumption, corporate earnings will not grow spectacularly in 2002 as Wall Street is aggressively touting, but will crash. If corporate earnings crash, stock prices will follow not far behind.

For investors in US stocks either already playing the current spectacular rallies or tempted to jump in, there is only one demand that they really need to make to corporate America, Wall Street analysts, and the mainstream financial media to know if the current rallies are for real or are simply alluring but hazardous bear market rallies. Yes, you guessed it. Investors in US equities need to shout…


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