Wednesday, August 9, 2017

Financial Companies: Two Disturbing Quality of Earnings Trends

After reviewing more than 1,000 Company SEC filings for the June 2017 Quarter, I see two disturbing quality of earnings trends, particularly in the Financial Industry.

The first one relates to the amazingly high and growing number of tax-advantaged REITS.  Many of them have solid or even blowout quarterly, year-to-date or annual earnings increases, but frequently this is due to large gains on sales of real estate property.

I see three problems with these large gains.

First, these REITs are just front-ending their earnings by recording gains now.  In future periods, they are giving up future earnings from these real estate properties.  

Second, REITs get into the trap of having to continually increase their quarterly or year-to-date earnings by having to sell even more real estate properties to match and also exceed the prior quarter's or prior year's gains.

And third, these large gains on real estate property sales are usually made by REITs selling their real estate properties to other REITs, who turn around and sale some of their real estate properties to other REITs to report upfront gains ..... and on and on ..... and there is always the risk that even something resembling a pyramid scheme has occurred in the case of some of these REITs.  After all, the Real Estate Industry is not exactly known for being pristine in its business ethics.

The second very significant quality of earnings problem I see, especially in the financial industry, is the growing number and amounts of reported front-end bargain gains when purchasing a business.

Measuring bargain gains on buying businesses is so incredibly subjective.  If you had ten different business valuation companies measure the amount of bargain gain in a given business acquisition, I am certain that the amounts would vary substantially with no two being really close to each other.  And when the business doing the acquiring attempts to measure its bargain gain, the computation is biased and the assumptions tend to be very rosy in order to maximize the reported bargain gain.

If you see a large reported bargain gain made at the end of a quarter and this bargain gain permits the company to have an up earnings quarter which they wouldn't have without it, I would be very suspect.

I think the FASB really blew it in allowing these front-end bargain gains just by purchasing a business.  In theory, it is logical.  However in practice it flat out sucks, substantially lowering investor confidence in not permitting the investor to be able to rely on the amounts of these clearly highly unreliable in amount bargain gains recorded upfront in earnings when a business is purchased.