Don’t blindly trust stock screeners and “reputable” stock Research Data Sources. I recently wrote an article about my opinion towards using automated stock screeners to find investment ideas. One of the items I touched upon was the “gaping hole” in stock screeners.
“The data used to power stock screeners (especially earnings per share) can often be inaccurate or delayed causing you to miss great stocks or buy stocks that appear cheaper than they really are.”
In Stock Screeners We Don’t Trust: Garbage in, Garbage out
As an investor, one of the worst feelings I have experienced arose from losing money or forgoing a chance to make big money because the data I used to support an investment decision was inaccurate.
One of the biggest problems I have encountered with stock screeners is the lack of accurate earnings per share data (EPS). Earnings per share is arguably one of the most widely used numbers investors reference to value stocks, yet it is can often be one of the most mistrusted. It is the key input for the Price to Earnings multiple (P/E). If you are a Peter Lynch junkie you understand the importance of the P/E ratio. Get it wrong and you could be the “greater fool” buying an overvalued stock that is about to go lower. I am sure that many of you can relate to a hypothetical example that I am about to describe. Sadly, I know I can.
The Greater Fool Theory
The greater fool theory (GFT) refers to those:
…who buy an investment based on the premise they will be able to sell it at a profit to a “greater fool.” Many investors subscribe to this theory, but don’t know they are engaging in it. In an ironic twist, they become the “greater fool,” and are left holding the bag when the investment falls and they either can’t find a buyer or they have to sell at a loss.”
Imagine that you come across a technology company that issues a press release right before the stock market is about to open, where it reports what looks to be a grand slam quarter. Sales are up 25%, EPS tripled, the management commentary is decidedly bullish and the P/E ratio went from a fairly valued situation to one where it appears that the stock is severely undervalued. The stock is not being bid up; “a gift,” you think to yourself. Christmas came early.
You buy the stock pre-market or right when the market opens laughing at the “fools” who did not find this gem yet, counting the loads of money you are about to make. Minutes later, after you told some friends and family to climb aboard, the stock starts tanking. By now you know something is wrong, so you read the earnings press release again, but this time more carefully. And there it is, tucked away as a line item in the disclosed income statement:
“Realized Gain From Sale of Asset.”
Oops. You instantly recognize that the sole reason the company made money was due to this one-time gain from a non-operating event and, that despite rising sales, their core business is losing tons of money, worse than the year before. The P/E is meaningless. Then it gets worse. You read the associated quarterly report filed with the SEC where management discloses they lost a major customer. You then get angrier, thinking, “what the heck was management so bullish about in the press release!”
Now your only hope is that some other suckers make the same mistake you just made, temporarily lifting shares from their bottom, after they run a screen where the application does not adjust EPS for these non-operating events. You decide to take the loss after learning a valuable lesson. Always do your own research, leaning on sources/investors you know you can trust. Don’t blindly rely on stock screeners!
Don’t Blame Management, Blame Yourself: GAAP vs. non-GAAP
Technically, in the above example management did not violate any rules. The market regulators like the Security and Exchange Commission only require companies to report financial numbers under Generally Accepted Accounting Principles (GAAP) which, in some cases, can distort the true operating picture of a firm. The previous example included a line item that helped the company appear more profitable than it really was. But it can work the other way too.
For example, sometimes expense lines may include one-time non-recurring items like legal or severance costs. Adjusting financial statements to eliminate non-operating or non-recurring expense or income items is a valuable exercise to calculate a “cleaner” EPS number referred to as adjusted/non-GAAP EPS. Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) is another non-GAAP figure used by many investors. To complicate matters, management will often present GAAP and non-GAAP (see the difference) figures in press releases to appear more transparent. But in reality management has a great deal of latitude in their calculation of non-GAAP financial measures to inflate earnings. I have come across some companies that present EPS that are actually EBITDA’s, add back cash expenses that are recurring in nature and distort financial statements by mis-categorizing clearly noncollectable receivables as assets and revenue.
It all comes down to the same theme. We need to perform our own research and calculations, even when it appears that management is being transparent. We only have ourselves to blame when we get complacent.
It’s Getting Better, But Not Good Enough
I will admit that behemoth information providers like Reuters, Capital IQ, Factset and Bloomberg have been doing an increasingly better job of dealing with the EPS data issue to power their stock screeners, but mainly as it pertains to larger capitalized stocks. It’s still a mess on the micro-cap level where data errors filter through to places the everyday investor performs research, like on Google Finance and Yahoo Finance. Furthermore, a basic screener is not going to reveal that a company just lost a customer. In an upcoming article I will illustrate some of the adjustments investors need to make to companies that reported GAAP and non-GAAP earnings per share. This is a task is I perform on a daily basis during earnings season and in my ongoing research.