Archived article
Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
In exclusive new research, using the last 10 years report and accounts for every FTSE 100 firm, AJ Bell shows how the gap between stated (or statutory) operating profit and how companies prefer to present the same figure, on an adjusted, pro forma or underlying basis, is at its highest level in a decade:
Source: FTSE 100 companies’ Annual Report and Accounts in aggregate, 2007-2016
There are two, conflicting, possible interpretations for this:
- Companies are simply being more transparent, providing greater clarity to shareholders on the many moving parts which make up their business and enabling investors to get a better view of what is really going on under the bonnet.
- Companies are instead intentionally muddying the waters. Some even present sales figures in multiple formats of actual, underlying and underlying in constant currencies. Others point to underlying metrics of their own choosing and publish those figures first in regulatory announcements (while at least flagging that they are not based on generally accepted accounting principles, or GAAP). In both cases the goal is to put a positive gloss on their figures. The end result may therefore be a higher share price (to enhance the value of any executive’ shareholdings) or a profit metric which helps management to hit targets and trigger further bonuses or share and stock option awards.
Which interpretation investors prefer will go some way to shaping their view of the prospects for investment returns – good or bad – from the UK’s leading stock index in the coming months and years.
Mind the gap
It is particularly interesting to note that the gap between stated and adjusted earnings has grown wider as UK economic growth and inflation have persistently failed to reach genuine escape velocity and both the stock market and economic upturn have become increasingly long in the tooth.
The gap between stated and adjusted profits at the net level is also near ten-year highs, with only the Financial Crisis-stricken year of 2008 markedly exceeding the differential seen in 2016:
Source: FTSE 100 companies’ Annual Report and Accounts in aggregate, 2007-2016
In the eyes of some, this may be ominously reminiscent of the economist J.K. Galbraith’s concept of ‘The Bezzle’, which he outlined in his book The Great Crash 1929.
“At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – perhaps it should be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle.
“In good times it is plentiful, there are always people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off and the bezzle increases rapidly. In depression, all of this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest unless he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”
Galbraith’s words are particularly strong and the gap between stated and adjusted earnings flagged by AJ Bell research in no way implies that any FTSE 100 management team is doing anything illegal.
But BT’s Italian woes, shareholder discontent over how the thresholds for executive bonuses are set and triggered and the ever-growing gap between stated earnings and the manner in which management teams and their advisers prefer to present them suggests investors need to be even more diligent than ever when it comes to doing their company research – especially as a nine-year bull run in share prices leaves headline indices like the FTSE 100 and the FTSE All-Share near their all-time highs.
Investor action plan
A big gap between stated and adjusted earnings does not necessarily mean a company is inherently a poor investment.
Investors still need to assess its competitive position, financial strength and management acumen but checking the accounts can be a useful way to check the quality as well as the quantity of profits and cash flow.
Even if earnings are plentiful, investors may still choose to pay a lesser multiple to access them if they feel there may be additional risks attached to those profits, so management may not necessarily achieve their goal of puffing a share price higher (if indeed that was their goal at all).
As legendary US investor Warren Buffett once put it:
“Managers and owners need to remember that accounting is but an aid to business thinking, never a substitute for it.”
To protect themselves, and their portfolios, investors can apply the following checks:
Watch out for frequent “exceptional” items (an oxymoron if ever there was one) or a growing gap between stated and adjusted earnings.
The Banks and Mining sectors are those where the gap between stated and adjusted earnings has been consistently large and performance has therefore been very mixed over the past decade.
The gap grew quickly just before Tesco’s profit and accounting woes tripped up the shares in 2012-13 and stocks where the difference between adjusted and stated profits at the operating level has begun to creep higher of late include AstraZeneca, Babcock, BT, GKN, GlaxoSmithKline, Imperial Brands, ITV, Marks & Spencer and Shire.
In some cases acquisitions explain the disparity but frequent deals can be a red flag in themselves and good reason to pay a lower multiple until the purchases prove themselves – if nothing else the greater number of (allegedly) “exceptional” items may suggest management is having to work harder and harder to keep earnings on track in the current low growth environment.
Watch out for restated numbers, unclear numbers or unintelligible commentary.
As an equity investor, your time horizon should be five to ten years at least, as this is when the power of dividend reinvestment really makes itself felt.
Yet depressingly few firms provide a clear ten-year history of their numbers in the Report and Accounts (British Land, GKN and Hammerson deserve praise here).
Those firms which restate the numbers or feature a much more limited history or emphasise adjusted over restated earnings should be given further scrutiny and potentially a discount rating relative to the wider UK market.
Make sure you know what triggers management bonuses, share awards and stock options.
These thresholds are designed to focus executives’ minds and align their interests with those of shareholders but there is a danger that they start to become an end in themselves (as rather happened at FTSE 250 house builder Bovis in 2016).
As Warren Buffett’s long-time business partner Charlie Munger once noted:
“Show me the incentive and I will show you the outcome.”
Investors therefore need to check these triggers, particularly if they are changed and particularly if they are structured so that they are based on underlying or adjusted profit figures. Under such circumstances, a management team may (and we emphasise “may”) be tempted to start gaming the system and focus on short-term pay triggers (“managing the numbers”) rather than doing what they should be, which is deepening a company’s competitive position (“managing the assets.”)
Apply the rule of three.
If sales, operating profit and cash flow all grow consistently, and at broadly similar rates, the chances are the company is a very solid one, with a strong competitive position, pricing power and a reliable set of accounts for good measure.
If sales and profits grow but cash flow lags (or does not grow at all) then more research is required to ensure the company is not flattering its reported numbers, perhaps through aggressive revenue recognition.
Go by the book.
Net asset value (NAV) measures what investors collectively own through their shareholdings – it is the total assets of a company minus its liabilities and represents what would be left if the firm were wound up today. Companies that consistently grow earnings will grow NAV over time.
Those which conjure profits from accounting manoeuvres, or frequently take asset write-downs to cover restructuring operations, especially after acquisitions, may not – especially if the acquisitions prove to be a dud or over-priced or mismanaged.
NAV per share growth is also important as those firms which liberally issue new shares, to raise much-needed cash or fund deals, can dilute down existing shareholders.
One test of the quality and reliability of a company’s earnings is therefore growth in NAV per share, especially when coupled with the gap between adjusted and stated net profit.
The table below shows the top ten and bottom ten FTSE 100 firms in terms of total shareholder returns (capital gains plus reinvested dividends) from 1 July 2007 to 1 July 2017 and compares that to NAV growth and the adjusted/stated net earnings gap between 2007 and 2016.
While some allowances need to be made for the impact of acquisitions and disposals two trends are apparent:
- Within the top ten, all of the companies generated healthy growth in NAV per share and five showed very little variance between stated and adjusted net profit, to suggest the quality as well as the quantity of their earnings is relatively high.
- Within the bottom ten, six saw a drop in NAV per share over the period and the bottom five all showed a big variance between stated and adjusted net profit.
| 10-year total return (%) | 10-year NAV per share growth | 10-year net profit gap (%) | |
| Ashtead | 1,200.8% | 353% | 9% |
| Micro Focus | 1,027.8% | 2,399% | 51% |
| Hargreaves Lansdown | 780.5% | 471% | 4% |
| Croda | 671.4% | 189% | 1% |
| Randgold Resources | 569.0% | 661% | 0% |
| Compass | 509.0% | 43% | 7% |
| Paddy Power Betfair | 504.7% | 6,284% | 36% |
| DCC | 454.8% | 142% | 13% |
| Intertek | 409.3% | 233% | 71% |
| Mondi | 408.8% | 41% | 32% |
| FTSE 100 | 62.6% | 73% | 34% |
| British Land | (9.9%) | (33%) | (5%) |
| Hammerson | (11.4%) | (29%) | 16% |
| Standard Chartered | (16.1%) | 75% | 21% |
| Marks & Spencer | (16.8%) | 121% | 10% |
| Sainsbury | (35.1%) | 9% | 8% |
| Tesco | (46.3%) | (48%) | 77% |
| Barclays | (57.1%) | (16%) | 59% |
| Anglo American | (58.8%) | 50% | 108% |
| Lloyds | (69.6%) | (72%) | 1,001% |
| Royal Bank of Scotland | (95.0%) | (48%) | 109% |
Source: FTSE 100 companies’ Annual Report and Accounts in aggregate, 2007-2016, Thomson Reuters Datastream
If these scratch and sniff tests mean the investor is not satisfied at the end, then he or she has two options.
They can either
- Avoid the shares altogether (or sell them if they own them)
- Pay a discount valuation, relative to sector peers or the wider stock market, until their qualitative doubts are soothed.
Clarity is king
Clarity and consistency of reporting standards are a good sign. Restatements and obfuscation are not.
To leave the final words to master investor Warren Buffett:
“Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as EBITDA or pro forma they want you to unthinkingly accept concepts that are dangerously flawed. In golf my score is frequently below par on a pro forma basis. I have firm plans to ‘restructure’ my putting stroke and therefore only count the swings I take before reaching the green.”
This is a particularly clever analogy as it shows how Buffett could improve his golf score (“manage the numbers” in company terms) without actually becoming a better golfer (“manage the assets” more effectively, in company terms, to improve the firm’s long-term competitive position and by extension its investment case).
Russ Mould, AJ Bell Investment Director
Written by:
Russ Mould
Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.
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