Beware misstated earnings, warns SG quant strategist

Yesterday we considered the bearish views of Société Générale economist Albert Edwards and the dangers facing equity investors. He made his remarks recently to a room of Hong Kong hedge fund managers; they were meant to set the stage for SG's global quant strategist, Andrew Lapthorne.

Lapthorne's message didn't offer much in the way of comfort either. He says it is the nature of equity analysts to always forecast earnings growth, but this year they have become especially bullish. In the second and third quarters of 2009, more than 70% of companies covered by sell-side analysts in Europe and the US beat expectations, despite the economic slump.

This makes little sense to Lapthorne, who believes the impressive levels of profits US companies have achieved despite weak demand have been due to cost-cutting and slashing headcount. They have beaten analyst expectations, he adds, by restating losses as 'exceptional' events on the balance sheet or pushing certain items forward on the balance sheet.

"If you are buying companies on the cheap, make sure the earnings are correct," he warns investors. Fund managers should be conservative with regard to estimates about earnings per share and not get caught up in 'trash rallies'.

"Companies have not been using price to chase volumes," adds Lapthorne. "If demand falls further, you can't cut prices because you may not be able to reinstate them, so companies have cut costs instead."

Some blue-chips in leading positions, such as Unilever and Nestlé, have expressed regret at not using their pricing power this year, given the stronger-than-expected economic conditions. If they decide to cut prices to win market share next year, such moves will contribute to overall deflation.

And that will make it worse for the economy as a whole. For most companies, there is no pricing power; rather they are still grappling with surplus inventories and trying to rein in capital expenditure.

Lapthorne says company executives will also swear to financial analysts that they will maintain pricing discipline. But he suspects they will instead be forced in 2010 to reveal they have no pricing power.

This year's rally has obscured the fact that real damage has been done to many companies, and the majority of listed companies in the US are going to be increasingly hard to justify keeping in one's portfolio. What looked like value earlier this year will be re-rated; Lapthorne says today only 30-40 large-cap stocks in the US would meet his quantitative screens for deep value -- and are mostly in the energy sector.

He believes most so-called value stocks can be traded, but won't be suitable for buy-and-hold strategies. Nor will dividend-paying stocks protect investors: those companies with weakening balance sheets will probably cut their dividend payouts. He is also sceptical that investors will be able to play momentum strategies next year if volatility picks up and discernable trends vanish.

"We can no longer tell if volatility is cyclical or permanent," Lapthorne says. "Japan once enjoyed 30 years of stable markets but now suffers from permanent volatility." These days, he says, the optimal holding period for a Japanese stock is a mere 20 days; buy-and-hold hasn't served investors at all. He reckons the same is going to be the case for US and European markets.