If anyone watches CNBC, they will constantly hear that a company earned a certain number less “ex” one time charges.  When they say that, CNBC is reporting earnings on what is called a “pro forma” basis.  This is different than the GAAP (Generally Accepted Accounting Principles) rules for reporting financial information.  Not only do pro forma earnings fail to adhere to any set of standards, they are not audited like financial statements prepared on a GAAP basis.  GAAP reporting is a more accurate reporting of a company’s earnings.  When companies exclude “ex” items – such as takeover costs, costs for layoffs, currency losses, or stock based employee pay to name a few – using pro forma reporting, they aren’t showing the real bottom line.  Why do companies do this?  Because those costs are real and have a measurable impact on the bottom line, and they would prefer investors ignore that impact.

Below are two charts from Mauldin Economics.  The first one shows that in 2010, 70% of companies used pro forma reporting.  Today that number is 90%.  We believe this is a dangerous practice that can mislead unsophisticated investors, especially when coupled with the fact that company management has the discretion to compute pro forma earnings however it wants.  The second chart shows the impact of earnings if they were reported on a GAAP basis instead of on a pro forma basis.  Using GAAP earnings, the S&P 500 would currently be selling at 21.5x earnings compared to the reported 16.5x earnings.  In other words, investors are paying 30% more when considering the actual earnings of these companies.

What this means for your portfolio going forward?

In a world where things seem upside down – earnings shenanigans and negative interest rates – it is even more important to understand your investments and the risk you are taking with those investments.  THOR is underweight US large companies because, in our opinion, they are overvalued not only compared to other investments, but also on an historical basis.  When an analyst on CNBC says that the S&P 500 is priced correctly because historically it has sold for 16x earnings, they don’t tell you that, historically, pro forma was not used and you are comparing apples and oranges.  If an honest comparison was done, you would find that the S&P 500 is 30% overvalued today.  Makes you wonder about these “expert” analysts CNBC has on their shows

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