Good News... Earnings Are About to Look Much Worse

In April 2009, our big hedge-fund clients were in a panic...

First-quarter earnings per share ("EPS") for the S&P 500 Index had peaked two years prior. Current forecasts were for a number in the single digits.

The index had fallen more than 50% from its October 2007 highs to its March 2009 lows. It was still down more than 45% as earnings season kicked off.

Our clients were tripping over themselves to ask what stocks they should be shorting. My team and I rolled up our sleeves to search for compelling opportunities. But we just kept on coming back to the same conclusion, over and over again.

These companies that looked like they had terrible earnings... didn't.

It was all smoke and mirrors. Management teams were playing a game with the market, and investors hadn't caught on yet.

In company after company, we were seeing all the telltale signs of the "big bath." And now, it's happening again...

With a recession looming, we're dealing with a lot of uncertainty in the market. Today, we'll share a little-known strategy that companies use to improve their outlook in tough times... and how savvy investors can take advantage.

The stock market is an expectations dance...

Most of the time, management is trying to give investors better results than they expected. That's what causes stock prices to rise, after all.

However, there's one time when company leaders seek to do the exact opposite. They don't even try to slightly miss expectations. They try to blow a hole in them.

When a company expects bad news, a smart management team doesn't drag it out. It tries to get all the bad news over with at once... making future quarters look better by comparison.

That's the big bath.

Here's an important secret... Management teams have a lot more discretion than you think when it comes to reporting profits.

For example, the team can decide to write down goodwill and intangible assets from acquisitions if it expects earnings to fall slightly.

Said another way, if management chooses to be more pessimistic about the company's outlook... it can write down the value of its assets, taking a huge loss. It's that simple.

If management is thinking about laying off workers and closing plants in the coming years, it doesn't have to wait to take the expenses. The moment the team announces a plan, it can forecast the costs related to cleaning things up.

And management can take those expenses against earnings right now, pushing earnings down before it starts improving the business.

The same is true with potential legal expenses, write-downs of underperforming factories, and many other charges. And now that the company has written down all these assets at once, earnings will look a lot better in future quarters.

Said another way, it becomes much easier to do the No. 1 thing that will keep shares rising – beat investor expectations.

That's exactly what a lot of companies were doing back in 2009. It sent earnings for the S&P 500 as a whole artificially tanking. And it sent our clients into a panic... but not us.

Where they saw a looming disaster, we saw opportunity. Well-known businesses like online travel agency Expedia (EXPE), mining company Freeport-McMoRan (FCX), and chemical conglomerate DowDuPont were all taking a big bath.

Each of these companies' stocks had tanked double digits. Smart buyers who could see through the accounting noise reaped profits in the coming years. Our clients made gains of 180%, 222%, and 322%, respectively.

Now, it's not uncommon for one or two companies to take a big bath here and there...

It is uncommon, however, for it to happen across the economy.

When a bunch of companies play this game, it's a surefire signal that management teams are trying to get all the bad news out... because they think their fundamentals are already at their worst.

That's exactly when investors should buy in. And it's exactly what we're expecting in the coming quarters.

We're about to see a new wave of big baths, just like in 2008 and 2009. As interest-rate hikes work their way through the economy, companies will use the pessimistic outlook to their advantage.

Keep an eye out for companies that take huge one-time charges and severely miss their earnings expectations. This can be a telltale sign of big-bath accounting. And that, in turn, can be a sign that better days – and huge upside – are coming soon.

Regards,

Joel Litman
September 5, 2023