How advisers and clients can keep their heads when everyone else is losing theirs

They may not seem like it to everyone but these are giddy times. In the past few weeks alone:

- The Dow Jones crossed 22,000 for the first time (and the NASDAQ and S&P 500 set new highs as well)

- Japan’s Nikkei 225 reached 20,000 for the first time in two years

- The FTSE 100 came within a hair’s breadth of a new all-time high around 7,550

- 14 national benchmark indices set 12-month highs in the week to 11 August and just one (Israel) set a 12-month low

- US telecoms provider AT&T easily placing $25.5 billion in bonds in tranches from five to 41 years with narrow spreads over US Treasuries – this was the third-biggest bond issue ever

- Iraq issued its first sovereign bond since 2006, raising $1bn in seven-year paper with a 7% coupon

- Greece issued its first sovereign bond since 2014, raising €3bn with a 4.625% coupon

- Argentina issued a 100-year bond, raising $2.75 billion with a 7.125% coupon – even though the country has defaulted five times in the past century, according to the Financial Times

This all looks very bullish and speaks of elevated appetite for risk.

Yet all advisers and clients know that markets can be at their most treacherous when making money looks easiest and if they listen carefully then they may be able to pick up echoes from prior market corrections and even more serious accidents.

One such potential echo is a developing trend in how FTSE 100 firms report their profits.

While advisers and clients will have neither the time nor the inclination to analyse specific companies or their Annual Report and Accounts, it will be worth raising this topic in any meetings with UK equity fund managers.

Those who are on top of this trend may merit fresh or ongoing support, and prove worth their fees, as they will already be preparing for the potential consequences.

Trend may not be the friend of advisers or clients

Exclusive new research from AJ Bell, using the last 10 years’ reports and accounts for every FTSE 100 firm, 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.

Covers the 89 FTSE 100 firms with a full ten-year reporting and share price history
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 advisers and clients 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 GAAP

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:

Covers the 89 FTSE 100 firms with a full ten-year reporting and share price history.
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."

Safety first

Galbraith’s words are particularly strong and the gap between stated and adjusted earnings flagged by AJ Bell’s research in no way implies that any FTSE 100 management team is doing anything illegal.

Nor does a big gap between stated and adjusted earnings necessarily mean the FTSE 100 is inherently a poor investment or that the UK market is primed for a crash of some sort.

But some advisers and clients may see it as ominous that trends which were apparent before one market accident may have started to develop again now, more than eight years into an equity bull market and at a time when other classic warning signs are in evidence, including

  • cheap credit and abundant liquidity
  • widespread faith in revolutionary technologies (electric cars, cryptocurrencies, the Internet of Things)
  • elevated appetite for risk
  • widespread fear of missing out (FOMO)
  • lofty valuations, by historic standards, and the degree of effort expended to explain why it will be “different this time”

None of these are helpful as timing tools or a catalyst for broad market decline in their own right.

Moreover, the pressure to go with the flow is considerable and failure to do so may well mean near-term underperformance.

Whether advisers and clients view any such performance lag as a price worth paying in return for keeping their capital safe if (and when) acceptance of the currently relatively lax reporting standards leads to trouble will be up to them and their own particular time horizons, target returns and overall investment strategies.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine 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 as AJ Bell’s Investment Director in summer 2013.