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free cash flow
04/16/2018
A Little Perspective – How We May Have Gotten Here
By: Ted Theodore
A LITTLE PERSPECTIVE – HOW WE MAY HAVE GOTTEN HERE

 

 

Beginning in the early 1980s a whole professional class of consultants grew to offer assistance to a rapidly growing pool of institutional investment funds, largely in what are now labeled as old-fashioned pensions, which provided a defined stream of benefits to retirees. One of the tasks undertaken by the consultants was to measure performance and to recommend replacing managers if the performance was disappointing. As the data began to accumulate late in that decade, major doubts arose about whether the investment managers were adding value. This created a new pressure on manager selection. Managers were challenged to at least cover their own fees. Sometimes they did, but often they did not.

During the 1990s, in what was one of the most powerful, long-lasting bull markets in recent history, the generalized performance pressure seemed to ease, and the role of the consultants gradually morphed into suggesting more targeted, specialized investment approaches or “styles.” Managers, for example, were required to choose whether to invest in large cap stocks or small cap stocks, but generally not both. Similarly, were they going to be growth managers or value managers? Consultants kept close track and watched carefully for any “style drift.”
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Beginning in the early 1980s a whole professional class of consultants grew to offer assistance to a rapidly growing pool of institutional investment funds, largely in what are now labeled as old-fashioned pensions, which provided a defined stream of benefits to retirees. One of the tasks undertaken by the consultants was to measure performance and to recommend replacing managers if the performance was disappointing. As the data began to accumulate late in that decade, major doubts arose about whether the investment managers were adding value. This created a new pressure on manager selection. Managers were challenged to at least cover their own fees. Sometimes they did, but often they did not.

During the 1990s, in what was one of the most powerful, long-lasting bull markets in recent history, the generalized performance pressure seemed to ease, and the role of the consultants gradually morphed into suggesting more targeted, specialized investment approaches or “styles.” Managers, for example, were required to choose whether to invest in large cap stocks or small cap stocks, but generally not both. Similarly, were they going to be growth managers or value managers? Consultants kept close track and watched carefully for any “style drift.”

After the year 2000, the data started to accumulate to show that no matter which “style box” a manager was in, as a group, managers failed to beat their relevant benchmarks.

The chart shows a representative sample gathered by Standard & Poor’s in their “SPIVA” data (S&P Index vs. Active).

From the early days of this performance pressure, it was increasingly clear that portfolio managers’ fees were a big reason for underperformance. As well, the research needed to create the portfolios was increasingly expensive. The pressures on managers grew.

Competing Returns and a Breakthrough

 

Even before these performance shortcomings came under increasingly intense scrutiny, “index investing” became of greater interest. A portfolio could easily be constructed which exactly replicated the index. This passive approach came with extremely low management fees. “Indexing” was partly premised on a growing body of academic interest in the early and mid-1970s as well as from veteran investors who sensed (or learned the hard way) just how difficult and expensive it was to “beat the market.” Given the rapid overall growth of assets, indexing initially only accounted for a very small portion of the total. However, there were other, newer, pressures on the traditional managers as well.

Before 1999, investor—particularly investment strategists—each had their own opinion about which sector and industry a company might belong in. It was a particularly fluid set of definitions. When energy stocks got hot, for example, some strategists included the railroads as energy stocks because they hauled coal and had some rights of way that included potential energy production. Companies in the higher tech aerospace business sometimes were classified as industrials and sometimes as technology.

The lack of a standard classification for each company slowed the growing attempts by outside consultants to attribute performance to sector weightings and selection. That all changed in 1999 when Standard & Poor’s and Morgan Stanley Capital International (MSCI) joined forces to classify each company worldwide into one of ten sectors and about 100 industries. What turned the project into the standard was that the classifications were accompanied by more than ten years of historical data. This Global Industry Classification Standard (GICS®) set the stage for the historic takeoff of growth in the ETF world. Strategists stopped dreaming up classifications and, instead, went to work employing the products that grew in the wake of the project.

Targeting Returns

 

Both before and especially after 1999, ETFs began to be created to reflect different segments of the overall market. ETFs for small, mid cap, international, industry, country and more began to be offered. Investment strategists who typically had a macro and “top down” perspective were big supporters of this slicing and dicing of the whole traded market. Some of those pre-1999 strategists who were forced to create their own sectors and segments were faced with the additional frustration of not having any specialized security to use for implementing their strategy.

While there were several “sector” mutual funds, like a fund specializing in retailers, or a fund specializing in technology stocks, strategists were not guaranteed to receive just a generic retail return or a generic technology return. Rather, for good or bad, the returns were highly dependent on the success of the individuals managing those funds. As strategists dipped into the pool of industry mutual funds, they never really knew what would come back in performance; but the new ETFs were designed from the start to be just passive reflections of their sector or segment. No person would intervene in the process.

The first major ETF-like products to employ GICS were State Street Bank’s Sector SPDRs (“Spiders”). A version of these products had been offered in 1998, but they were soon revised to reflect the new GICS scheme. Competing ETFs rapidly followed. Investors who became bearish, as an example, could now quickly sell all their technology “exposure” and buy just utilities, hoping to perform relatively better if general concerns turned bearish. All it took was two ticker symbols. Inevitably, assets were taken from traditional, “active” managers.

Still Another Way to Slice the Market

 

The “fundamental” company research being conducted by traditional portfolio managers was not completely scorned. After all, would it not be nice to own stocks that were relatively inexpensive compared to their earnings? In a passive index fund, the securities are owned in the same percentages they represent in the index. Virtually every index at that time (whether for the market or a segment) was merely an index of the total market value of all the member stocks. That is, the portion of a portfolio any individual stock represented was its relative market value weight. However, analysts and some academics contended that the index contained a range of stocks, from overvalued to undervalued. What if instead of weighting each stock by its market capitalization, the weights were proportional to the amount of earnings a company had to the total earnings in the index? In theory, stocks that were cheap had lots more earnings per market value dollar than those which were expensive. So, a scheme that weighted earnings would result in a tilt of the portfolio toward theoretically more attractively valued stocks. Early in the decade of the 2000s, the first of these kinds of ETFs were introduced.

In what turns out to be a brilliant marketing stroke, these ETFs were called “smart beta.” “Dumb beta” was seen by some as just the prior group of capitalization weighted index ETFs. Others joined in and weighted their portfolios by the dividends in the index. Others by the revenues. In the 15 years since, smart beta ETFs have grown to almost $700 billion in assets just in the US. Interest in these funds has grown apace internationally.

A 1952 Concept Still Called “Modern”

 

The notion of “beta” is at least a half century old. “Modern Portfolio Theory” (MPT) was heralded by Harry Markowitz in 1952, promoting the notion that a portfolio could absorb the disparate individual volatilities of the member stocks. About a decade later, William Sharpe introduced the Capital Asset Pricing Model (CAPM), suggesting the market will proportionately reward risks (defined then as a stock’s beta). In academia it became accepted that investors were rational—so much so, that the market was “efficient” (Efficient Market Hypothesis – EMH) and no special reward could be actively earned by investors beyond the risks they took.

Over the last several decades, while still somehow giving EMH its due, academics introduced so-called “anomalies” into the literature. The first of these was the idea that cheap stocks could earn

a premium and then, a second, was that smaller capitalization stocks could as well. By now, however, the EMH hypothesis is getting a little stretched, as more than several dozen anomalies have been posited. Virtually every one of these “factors” has had a place among traditional, active portfolio managers. Perhaps a little sheepishly, academia has started to label its highly mathematically-oriented discourse as “Standard Finance” rather than MPT. But how “efficient” and “rational” is a market with dozens of so-called “anomalies?”

“Smart” Not Smart? “Active” Not Active?

 

A portfolio weighted by, say, earnings, cannot long stay as different as it was initially to a portfolio weighted by market capitalization. As more money goes into a winning smart beta ETF, the undervalued stocks will tend to gradually become much less undervalued as they receive a disproportionate amount of new funds. From this, it follows that a fundamentally-weighted scheme cannot always outperform the market cap index. One answer to the problem is that if the smart beta ETF were “rebalanced” frequently, then the drift mentioned here would be mitigated. However, this presupposes that the value (or other) anomaly is rewarded before the rebalancing. Unfortunately, most academic studies suggest that, in fact, it typically takes somewhere between three and five years for anomalies to be rewarded. Meantime, there is a good probability that during periods shorter than that there could be noticeable underperformance. Therefore, the results obtained seem unduly influenced by the timing of the purchase and sale of the smart beta ETF. In other words, it is the investor who needs to be smart in these cases, because even a smart beta fund is just another passive (dumb?) fund. Smart beta ETFs, in a sense, were perhaps smart on the day they were conceived but, thereafter, discretion passed to the outside investor or advisor.

On December 24, 2015, a CNBC host said that actively managed funds have “stock pickers” at the helm. But perhaps recognizing the challenges mentioned above and the desire to be different, ETF issuers have recently begun to hint that what they are offering is really an active fund, which is a relatively new definition of active.

However, this activity seems to be at least somewhat mechanical. In one case, the rebalancing is just done more frequently and thus there is more activity in the portfolio. In another approach, a manager or a computer program watches to make sure the factors stay within prescribed limits and makes trades to rebalance them back into line, instead of waiting for the calendar to tell them when to rebalance, as is the case for other ETFs, both smart and dumb.

The very newest wrinkle is to employ artificial intelligence and “deep learning” (neural networks) to find and implement factors. Again, humans are clearly involved in the research and rulemaking, but that may be the only place for exercising discretion. Investors in these new concepts should probably be aware that in the general debate between man and machine, the estimates run from now to thirty years from now when the machines can successfully do the kind of activities contemplated here.

It’s Our Fault

 

The fundamental challenge is that the markets are not rational. Why? Humans are not rational, not even generally or partly or usefully. Even those humans involved in building the AI networks are subject to all kinds of behavioral biases. The chances that there could be antiseptic for behavior are very low.

Even the choice to invest in any fund—smart, dumb, intelligent, or active—is obviously an action. In the end, it is clear that discipline is needed by someone. Obviously the better that discipline is supported by logic and evidence, the higher the odds for success. It is only adroit marketing that can make it seem as if there were some other, easy way to invest.

free cash flow
02/18/2018
JAPAN RISES
By: Janet Johnston
JAPAN RISES

Japan Rises Again

The Land of the Rising Sun is clearly emerging from its “Lost Decade.” We believe that now is the right
time to buy, or increase, exposure to Japanese equities.

After the spectacular crash of Japan’s stock market and property market bubble in 1990, the “Lost Decade” began and became a secular downtrend of “great deflation” lasting 25 years. Both consumers and companies saved excessively, reinforcing this downward spiral. Due to Japan’s corporate culture of lifetime employment and other benefits, companies were slow to restructure and adapt to current market conditions. These behaviors exacerbated the deflationary environment. […]

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Japan Rises Again

The Land of the Rising Sun is clearly emerging from its “Lost Decade.” We believe that now is the right
time to buy, or increase, exposure to Japanese equities.

After the spectacular crash of Japan’s stock market and property market bubble in 1990, the “Lost Decade” began and became a secular downtrend of “great deflation” lasting 25 years. Both consumers and companies saved excessively, reinforcing this downward spiral. Due to Japan’s corporate culture of lifetime employment and other benefits, companies were slow to restructure and adapt to current market conditions. These behaviors exacerbated the deflationary environment.

In 2014, Shinzo Abe, gained control of both chambers of his party, allowing him to implement “Abenomics.” He believed, “escaping deflation was the greatest and urgent issue facing Japan.” His shock and awe campaign of using unprecedented amounts of monetary and fiscal stimulus has been successful in reversing the downward spiral. Abe also focused on structural reform and growth of the private sector. His reelection this fall signals longer term stability of Japan’s monetary and fiscal policies.

Japan is now a major exporting powerhouse, as the country benefits from a weaker Yen, enabling Japanese products to be more competitively priced, as well as benefitting from synchronized global growth.

Japan’s manufacturing sector has restructured, as margins are strong and improving. One of the major contributions to margins may be the implementation of industrial automation through robotics. Japan is also the leading manufacturer of industrial robots, an increasingly significant future technology trend. Earnings at large and small companies are not only beating estimates, but increasing at a strong pace. The growth of smaller companies in Japan is an indicator that there is organic local growth along with the growth of large companies that export. The unemployment rate is healthily below 3 percent. More women between the ages of 25-54 are entering the labor force, helping to offset their older demographics.

Japanese Companies are generating 4x more cash relative to GDP than US companies. Japanese stocks have an average dividend yield of 2% which is 200 basis points over comparable 10-year Japanese bonds. Relative to other major markets like the US, the Japanese market is cheap on both a P/E and valuation basis.

One of the most compelling reasons to own Japanese stocks may be investor sentiment. With the long and seemingly never ending “Lost Decade,” Japanese equities are under-owned both by Japanese institutions and at the local level. Only 10% of Japanese households own Japanese stocks. Over half of Japanese individual assets are in bank deposits earning 0%. As Japanese individuals and institutions become more confident in their country’s future, I would expect cash to come off the sidelines and into Japanese equities.

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free cash flow
02/19/2018
Can you tell what stock buyback news is just noise and what really matters?
By: Ted Theodore
CAN YOU TELL WHAT STOCK BUYBACK NEWS IS JUST NOISE AND WHAT REALLY MATTERS?

What is a Stock Buyback?

Before we dive into the nuances, let’s first start with the basics. Stock buybacks, also known as share repurchases, are just one of the ways that companies can return wealth to their shareholders; the other more-common ways come in the form of capital appreciation—that is a rising stock price—and/or dividend payouts.

As the term implies, a stock buyback is simply the action of a company buying back its own shares.

How is this done?

Buybacks are carried out in one of two ways

1. Tender Offer: In this case the company will make an offer to repurchase a certain number of shares within a desired price range.

2. Open Market: In this case the company will act as an individual investor and buy its own shares on the open market.

[…]

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What is a Stock Buyback?

Before we dive into the nuances, let’s first start with the basics. Stock buybacks, also known as share repurchases, are just one of the ways that companies can return wealth to their shareholders; the other more-common ways come in the form of capital appreciation—that is a rising stock price—and/or dividend payouts.

As the term implies, a stock buyback is simply the action of a company buying back its own shares.

How is this done?

Buybacks are carried out in one of two ways

1. Tender Offer: In this case the company will make an offer to repurchase a certain number of shares within a desired price range.

2. Open Market: In this case the company will act as an individual investor and buy its own shares on the open market.

The result: the total number of shares outstanding is reduced and current investors end up owning a “larger piece of the whole pie”.

Buyback Announcements vs. Action

The misunderstandings start as soon as the buyback announcement is made. Plain and simple, all too many investors fail to make a distinction between a “buyback announcement” and an actual reduction in shares outstanding.

What does that mean exactly? Some investors will rush to buy a stock as soon as they catch whiff of a buyback announcement because they want to “own a larger piece from the whole” as mentioned previously. The problem is that they are only assuming that the buyback will take place.

The reality is that the company is under no legal obligation to follow through with their buyback announcement. Put another way, there is nothing set in stone that guarantees a buyback announcement will translate into an actual reduction in shares outstanding for a given stock.

While one would expect that management doesn’t make empty promises, the key nuance to buyback announcements is that they are just that—an announcement—and nothing more.

At TrimTabs Asset Management, we do not pay any attention to announcements. Instead, we focus on tracking actual reductions in the net shares outstanding.

Another Myth about Buybacks Busted

There is a pervasive belief that buybacks form a kind of cushion for the market. Investors who are fooled into believing this generally do so because their thought process goes as follows: the company won’t let its share price fall below a certain “floor level” because that’s where they are repurchasing shares at.

This couldn’t be further from reality.

What actually happens is that companies who have made buyback announcements will typically delay their repurchases when the overall market is declining, thinking if they wait a little longer, the cost of the buyback program might be reduced. Remember that there is no strict obligation that dictates when a buyback announcement must be carried out, and so the timing of the repurchase is left to the company, which effectively busts any “price cushion” myths.

Bottom Line

Investors can be easily misled by buyback announcements in the news. First and foremost, remember that a buyback announcement is not the same as an actual share repurchase; the former is just that, an announcement, and the company is under no legal obligation to follow through with that announcement. The surefire way to tell if management is keeping good on its buyback promise is to track actual reductions in the net shares outstanding.

Furthermore, because companies dictate the timing of their share repurchases, some might wrongfully assume that a buyback announcement will create a cushion for the share price. The reality is that companies will delay buybacks when the broad market is weak.

Thanks

free cash flow
02/12/2018
The V.I.P.s
By: Ted Theodore
THE V.I.P.S

The year was 1963. Beyond doubt the power couple of Hollywood then was Elizabeth Taylor and Richard Burton. While they were a couple, they made more than a half dozen films. After finishing “Cleopatra” they stopped in London to knock out a movie with very little of the spectacular settings required on location in Egypt and Rome. That movie was “The V.I.P.s” and the movie set was a reproduction of the VIP lounge at Heathrow Airport. […]

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The year was 1963. Beyond doubt the power couple of Hollywood then was Elizabeth Taylor and Richard Burton. While they were a couple, they made more than a half dozen films. After finishing “Cleopatra” they stopped in London to knock out a movie with very little of the spectacular settings required on location in Egypt and Rome. That movie was “The V.I.P.s” and the movie set was a reproduction of the VIP lounge at Heathrow Airport.

While the film earned a better than average reception of the couple’s work, I had a problem with it. Burton played the role of a millionaire mogul. At one point a traveler, recognizing the famous business person, approached him and told him he had a company that he thought would be a great investment.

As proof, the traveler showed Burton the audited balance sheet. Burton said, “You’re right – this looks really good.” I let out a hoot in the quiet theater. My date poked me and said, “What’s so funny?” We were in a theater in Ann Arbor and I was finishing up my final semester at the University of Michigan’s business school to earn a master’s degree in finance.

I was completing a course on investing and the semester’s assignment was to analyze and then evaluate two companies and then pick one of the two as the preferred investment. The two companies assigned to me were Bulova Watch and Hamilton Watch (now long gone as companies). After doing as much spade work as possible I asked the professor for a little help and he sensed I was stuck on the major issue: the valuation of each company. Having completed a couple of semesters in Accounting, I thought the answer was obvious. There could be no way to choose between the two because each was fairly accounted for by their own book value.

The concept of Owner’s Equity, or book value, originated in Italy early in the 13 th century, or more than 800 years ago. The basic premise was that Assets equal Liabilities plus Owner’s Equity. From that equation there arose the notion that changes on one side had to be matched by changes on the other. Thus, the practice of “double entry” accounting was born.

My accounting text was referred to as “Paton and Paton,” both of whom, father and son, conveniently were or had been professors at Michigan. It was the standard accounting text at the time. Armed with the rigor and detail of their work, I approached my finance professor with my dilemma. It was clear he was looking for something other than simply reciting the book values of two watch companies. He asked, “How many stocks of companies trade always, and only, precisely at their book value?” Wanting to get a passing grade, I waited a bit before answering.

Indeed, some many, many years later I have co-authored an article in the current issue of the Journal of Investment Management. Its title is “What is Value in an Equity Market?” In that research we examine
five different measures of value. Yes, price to book is one of them. But we also include price to earnings, price to dividends, price to sales and price to the replacement value of assets.

The Securities and Exchange Commission requires each public company to release independently audited quarterly and annual reports of their revenues, expenses, assets and liabilities. These reports must conform to what is known as GAAP accounting: Generally Accepted Accounting Principles. In total, companies spend billions on these audits. But, as my finance professor knew back in 1963, many other concepts than book value are at play in the open securities markets.

At first, one might wonder why if there are “Principles” or rules the SEC requires to be followed, how there can be other concepts affecting the price of a stock? The answer is that managements, even
conforming to these rules, have been granted enormous discretion within those rules. And the reason for that discretion is that accounting is actually a language, akin to a computer program. It has rules and syntax. These are, therefore, general tools to be applied to the task of describing parts of a company. Given the diversity and change in companies, it should not be a surprise that there can be legitimate differences in how these tools are applied. It has been accepted that managements are in the best position to apply the rules. Yes, they must stay within the rules, but the range of possibilities is as wide as the diversity of companies.

When is a “sale” made? Is it when the sales person puts down the phone and yells “Yes!!?” Is the sale made when the invoice is collected? If the product sold is a complex one and is going to be delivered in portions, is the sale recognized in installments? The same questions arise for expenses. And assets like equipment take on value it seems when management judges business is good but are treated as scrap in “bad times.”

All of these determinations are made within really broad guidelines by management. As a result, accounting provides very little of the certainty it seems to imply for many. Investors rightly should consider much more than the face value of the accounts.

Maybe Richard Burton saw more in that balance sheet than what the raw numbers revealed. Possibly that is why his character was a millionaire. But I thought that scene made it more of a humorous movie than a good investment.

other
02/12/2018
TRUSTING THE NUMBERS!
By: Ted Theodore
TRUSTING THE NUMBERS!

Before getting to the requirement for accurately forecasting the future, it is important to note that even the past record of earnings has serious challenges. In its lead article one year ago, the Financial Analysts Journal (January-February 2016) published “The Misrepresentation of Earnings.” […]

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Before getting to the requirement for accurately forecasting the future, it is important to note that even the past record of earnings has serious challenges. In its lead article one year ago, the Financial Analysts Journal (January-February 2016) published “The Misrepresentation of Earnings.”

The research was the result of a survey of 400 chief financial officers, and the findings are sobering. Fully 20% of earnings reports were felt by the respondents to be intentionally distorted and by a significant amount: 10%. In an age where “missing by a penny” causes great shock to the market, this is a serious finding. Further confirming the general nature of the distortions, about two-thirds were in favor of higher earnings.

Public companies are required to issue reports in compliance with “Generally Accepted Accounting Principles” (GAAP). While it sounds as if this standard would allow no wiggle room, independent accountants who certify these results cede fairly large degrees of discretion to management in important areas. As most businesses today have some degree of complexity, it is no surprise that there are innumerable occasions where interpretation of accounting entries can, legitimately, vary widely. Indeed, managements have reasonably great latitude and discretion in their recognition of revenues, expenses and balance sheet items. Most of the time (80%, according to the CFO survey) management does a straight-up job.

Certainly, management is not going to announce they have misrepresented their results. The prescription, from the CFOs themselves, is to rely specifically more heavily on the metric, “cash flow,” rather than earnings.

free cash flow
08/02/2017
Here’s why GAAP is No Good for Investors in 1 Chart
By: janet Johnston
HERE’S WHY GAAP IS NO GOOD FOR INVESTORS IN 1 CHART

It’s counterintuitive but worth some serious consideration: the very same set of standards put in place to serve investors, that is, GAAP (Generally Accepted Accounting Principles), may be doing more harm than good in some cases.
[…]

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It’s counterintuitive but worth some serious consideration: the very same set of standards put in place to serve investors, that is, GAAP (Generally Accepted Accounting Principles), may be doing more harm than good in some cases.

How Reliable is GAAP for Investors?

Public companies are required to issue reports in compliance with GAAP. While it sounds as if this standard would allow no wiggle room, the opposite is actually true; in fact, earnings results cede fairly large degrees of discretion to management when it comes to reporting for these important areas.

In its lead article one year ago, the Financial Analysts Journal (January-February 2016) published “The Misrepresentation of Earnings.” The research was the result of a survey of 400 chief financial officers, and the findings are sobering.

Consider this: Fully 20% of earnings reports were felt by the respondents to be intentionally
distorted and by a significant amount of 10%.

In an age where “missing by a penny” causes great shock to the market, this is no small finding. Further confirming the general nature of the distortions, the survey goes onto show that about two-thirds of respondents were also in favor of higher earnings.

Does GAAP Accurately Predict Stock Returns?

Since GAAP is considered to be “the standard”, one would expect to find some degree of correlation between firms that have outstanding metrics and positive forward returns. Think again.

Consider the chart below which shows one month forward returns using prior six month GAAP earnings growth:

The above chart shows a dotted line which represents the best statistical representation (technically, the line of “best fit” or trend line characterizing the data points) of the relationship between the corporate accounts as evaluated by GAAP and stock price changes one month later.

graph

Bottom Line

Companies can, and have, misinterpreted earnings when filing quarterly reports in an effort to show more encouraging earnings growth than is actually present. While standards like GAAP are put in place to protect investors, those who are unaware of the “financial gimmickry” taking place underneath the surface may be blindsided if they take earnings reports completely at face value. Do yourself a favor and educate yourself on free cash flow because it can help you conduct a more thorough and accurate analysis of a company’s true financial health.

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