Scott MartindaleBy Scott Martindale
President, Sabrient Systems LLC

Another day, another new high in stocks. Some observers understandably think this is a sign of excessive complacency and a bad omen of an imminent major correction, as valuations continue to escalate without the normal pullbacks that keep the momentum traders under control and “shake out the weak holders,” as they say. But markets don’t necessarily need to sell off to correct such inefficiencies. Often, leadership just needs to rotate into other neglected segments, and that is precisely what has been happening since the mid-August pullback. Witness the recent leadership in small caps, transports, retailers, airlines, homebuilders, and value stocks, as opposed to the mega-cap technology-sector growth stocks that have been driving the market most of the year.

Yes, the cap-weighted Dow Industrials and S&P 500 have both notched their eighth straight positive quarter, and the Nasdaq achieved its fifth straight, and all of them are dominated by mega-cap stocks. And the new highs have just kept coming during the first week of October. But it’s the stunning strength in small caps that is most encouraging, as this indicates a healthy broadening of the market, in which investors “pick their spots” rather than just blindly ride the mega caps. Rising global GDP, strong economic reports, solid corporate earnings reports, and the real possibility of tax reform have all helped goose bullish sentiment.

Those of you who have read my articles or attended my live presentations on the road know that I have been positive on small caps and that the momentum trade so far this year and high valuations among the mega cap Tech stocks likely would become self-limiting, leading to a passing of the baton to other market segments that still display attractive multiples, particularly those that would benefit the most from any sort of new fiscal stimulus (including tax and regulatory reform), like small caps. Moreover, I believe that with a still-accommodative Federal Reserve moving cautiously on interest rates, and with strong global demand for US Treasuries and corporate bonds, the low-yield environment is likely to persist for the foreseeable future.

In this periodic update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable ETF trading ideas. In summary, our sector rankings still look bullish, while the sector rotation model also maintains its bullish bias, and the overall climate continues to look favorable for risk assets like equities. Although October historically has been a month that can bring a shock to the market, it also is on average one of the strongest months for stocks, and of course Q4 is seasonally a bullish period. Read on...

Nicholas YeeBy Nicholas Yee
Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Over the past five years, Gradient Analytics has observed a shift from companies making acquisitions for strategic purposes to companies acquiring mainly for short-term financial gains. This stems at least in part from investors and a sell-side community that have become complacent in accepting managements’ accounting statements at face value without looking “under the hood.” To be sure, the complexity of acquisition accounting and the opaqueness of financial performance analytics is daunting. Therefore, it is incumbent upon earnings quality analysts to try to understand whether a company’s senior management may have other motives fueling an acquisition platform (aka “roll-up”) strategy.

Where previously we might have screened for deteriorating free cash flow and accruals to identify poor earnings quality trends, we now find that some managers have been circumventing cash from operating activities (CFOA) and moving working capital into investing activities on the cash flow statement through acquisitions. Why is this important, you ask? Should analysts always lump the cash paid for an acquisition into free-cash-flow calculations? Not necessarily; there is no hard and fast rule here to put into an automated screener in this situation. Rather, our analysts must perform a deep dive to determine whether the company is a “serial acquirer.” Is this a one-time acquisition that integrates seamlessly into the parent company, or is this just one of a series of mediocre acquisitions used to aesthetically grow the top-line and obfuscate traditional performance metrics?  Read on....

smartindale / Tag: forensic accounting, earnings quality, acquisition, 10-K, 10-Q, GAAP, non-GAAP, roll-up, cash flow / 0 Comments