It shouldn’t come as a surprise to hear that the best investors never stop learning. And they don’t just learn by being “in the field” investing—they keep reading up on what academics are doing.
Finance professionals and finance professors often intersect, with the latter often moonlighting as the former and vice versa. This is a market necessity—the pay gap between academia and practice is too big, especially for the best performers. That also means finance is unusual in that there isn’t a culture divide between those who do and those who teach—a divide that is familiar in other industries.
It also means that academic papers on esoteric financial topics are often of extreme interest to in-the-mines practitioners. And one academic study is of particular interest, because it cuts to the heart of much of the assumptions of modern-day investing.
The study comes from two New York professors—Feng Gu at SUNY Buffalo and Baruch Lev of NYU’s Stern School. The co-authors studied and published on the lack of predictability of following GAAP earnings.
Let’s unpack this a bit. According to Gu and Lev, many years ago investors could get superior returns if they looked at GAAP earnings trends, invested in companies with better earnings and earnings growth rates, limited P/E ratios they were willing to pay for stocks, and investing accordingly. That broke apart in the 1990s and is utterly disastrous in the 2010s, where some of the highest P/E ratio stocks, such as Amazon (AMZN) and Netflix (NFLX), have absolutely crushed the market despite low earnings rates.
This trend has been recognized by many as an indicator of the death of value investing. Buying earnings, they claim, is simply not the way to invest in the 21st century.
Gu and Lev don’t think value investing is entirely over, however. Instead, they think the problem lies in the accounting. GAAP sets down very strict rules on what is and is not earnings and how they are calculated—and those principles were established long ago when firms’ profits primarily came from capital expenditure on tangible assets. Nowadays, however, companies’ future revenue growth relies not on tangible assets but on intangible assets—goodwill, branding, and so on. The shift from tangible to intangible means that the old GAAP methods of measuring earnings are entirely outdated.
Of course, if you’re a financial professional and you realize this, you suddenly have a market advantage over those who do not. If Gu and Lev are right, finding a new standard non-GAAP method of calculating earnings would become a powerful tool to find good companies and avoid bad ones—especially since the GAAP EPS numbers won’t tell that story. Hence why their study is getting a lot of attention in financial circles.
However, this is all quite esoteric and, frankly, involves a lot of hard work. So it’s not going to be picked up by the mainstream financial press, whose hunger for clicks results in wave after wave of “crash imminent” articles that are identical to each other—and often rely on the same simplistic assumptions about earnings as expressed by GAAP numbers.
This is a fundamental difference between professional and retail investors, and a very good lesson for aspiring financiers. The in-depth research done in academia is a source of tremendous investment opportunities when mined well and incorporated into a new investing strategy. This is why financial professionals cannot afford to stop learning.