Just recently, Wealth Management had an interesting interview with Jeremy Grantham in which Jeremy suggests the “rules have changed” for value investors. To wit:

“The market was extremely well-behaved from 1935 until 2000. It was an orderly world in which to be a value manager: there was mean reversion. If a value manager was patient, he was in heaven. The market outperformed when it was it cheap, and when it got expensive, it cracked.

Since 2000, it’s become much more complicated. The rules have shifted. We used to say that this time is never different. I think what has happened from 2000 until today is a challenge to that. Since 1998, price-earnings ratios have averaged 60 percent higher than the prior 50 years, and profit margins have averaged 20 to 30 percent higher. That’s a powerful double whammy.”

He is correct. As shown below the average CAPE ratio level rose, beginning in 1980 to 21.67 from the average of 14.42 over the previous 80-years.

Of course, the bulk of that increase is due to the valuation anomaly of the 1999 “Dot.com” bubble which skewed earnings to astronomical extremes. If we normalize that period, average valuation levels have only slightly increased in recent years. However, there is no argument that fundamental valuation measures have indeed changed, and arguably for the worse.

There is some truth to the argument that “this time is different.” The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated “mark-to-market” accounting, have allowed an ever increasing number of firms to “game” earnings season for their own benefit. Such gimmickry has suppressed valuation measures far below levels they would be otherwise.

While operating earnings are the primary focus of analysts, the media, and hucksters, there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”  This problem has been exacerbated since the end of the financial crisis, as we will discuss more in a moment, to the point to where only 13% of total revenue growth is coming from actual revenue, the rest is from accounting gimmickry, buybacks, and outright fudging.

The Wall Street Journal confirmed as much in a 2012 article entitled “Earnings Wizardry” which stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”