The Fantasy Fallacy

What can Fantasy Football teach us about the stock market?

Photo: AJ Guel. Source: Wikipedia

Fantasy sports are hot. What started as sports-bar diversion, a fun way to follow individual player performance has grown into a multi-billion dollar business, with competing leagues, rules, and millions of dollars riding on every game. Today, it’s estimated that over 19 million people compete in public and private leagues. It’s even gotten into the latest Presidential debates, with talk of regulation.

Whether you think fantasy sports are a harmless diversion or a dangerous new form of gambling, there’s one aspect of them that everyone agrees on: they’re totally dependent on the integrity of the statistics. Whether it’s the number of touchdown passes or rushing yardage or basketball rebounds, the fantasy leagues need objective, clear statistics in order to score their games.

In this way, they’re similar to the stock market. Only some companies seem to have a preference for fantasy accounting, rather than refereed financial scores. Every quarter, public companies in the US are supposed to report their revenues, earnings, and balance sheet data. But now there are a growing number of companies that regularly present two types of results: those that adhere to generally accepted accounting principles (GAAP), and pro-forma numbers that help managers put the best spin on their operations.

You could call this non-GAAP reporting a reaction to an overly-academic accounting standards board, but it also seems like fantasy accounting. When companies can choose which costs they want to strip out of their net earnings, the temptation to distort their finances is huge. And the trend is growing: last year, 2/3rds of the companies in the S&P 500 reported non-GAAP earnings, up from less than half five years before.

This is particularly a problem in the pharmaceutical industry, and seems to be behind a lot of the recent problems at Valeant. Valeant executives liked focus on what they called “cash EPS”—a tailored figure that excludes stock-based compensation, legal settlements, and M&A expenses. For a serial acquirer like Valeant, that’s a big deal. Last year their GAAP earnings were $900 million—and pro-forma earnings of $2.8 billion. Gives a new meaning to “gap,” doesn’t it?

Source: Finviz

There can be honest disagreements about how companies to account for different items, like hedging, off-balance-sheet items, work-in-progress, and so on. We live in an accrual world, after all. But the rules are the rules. New rules are proposed, debated, and then implemented—or not. One benefit of having agreed-upon principles is they facilitate easy comparison between companies. Pro-forma accounting makes this a lot more difficult.

Fantasy sports allow anyone to pretend that they’re a franchise-owner, assembling a team, working within a salary cap, working with a draft and trades, and so on. Then you watch the results. But you can’t run a league on “pro-forma” sports scores—that would be ridiculous. When it comes to accounting, the best fantasy is no fantasy.

Douglas R. Tengdin, CFA

Chief Investment Officer

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