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Ironing Out an Investing Mystery


Ironing Out an Investing Mystery

Emerging markets have finally emerged—by one measure, anyway.

It’s not that companies whose shares trade on the stock markets of developing nations have been generating great returns lately. Instead, they’ve adopted at least one major characteristic of the world’s most-advanced economies: artificially smoothing their earnings to pander to analysts and investors.

Research from Rayliant Global Advisors, an investment firm based in Hong Kong, finds that such “earnings management” has become even more widespread in emerging markets than in developed markets like the U.S., Europe or Japan. That could help explain the disappointing performance of developing markets in recent years—and suggests they remain riskier than some U.S. investors may think.

Rayliant sized up earnings management by tracking return on equity at thousands of companies from 1998 through 2018. That yardstick of profitability measures net income as a percentage of shareholders’ equity, which is an indicator of corporate net worth. Analyzing return on equity rather than earnings prevents company size from skewing the results.

The difference between developed and emerging markets is striking.

More than Zero

Companies based in emerging markets are far more likely than those in the U.S. to barely break even. That suggests they may be managing their earnings to avoid reporting losses.

Publicly traded companies

Reported 0 to 1% profitability

Publicly traded companies

Reported 0 to 1%


Publicly traded companies

Reported 0 to 1% profitability

Publicly traded companies

Reported 0 to 1% profitability

In the U.S., companies reported a zero to 1% return on equity in 1.7% of all instances. In China, that happened only 0.29% of the time.

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In 6.5% of cases, U.S. firms reported a return on equity between zero and negative 5%. In China, such minimal losses turned up only 1.7% of the time.

What about companies whose return was barely positive, ranging from just above zero to 5%? In the U.S., that happened at a 14% frequency; in China, it occurred 28% of the time.

Looking across Brazil, India, Russia, South Korea and Taiwan, the Rayliant researchers found the same peculiar pattern: almost no companies reporting zero profitability, extremely few reporting tiny losses and hordes of them reporting tiny profits.


Do you think companies in the U.S. and emerging markets are too concerned with meeting analysts’ expectations for earnings? Join the conversation below.

Using managerial discretion, accounting tricks, sweetheart deals or government financing, emerging-market companies seem to be pulling out all the stops to report a profit—any profit.

In the developing world, corporations often answer not just to financial markets but to politburos and strongmen. In China, reporting losses is like playing with fire: The Shanghai Stock Exchange will issue a “delisting risk warning” to a company that loses money two years in a row. If the firm runs a third consecutive annual loss, trading in its stock is suspended.

No wonder many emerging-market companies show piddling profits that, without aggressive earnings management, would likely be a loss.

In the game of managing earnings, the investor is often the patsy. “When managing the reported numbers is rewarded more than doing the hard work of managing the business, that incentivizes some of the worst forms of managerial behavior,” says Rayliant’s founder and chairman,

Jason Hsu.

Share prices that rise in response to artificially inflated earnings can prompt corporate managers to focus on “accounting voodoo magic, rather than business strategy and execution,” he says.

Emerging-market firms aren’t the only culprits. U.S. companies are notorious for managing earnings—both to avoid reporting a loss and to prevent falling short of analysts’ forecasts.

To be sure, many of those surprisingly buoyant results come because companies poured cold water on analysts’ expectations—not because they managed earnings.

Either way, companies are gaming the market. From 1983 through 2018, on average, 55% of U.S. companies matched or beat analysts’ expectations for annual earnings, according to accounting professors Patricia Dechow of the University of Southern California and Annika Wang of the University of Houston. Last year 60% did.

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After a company reports a “positive earnings surprise,” or profits higher than Wall Street expected, the expectations change. Analysts ratchet up their forecasts, investors bid up the shares—and the company’s managers, whose pay is tied to the stock price, push harder. Now earnings have to meet or beat a higher hurdle. If they do, expectations will rise again. If they don’t, the stock will tank.

Blame the ventral tegmental area and the substantia nigra, deep in the human brain, where neurons monitor rewards. When you get exactly what you expected, the activity in these neurons doesn’t change. When you get more than you anticipated, these neurons emit rapid-fire pulses of dopamine—one of the brain’s transmitters of learning and motivation. Finally, if you get a smaller reward than you expected, the dopamine dries up momentarily.

Once earnings expectations form, analysts, companies and investors can all get locked into this kind of primal craving for ever-more-positive results. Disappointment can lead to shock, as investors found in 2018; the MSCI Emerging Markets index lost almost 15%, while the S&P 500 returned a 4% loss.

Emerging-market stocks are cheaper than U.S. shares by several valuation measures, and some respected investors find them attractive. The earnings-management game suggests, however, that they may be less of a bargain than they appear.

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