Skip to main content
taking stock

When Manulife Financial unveiled its third-quarter results last month, the insurance heavyweight included a new gauge designed to showcase the true strength of its business, making it easier to draw comparisons with its international peers and presumably persuade skeptical investors to show a little more love.

Manulife assured us that the measure, known as core earnings, was purely for the benefit of the investing public. "We've listened to the analysts and investors and what they want to understand is the underlying earnings capacity of the organization," Manulife chief executive Donald Guloien intoned.

The problem for Manulife and most other companies with a lot of exposure to volatile markets and interest rates, particularly since the global financial meltdown of 2008, has been the huge swings in net income from one quarter to the next. Flatten out that fever line and remove all those annoying extraordinary items that only sow more confusion, and you're left with the picture of a nice, steady business with stable earnings. So forget Manulife's net loss in the quarter of $227-million (including a huge charge and goodwill writeoff) and focus instead on the terrific core profit gain of $556-million.

Some market watchers greeted the new metric with open arms. "We were all over the place – all the analysts had their own definition and I was spending time justifying my definition to investors rather than talking about the merits of the quarter," said Mario Mendonca, a senior analyst at Canaccord Genuity.

But others have their doubts that breaking out core numbers will make it any easier for investors to navigate their way through complex financial shoals. As Ramy Elitzur, a professor at the University of Toronto's Rotman School of Management, told The Globe and Mail: "Management teams will manipulate financial statements in a way that fits them the best."

Statistics expert Philip Green would certainly second that. He has added core earnings, which are becoming increasingly popular, to his lengthy list of misleading financial and economic numbers that can – and often do – cause governments, businesses and investors to make faulty decisions.

Mr. Green's main objection is that the focus on the core distracts people from what companies persist in calling extraordinary items, but which are now so ubiquitous they ought to be labelled ordinary.

"The problem with core earnings as an indicator is that it attempts to determine the revenue from the main or principal business, as opposed to the supposedly 'minor' or 'secondary' business of exceptional items," he writes in his latest blog post. "The goal is to get rid of the ambiguity caused by earnings statements that report or exclude exceptional or special items. But these items are all too frequent."

And in the case of major financial firms like Manulife, part of what they do for a living is dealing with volatility and unpredictable markets. "It seems to me that it's core to how you make money in that industry," says Mr. Green, whose Mississauga-based consulting firm, Greenbridge Management, helps clients separate the statistical iron pyrites from the gold nuggets.

The new metric suggests that there's a way to achieve "some sort of gauge of what the business should be, if you forget all this other stuff. But that just doesn't happen. These wild gyrations and strange things going on are just life in the capital markets. If you have to define a new indicator [like core earnings] to exclude them, then they hardly count as extraordinary any more."

In any case, earnings of any kind don't actually amount to a true measurement, in the scientific sense of the term, argues Mr. Green, co-author of misLeading Indicators, which was published in March. Unlike, say, temperatures, there is no standard to measure profits against. "There is tremendous discretion in determining earnings. … For example, in determining when to book revenue, choosing a depreciation rate, deciding how to treat inventory and inventory writedowns and reporting pension fund growth."

Mr. Green's advice to investors is to delve deeply into a company's numbers and pay close attention to the stuff left out of the core profit figure. "Why are there these extraordinary items? What do they mean and are they extraordinary or are they part of a business strategy which has gone awry?"

Just as core inflation, which excludes volatile food and energy prices, doesn't reflect daily reality for consumers, core earnings can mislead market players by dispensing with what he calls the outliers. "Core earnings don't reflect the reality that you live with as an investor," he says. "It's a natural human tendency to want to get rid of the outliers. But it's almost always the outliers that tell you something interesting about what's going on. That's where you can learn the most about what's working well or not well in a company. It's when your expectations are not met that you're going to learn something new."