inside-the-investments-of-warren-buffett

Writing books about Warren Buffett is a bit of a cottage industry, and one that is getting scarce for new ideas.  This book takes a new approach because the author takes 20 companies that Buffett bought, and analyzes them himself using principles derived from things Buffett has written.

That brings me to my first critique of the book.  You are getting the author’s point of view for analysis, which is somewhat similar to Buffett’s, but is usually not Buffett’s view.  In a minority of cases he references something Buffett wrote at the time.  He did not interview Buffett for this book, which is normal for most books about Buffett.

Buffett didn’t typically do simple analyses, though by the end, he could simplify them to make it understandable to average people.  I’m not saying Buffett’s math wasn’t simple; I am saying that he took great account of qualitative aspects of a business — honest & competent management, owner earnings (free cash flow), moats (sustainable competitive advantages), ability to reinvest excess earnings profitably, etc.  The author takes account of many of these things much of the time, but my view is that Buffett did more still.  Also, Buffett spent more time on margin of safety issues than the author did.

My second critique is that the book is a lot shorter than it looks.  Many of the pages are filled with the financials of the companies being analyzed, and only a tiny portion of the data there is referenced by any analysis in the book.  The book of 260 pages is more like 200 in total length.  For some readers that will be a plus, for others a minus.

The book does well in picking a range of investments by Buffett in terms of success.  Some of his less successful decisions are here — Berkshire Hathaway itself, US Air, Salomon Brothers, Gen Re, and IBM.  It also looks at investments where Buffett bought it all, and where Buffett bought part of a company.  Additionally, it covers investments initiated over a long time, ranging from the partnership years to the present.

My third critique is that in addition to the financial data, there is occasionally more padding in the book than needed — an interview of Buffett by Matt Rose of BNSF stands out, though many of the descriptions of the businesses involved could have been tighter.

On the whole, it is a good book, giving the opinions of another value investor on twenty asset purchase decisions by Buffett.  Those familiar with Buffett will probably want to pass by the book; better to read Buffett himself.  Never investors could benefit from the author’s viewpoint, as it gives a consistent way to build a value investing philosophy in a single book.

Quibbles

Already mentioned.

Summary / Who Would Benefit from this Book

Those more experienced with Buffett’s own writings could ignore this book.  Those who are newer to value investing could benefit.  If you want to buy it, you can buy it here: Inside the Investments of Warren Buffett: Twenty Cases.

Full disclosure: The publisher asked me if I wanted a free copy and I assented.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Fuller disclosure: long BRK/B for myself and clients

Photo Credit: Rex Babiera ||Ours is an old house, and its guts reflect that.

Photo Credit: Rex Babiera || Ours is an old house, and its guts reflect that.

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A question from a reader on my recent post Me Too!:

I recently ran across Ed Thorp’s “Beat the Market.” I find reasonable his idea that you can take on risks that (almost / essentially) cancel each other out. Find assets that are negatively correlated to buy one long and the other short (he did it with stock warrants in the 60’s but when I started looking into that, well, I’m late to that party, so nevermind).

I’m uncomfortable with shorting anyway, so what about going long in everything and rebalancing when the assets get out of whack? Aren’t a lot of the price movements of various assets (cash, bonds, stocks, real estate, precious metals) the result of money flowing towards or away from that asset? If people are, on net, selling their stocks, to what type of asset are they sending the proceeds? I can’t predict where people will stash their money next, but if I own a little of everything, I’m both hedged against prolonged depression of one asset class and aware of what’s gotten “expensive” and what’s “cheap” now.

Along these same “indexing” lines, what do you think of using ALL the sector ETFs (Vanguard has 11) to index each sector and then rebalance among them as they change in value? How would that application of your portfolio rule 7 differ than when applied to individual stocks? Also, do you think it would be subject to the same / similar danger as everyone else “indexing” as you wrote about above?

My, but there is a lot here.  Let me try to unpack this.

Paragraph 1: All of the easy arbitrages are gone or occupied to the level where the risks are fairly priced.  Specialists ply those trades now, and for the most part, they earn returns roughly equal to short-term risky debt.  They tend to get hurt during financial crises, because at those points in time, fundamental relationships get disturbed because of illiquidity and defaults amid demands for liquidity and safety.

Paragraph 2: First, rebalancing is almost always a good idea, but it presumes the asset classes/subclasses in question is high quality enough that it will mean-revert, and that your time horizon is long enough to benefit from the mean reversion when it happens.  Also, it presumes that you aren’t headed for an utter disaster like pre-WWII Germany with hyperinflation.  Or confiscation of assets in a variety of ways, etc.

Then again, in really horrible times, no strategy works well, so that is not a criticism of rebalancing — just that it is useful most but not all of the time.

Aren’t a lot of the price movements of various assets [snip] the result of money flowing towards or away from that asset?

Back to the basics.  Money does not flow into or out of assets.  When a stock trade happens, shares flow from one account to another, and money flows the opposite direction, with the brokers raking off a tiny amount of cash in the process.  Prices of assets change based on the relative desire of buyers and sellers to buy or sell shares near the existing prior price level.  In a nutshell, that is how secondary markets work.

Then, there is the primary market for assets, which is when they were originally sold to the public.  In this case, corporations offer stocks, bonds, etc. to individuals and institutions in what are called initial public offerings [IPOs].  The securities flow from the companies to the accounts of the buyers, and the money flows from the accounts of the buyers to the companies.  The selling prices of the assets are typically set by syndicates of investment bankers, who rake off a decent-sized chunk of the money going to the companies.  In this case, yes, the amount of money that people are willing to pay for the assets will dictate the initial price, unless the deal is received so poorly that it does not take place.  After that, secondary trading starts.  (Note: this covers 95%+ of all of the ways that assets get to public markets; there are other ways, but I don’t have time for that now.  The same is true for how securities get extinguished, as in the next paragraph.)

The same thing happens in reverse when companies are bought in entire, either fully and partially for cash, and in the process, cease to be publicly traded.  The primary and secondary markets complement each other.  Corporations and syndicates take pricing cues from the levels securities trade at in the secondary markets in order to price new securities, and buy out existing securities.  Value investors often look at primary markets to estimate what the assets of whole companies are worth, and apply those judgments to where they buy and sell in the secondary markets.

Trying to guess where market players will raise their bids for assets in secondary trading is difficult.  There are a few hints:

  • Valuation: are asset cheap or rich relative to where normalized valuation levels would be for this class of assets?
  • Changes in net supply of assets: i.e., the primary markets.  Streaks in M&A tend to persist.
  • Price momentum: in the short-run (3-12 months), things that rise continue to rise, and vice versa for assets with falling prices.
  • Mean-reversion: in the intermediate term (3-5 years), things that currently rise will fall, and vice-versa.  This effect is weaker than the momentum effect.
  • Changes in operating performance: if you have insight into companies or industries such that you see earnings trends ahead of others, you will have insights into the likely future performance of prices.

All of these effects vary in intensity and reliability, both against each other, and over time.  If you own a little of everything, many of these effects become like that of the market, but noisier.

Paragraph 3: If you want to apply rule 7 to a portfolio of sectors, you can do it, but I would probably decrease the trading band from 20% to 10%.  Ditto for a portfolio of country index ETFs, but size your trading band relative to volatility, and limit your assets to developed and the largest emerging market countries.  With a portfolio of 35 stocks, the 20% band has me trade about 4-5 times a month.  With 11 sectors your band should be sized to trade 1-2 times a month.  20 countries, around 3x/month.  If it is a taxable account set the taxation method to be sell highest tax cost lots first.

Remember that portfolio rule 7 is meant to be used over longer periods of time — 3 years minimum.  There are other rules out there that adjust for volatility and momentum effect that have done better in the past, but those two effects are being more heavily traded on now relative to the past, which may invalidate the analogy from history to the future.

Using portfolio rule 7 overweights smaller companies, industries, sectors, or countries vs larger ones.  It will not be as index-like, but it is still a diversified strategy, so it will still be somewhat like an indexed portfolio.

Finally, even if we get to the point where active management outperforms indexing regularly, remember that indexing is still likely to be a decent strategy — the low cost advantage is significant.

That’s all for now, and as always, comments and questions are welcome.

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I have sometimes said that it is common for many people to imitate the behavior of others, rather than think for themselves.  There are several reasons for that:

  • It”s simple.
  • It’s fast.
  • And so long as you don’t run into a resource constraint it works well.

People generally have a decent idea who their smartest friends are, and who seems to give good advice on simple issues.  If your neighbor says that the new Chinese food place is excellent, and you know he knows his food, there is a very good chance that when you go there that you will get excellent Chinese food as well.

You might even tell your friends about it; after all, you want to look bright as well, and its neighborly to share good information.  That works quite well until the day that Yogi Berra’s dictum kicks in:

Nobody goes there anymore. It’s too crowded.

The information indeed was free, but space inside the restaurant was not, even if patrons weren’t paying to get in.  And even if they have carryout, the line could go around the block… a hardship for many even if you are getting the famous Ocean Broccoli Beef.  (Warning: Hot in every way.)

Readers of my blog know that the same thing happens in markets.  Imitation was a large part of the dot-com bubble and the housing bubble.  When a less knowledgeable friend is making what is seemingly free money, it is very difficult for many people to resist the temptation to imitate, because if it works for him, it ought to work better for the more knowledgeable.

As such, prices can get overbid, and the overshoot above the intrinsic value of the assets can be considerable.  It all ends when the cost of capital to finance the asset is considerably higher than the cash flow that the asset throws off.  And as with all bubbles, the end is pretty ugly and rapid.

But what if you had a really big and liquid strategy, one that threw off decent cash flow.  Could that ever be a bubble?  The odds are low but the answer is yes.  It is possible for any strategy to distort relative prices such that the assets inside a strategy get significantly above intrinsic value — to the point where they discount negative future returns over a 5-10 year horizon.  (As an aside, negative interest rates are by definition a bubble, and the instruments traded there are in big liquid markets.  The severity of that bubble collapsing is likely to be limited, though, unless there is some sort of payments crisis.  The relative amount of overvaluation is small, and has to be small.)

Indexing as Imitation

Today, indexing is a form of imitation in two ways.  The first way is not new — it is a way of saying “I want the average result, and very low fees.”  It’s a powerful idea and generally a good idea.  If used for long-term investment, and not short-term speculation, it allows capital to compound over long periods of time, and keeps people from making subpar investment decisions through panic and greed.

Then there is the second way of imitation: indexing because it is now the received wisdom — all your friends are doing it.  This is a momentum effect, and at some point even indexing through a large index like the S&P 500 or Wilshire 5000 could become overdone.  The effects could vary, though.

  • You could see more larger private corporations go public because the advantage of cheap capital overwhelms the informational and other advantages of remaining private.
  • You could see corporations reverse financial engineering, and issue more cheap stock to retire expensive debt.  On the other hand, it would be more likely that credit spreads would tighten significantly, leaving debt and equity balanced.
  • You would see pressure on corporations with odd capital structures like multiple share classes to simplify, so that all of the equity would trade at high multiples.
  • Corporations could dilute their stock to pay for resources — labor, land, intellectual capital and physical capital.  Or, buy up competitors.  If you think that is farfetched, I remember the late ’90s where it was cool for executives to say, “Let the stock market pay your employees.”
  • People could borrow against their homes to buy more stock, or just margin up.

If you see what I am doing — I’m trying to show what a distorted price for publicly traded stocks in an big index could do — and I haven’t even suggested the obvious — that an unsustainable price will correct eventually, and maybe, in a dramatic way.

I’m not saying that indexing is a bubble presently.  I’m only saying it could be one day.  Like the imitation illustrations given above, when a lot of people want to do the same thing without bringing additional information to the process, shortages develop, and in some cases prices rise as a result.

One final note: active management would get more punch at some point, because informationless index investing would lead to some degree of mispricing that active managers would take advantage of.  At the rate money is currently exiting active management and going into indexing, that could be five years from now (just a guess).

As with all things in investing, the proof will be seen only in hindsight, so take this with a saltshaker of salt.  As for me, I will continue to pick stocks.  It has worked well for me.

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Before I write my piece, I want to say a word about the virtue of voting for third party candidates for President.  Personally, I would like to see an option where we can vote for None of the Above, on all races.  That would allow us to break the duopolistic power of the Democrats and Republicans without having to have a viable third party.  The ability to reject all of the candidates so that a new election would have to be held with new candidates would be powerful, and would make both parties more sensitive to all of the voters, not just minorities on the left and right.

Still, I’m voting for a third party candidate mostly as a protest.  I consider the protest to be an investment, because it has no value for the current election, but may have value for future elections if it teaches the two main parties that they no longer have a stranglehold on the electorate.  The cost of doing so in this election for President is minuscule, because both candidates are dishonest egotists.

Character matters; if a person is not honest you will not get what you thought you were voting for.  In this election, more than most, people are projecting onto Hillary and Donald what they want to see.  Trump is not a man of the people, and neither is Clinton.  They are both elitist snobs; they are members of rival cliques that dominate their respective parts of the main country club that the privileged enjoy.

There is no loss in not voting for them.  If you want to send a message, vote for someone other than Clinton or Trump.

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Of Milk Cows and Moats

It’s become fashionable to talk about moats in investing as an analogy for sustainable competitive advantages.  Buffett popularized it, and many use it in investment analysis today.  Morningstar has made a lot out of it.

I’d like to talk about the concept from a broader societal angle.  This may look like a divergence from talk on investing, but it does have a significant influence on some investing.

I live in the great state of Maryland.  A while ago, I wrote an award-winning piece on publicly traded companies in Maryland.  My main conclusion was that many corporations are in Maryland because the founder lived here.  Other corporations were in Maryland because of the talent available to manage healthcare firms, defense firms, hotels, and REITs.  Only the last one, REITs, had any significant advantage imparted by the state itself — Maryland was the first state with a statute allowing for REITs.

Why do corporations leave Maryland?  Well, when a merger takes place, the acquirer usually figures out that the company would likely be better off reducing its presence in Maryland, and increasing its presence elsewhere.  Costs, taxes and regulation will be lower.  The countervailing advantage of an educated workforce is usually not enough to keep jobs here, unless that is the main input to what the firm does, such as biotechnology — hard to beat the advantage of having Johns Hopkins, NIH, and the University of Maryland nearby.

All of this suggests a model of businesses and people entering and leaving an area that is akin to the moats we describe in business.  Most businesses know that it will be expensive to move.

  • They will lose people, or, it will be costly to move them
  • There will be an interruption to operations in some ways.
  • The educational quality of people might not be as great in the new area.
  • Some taxes and regulations could be higher.

Thus to induce a move, another municipality might offer incentives of tax abatement, a low interest loan, etc.  The attracting municipality is making a business decision — what do they give up in taxes (and have to spend on services) versus what they gain in other taxes, etc.  The attracting municipality also assumes that there will be some stickiness when the incentives run out.  If you need an analogy, it is not that much different than what it takes to attract and retain a major league sports franchise.

What municipalities lose businesses and people?  Those that treat them like milk cows.  Take a look at the states, counties and cities that have lost vitality, and will find that is one of the two factors in play, the other being a concentrated industry mix in where the dominant industry is in decline.

The more a municipality tries to milk its businesses and people, the more the businesses begin to hit their flinch point, and look for greener pastures.  With the loss of businesses and people, they may try to raise taxes to compensate, leading to a self-reinforcing cycle that eventually leads to insolvency.

A municipality can fight back by offering its own incentives to retain companies and people.  This can lead to a version of the prisoners’ dilemma, or a “race to the bottom” as corporations play off municipalities against each other in order to get the best deal possible.  There is an analogy to war here, because the mobile enemy has significant advantages.  There is an analogy to antitrust as well, because municipal governments are allowed to collude against corporations, and it would be to their advantage to do so, if they could agree.

In a game like this, the healthiest municipalities have the strongest bargaining position — they can offer the best deals.  There is a tendency for the strong to get stronger and the weak weaker.  Past prudence has its rewards.  Present prudence is costly, both economically and politically, is difficult to achieve, and future people will benefit who will not remember you politically.

One more note: Maryland has another problem, which affects some of my friends in the industry who have Maryland-centric.investment management practices.  (My firm is national.  More of my clients are outside of Maryland than inside.)  When wealthy people in Maryland retire, their probability of leaving Maryland goes up, as the “moat” of their Maryland job disappears.  Again states can adjust their tax policies to try to retain people in their states.  On the other hand, some attempt to tax former residents who earned their pensions in their states, and things like that.

This is just another example of how municipalities have limits to the amount they can tax before the tax base erodes.

(Dare we mention how the internet is still costing states some of their sales taxes?  Nah, too well known.)

Upshot

When considering businesses that rely on a given locality, ask how the health of the locality affects the business.  It’s worth considering.  For those who invest in municipal bonds, it is a critical factor.  Particularly as the Baby Boomers age, weak municipalities will come under pressure.  Stick with strong municipalities, and services that would be impossible to do without.

Finally, think about your own life.  Is it possible:

  • that your firm could move and leave you behind?
  • that your taxes could rise significantly because businesses and people are leaving?
  • that your taxes could rise significantly because state employee benefit plans are deeply underfunded?
  • that your municipal job could be put in danger because of prior weak economic decisions on the part of the municipality?
  • that real estate prices could fall if the exodus of people from your area accelerates?
  • Etc.

Then consider what your own “plan B” might be, and remember, earlier actions to leave are better actions if you are correct.  The options are always lousy once an economic bust arrives.

Data Source: Media General || Note: Do not cite or republish this graph without publishing the limitations paragraph below.

Data Source: Media General || Note: Do not cite or republish this graph without publishing the limitations paragraph below.

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Before I start this evening, I want to state again that I welcome comments at this blog. It may not seem so from the last few months, but I have shaken the bugs out of the software that protects my blog, which was hypersensitive on comments. The only thing I ask of commenters is that you be polite and clean in your speech. Disagree with me as you like — hey, even I have doubts about my more extreme positions. 😉

Limitations

The graph above and the text explaining it could very easily be misused, so I am giving a detailed explanation of how I calculated the figures so that people looking at them can more easily critique them and perhaps show me where they are wrong.  Please use the above figures with care.

I summed up the net income data for 2706 firms in the Media General database used in the AAII Stock Investor Pro screening software.  Those firms had:

  • Seven years of historical earnings data (2009-2015)
  • Earnings estimates that go out to 2018, and
  • An estimate of the diluted common shares of each

In short, it is all of the firms trading on US exchanges (that Media General covers) that have seven years of earnings history, and significant analyst coverage extending out for two years.  Please note that not all fiscal years are equivalent, and that the historic data is on fiscal years, aside from 2016YTD, which is a trailing twelve months figure.  That means 2016YTD is largely from the first half of calendar 2016 and the last half of calendar 2015.

Note that companies that went out of existence between 2009 and today are not reflected in these figures.  They represent only the companies that exist as publicly traded firms today.  Also note that foreign firms trading on US exchanges are in these figures.

The projected Non-GAAP earnings are the product of average sell-side earnings estimates and the most recent estimate of fully diluted common shares.  2016, 2017 & 2018 are the current, next year, and two years ahead estimates of adjusted earnings, which are Non-GAAP.

Remember that sell-side estimates are designed (in theory) to eliminate transitory factors and provide an estimate of run rate earnings for the future.  Whether that is true in practice is another matter, as we may see here.

There is one more piece of data that you need before you can interpret the above graph: because of foreign firms that are included, the total market capitalization underlying the graph is $28.8 Trillion.

Analysis

After my recent piece Practically Understanding Non-GAAP Earnings Adjustments, I felt there was something more to say, because regularly I would see earnings estimates that were higher than historic earnings by a wide margin, which would make me say “How does it get from here to there?”  The answer is simple.  It doesn’t.

Why?  We’re comparing apples and oranges.  GAAP earnings deduct many expenses out that were incurred in prior periods, but deferred.  GAAP earnings also have unusual and extraordinary charges that are expected not to occur.  Non-GAAP earnings exclude those (among other things, sometimes excluding interest and taxes).  As such, they are considerably higher than GAAP earnings.

Take a look at this table of price-earnings ratios.

Year

2009

2010201120122013201420152016YTD20162017

2018

P/E

36.61

24.8422.1323.2621.0121.7029.6930.6818.6816.02

14.06

Note: the same warning on the graph applies to this table.

Note that the current market capitalization is being applied against historic net income 2009-2016YTD.  2016-2018 are on projected non-GAAP net income estimated by the sell-side.  Obviously, in 2009 the market capitalization was much lower, and so the P/E then would have been higher.  Survivorship bias will have some impact here, but I’m not sure which way it would go.

See how much lower the P/Es are for the sell-side estimates (these would be bottom-up, not top-down).  Figures like this get cited by pundits who say the market isn’t that expensive.

Also, note how GAAP earnings have shrunk since 2014, and haven’t grown much since 2009.  I know only the media compares actual to prior, which is an anachronism, but maybe we need to do that more.

Summary

That leaves us with a few sticky questions:

  • Which is a better measure for growth in value?  GAAP or non-GAAP earnings?  (I think the answer varies by industry, and how long of a period you are considering.)
  • Should we allow non-GAAP earnings to be published? (Yes, after all management is going to explain the non-GAAP adjustments orally as they explain why the quarter was good or bad.)
  • Does this mean that the market is overvalued?  (Not necessarily.  Rational businessmen are still buying some firms out, which partially validates current levels. Also, free cash flow is not affected by accounting rules, so questions of overvaluation should not rely on accounting methods.  If it is overvalued on one, it should be overvalued on all, etc.)
  • Should we create a fifth main statement for GAAP accounting, that formalizes non-GAAP and gives it real rules? (Probably, but like most of GAAP, there will be some flexibility and industry-specific rules.)

As for me, this will give me a little help in making adjustments to earnings estimates as I try to think through valuation issues, and give me some rough idea as to whether the hockey stick that the sell side illustrates is worth considering or not, or to what degree.

Again, comments are welcome.  Please note that my findings are tentative here.

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Industries come and industries go. Jobs come and go, and they morph.  Perhaps we should take heart that politicians don’t change.  Most still think that certain types of jobs need to be preserved and protected.  Also, politics doesn’t ever seem to have productivity improvements, such that the same things could get done (or not) with fewer people.

Looking at the history of the past 200 years, and the jobs that existed then and exist now, you would conclude that less than 10% of people working in the US today occupy jobs remotely similar to what was done 200 years ago.  (I exclude homemakers who do valuable work for their households that is blissfully untaxed.)

There are places that had prosperity for a time because an industry grew large, and then that industry went into decline, or at least, increased labor productivity reduced employment in that industry.  I’ll toss out a few:

  • Agriculture generally
  • Coal mining
  • Iron ore mining
  • Steel
  • Auto production
  • Construction
  • Newspapers
  • Magazines
  • Bookstores
  • Textiles
  • Telephones
  • Apparel
  • Family farms
  • Many industrial jobs

The last two are notable for the passion that they generate.  Politicians will say that family farms have to be protected and that we need more good industrial jobs.  Both are hopeless causes.  Farms benefit from scale in general, though small farms can do well if they have a specialty where people are willing to pay up to gain the quality of the product.

Industrial employment is going down globally.  The application of information technology to industrial processes allows as much or more to be made, while hiring fewer workers.

The politicians may as well beg that we could stop time or reverse it.  Absent some astounding catastrophe it is hard to see how productivity would decline such that more workers  are needed in industrial jobs.  “Ned Ludd” lost that war over 200 years ago.

Politicians might be able to shift where jobs are located, but not the total amount that gets produced or the number hired globally.  Anytime you hear them say that they will increase the quantity, quality or pay of jobs, it is best to ignore the politicians.  They are promising something that they can’t control.  The same is true of central bankers; if they can do anything about the number of jobs, it is highly transitory, as policy loosens and tightens; jobs flow and ebb.

Anyone looking seriously over the last 200 years should conclude that in this modern world with the extended division of labor that jobs will continue to morph, appear, and disappear.  The internet has led to the disappearance and creation of many jobs, and I don’t think that that trend is complete yet.

My best advice to you is this: learn, grow, be flexible, and be willing to work in ways that you never imagined.  The clock will not be turned back on technology, which is the main factor affecting employment.  You must be your own defender, because the factors affecting employment are bigger than that which governments can control.  Finally, as an aside, don’t trust the politicians (from any party) who say they will improve your economic prospects.  Aside from reducing what the government does, they haven’t succeeded in the past; they will not succeed in the present.

Photo Credit: Constanza || Well, aren't many efforts at adjusting earnings patch jobs??

Photo Credit: Constanza || Well, aren’t many efforts at adjusting earnings patch jobs??

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Over the years, I’ve written a lot about earnings adjustments and non-GAAP earnings.  There are several basic questions to answer:

1) Which matters more?  GAAP earnings or non-GAAP earnings?

In the short-run, non-GAAP earnings matter more for two reasons: a) the non-GAAP earnings attempt in principle to eliminate special factors and estimate the change in run-rate earnings or free cash flow.  If done properly, it is a very valuable exercise.  If done wrong, it’s just an advanced form of chicanery, where companies attempt to keep the stock price higher than it deserves to be, before gravity catches up with them.  Gravity will catch up regardless and eventually, because fooling Ben Graham’s weighing machine invites a rude payback with compound interest.  Ask Enron.

b) the second reason is a weaker one, but the sell-side performs a service by estimating earnings, and they use non-GAAP earnings.  It is a control mechanism that allows investors to measure the progress of companies in the short-run.  Note that this does not encourage short-termism unless the non-GAAP adjustments are done wrong.  It’s fine to talk about the long-run, but what progress are you making toward it?  If the non-GAAP metric does not reflect the best efforts of the management team to create the long term value, then they need to adjust their non-GAAP earnings metric to reflect what maximizes long-run value creation.  After that, educate the sell-side on why you are right, and let the buy-side quietly consider whether they can improve on it.

That said, GAAP earnings are more important for the long run.  Even more important is the growth in book value plus accrued dividends.  These measures take into account the one-time adjustments.  The many one time adjustments.  THE CONSTANT ONE TIME ADJUSTMENTS!!  

(Ahem.) Management is responsible over the long haul for all of the things that they never anticipated, because they are supposed to be prepared for them on average.  It’s fine to complain about weather affecting sales or margins for one quarter, but to complain about it more than twice in a decade means you aren’t prepared as a management team.  The same applies to writing down goodwill and other asset values.  One surprise every now and then is fine, but if it becomes annual then it should be planned for… perhaps the recoverability estimates aren’t very good at all, and you need to write down ten years of a lack of expected profitability now, rather than eating the elephant of subpar decisions one bite at a time.

2) What should we look for in earnings surprises?

a) Be wary of companies that always beat estimates.  Those that do are one of two things — stupendous, or manipulators.  Earnings should be somewhat ragged, even for a growth company.  I actually like my companies to miss estimates every now and then, because it proves genuineness.

b) Be wary of companies that beat positive estimates frequently, but never seem to have GAAP earnings or book value that grows.  What that means is that the non-GAAP metric may not truly represent what is building value for the firm.

c) Be wary of companies that beat positive estimates frequently, and yet have to raise a lot of capital because the business isn’t throwing off a lot of cash that can be reinvested in the business.  Non-GAAP metrics should be strongly related to free cash flow, which should reduce financing needs.

d) For companies with negative forecast earnings, watch the date closely for when earnings are supposed to go positive.  If you see that date extended more than once, you might want to sell.

e) If a stock trades at a low valuation, don’t make too much out of missing earnings if the book value grows at a decent rate.

3) What else should we know?

a) Earnings misses and beats are frequently overestimated in importance.  Business has irregularities; get used to it, and don’t panic off of one or two bad numbers.

b) But repeated misses probably should be sold, unless the valuation is so cheap that an activist would have an easy time with the stock.

c) If a management is good at managing capital, and honest, an earnings miss can be a great opportunity to buy.  Remember that not all value is driven through short-term earnings.  Clever use of free cash flow to do small acquisitions that can be grown organically can be underestimated.  During times of crisis, a genuinely clever management team can occasionally do amazing things as conditions seem to be falling apart, by buying cheap assets from mis-financed sellers who need quick cash.

d) Stocks with high valuations should use excess cash to pay dividends; those at low valuations should buy back stock.

e) The height of the stock market tends to be determined by long-term estimates of unadjusted future earnings or free cash flow, rather than the current period expected earnings.  As with everything in investing, don’t get too excited about anything.  This is a business, and not primarily a game, though many things are game-like.

f) Situations where M&A are involved are always more complex, and require special handling.  I can’t give a simple general answer there.

g) Actual GAAP earnings and non-GAAP earnings do not live on the same planet on average.  At some point, I will put out a post showing how inflated non-GAAP earnings are on average versus GAAP earnings.  I have the study design ready to go, and just have to run the calculations.  If you look at past earnings, and compare them to forecast earnings, the naive will say, “Wow, what growth!”  The experienced will say, “There are things in the non-GAAP earnings that will not factor into long-term growth in value.”

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That’s all for now.  Your quality thoughts in response are always welcome, though I can’t answer every comment.

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

Photo Credit: Daniel Mennerich || A bridge described in fiction to bridge me to the counterfactual argument of this post

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I received an email from a longtime reader:

 

David, here is a (possibly useless) thought experiment.

In 2005, PIMCO’s Paul McCulley was begging Ben Bernanke to halt the on- going quarter-point raises in the Fed Funds rate at 3.5 percent. I forget his exact reasoning, but he clearly thought that the financial markets couldnot accommodate short-term rates above 3.5 percent without substantial disruptions.

Suppose that Bernanke had listened to McCulley and capped the Fed Funds rate at 3.5 percent until it was clear how the markets would fare at that level. Would that alone have been sufficient to postpone or even avert the housing crisis? Or would it have made the crash even worse?

According to FRED, the Funds rate reached 3.5 percent in August 2005, and as we know housing prices nationally peaked about one year later, just as the Funds rate was topping out at 5.25 percent. Question is, did the additional 1.75 percent of increases serve to tip the housing market into decline, or was the collapse inevitable with or without the last seven quarter-point raises?

Any thoughts?

Here was my response:

I proposed the same thing at RealMoney, except I think I said 4%.  My idea was to stop at a yield curve with a modestly positive slope.  It might have postponed the crisis, and maaaaybe allowed banks and GSEs to slowly eat up all of the bad loan underwriting.

I had Googlebots tracking housing activity daily, and August 2015 was when sales activity peaked.  I announced it tentatively at RealMoney, and confirmed it two months later.  From data I was tracking, housing prices flatlined and started heading down in 2006.  The damage was probably done by 2005 — maybe the right level for Fed funds would have been 3%.

The trouble is, hedge funds and other entities were taking risk every which way, and a mindset had overwhelmed the markets such that we had the correlation crisis in May 2005, and other bits of bizarre behavior.  Things would have blown up eventually.  Speculative frenzy rarely cools down without the bear phase of the credit cycle showing up.

So, much as it would have been worth a try, it probably wouldn’t have worked.  The housing stock was already overvalued and overleveraged.  But it might have taken longer to pop, and it might not have been as severe.

But now for the fun question.  Is the Fed trying to do something like that now?  Are they so afraid of popping any sort of asset bubble that they have to be extra ginger in raising rates?  It seems any market “burp” takes rate rises off the table for a few months.

I don’t know.  I do know that the FOMC has only 1% of tightening to play with before the yield curve gets flat.  Also, obvious speculation is limited right now.  There is a lot that is overvalued, but there is no frenzy… unless you want to call nonfinancial corporation and government borrowing a frenzy.

Thanks for writing.

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The FOMC is Afraid of its own Shadow

If I were the Fed, I would end the useless jabbering that they do.  I would also end the quarterly forecasts and press conference. I would also end publishing the statement and the minutes, and let people read the transcripts five years later. We would go back to the pre-Greenspan years, when monetary policy was managed better.   Before I did that I would say:

The Fed has three responsibilities: controlling inflation, promoting full employment, and regulating the solvency of the banking system.  We are not responsible for the health and well-being of financial markets.  The ‘Greenspan Put’ is ended.

We will act to limit speculation within the banks, such that market volatility will have minimal impact on them.  We want our pursuit of limited inflation and full employment to not be hindered by looking over our shoulder at the boogeyman that could affect the banking system.  To that end, please realize that we will not care if significant entities lose money, including countries that may get whipped around by our pursuit of monetary policy in a way that benefits the American people.

We are not here as guarantors of prosperity for speculators.  Really, we’re not here to guarantee anything except pursue a stable-ish price level, and to the weak extent that monetary policy can do so, aid full employment.

We hope you understand this.  We do not intend to use our “lender of last resort” authority again, and will manage bank solvency in a way to avoid this.  We may get called ‘spoilsports’ by the banks that we regulate, but in the end we are best served as a nation if solvency concerns dominate over the profitability of the banking industry.

As it is, the present FOMC fears acting because it might derail the recovery or spark a bear market in risky assets.  Going beyond the mandate of the Fed has led to bad results in the past.  It will continue to do so in the future.

The best way for the Fed to maintain its independence is to act independently and responsibly.  Don’t listen to outside influences, particularly when hard things need to be done.  Be the adult in the room, and tell the children that the medicine that you give them is for their good.  Recessions are good, because they clear away bad uses of capital from the ecosystem, and make room for new more productive ideas to use the capital instead.

As it is, the Fed is afraid of its own shadow, and will not take any hard actions.  That will either end with inflation, or an asset bubble that eventually affects the banks.  A central bank like that does not follow its mandate does not deserve its independence.  So Fed, if you won’t act for our long-term good, will you act to preserve your existence in your present form?