Data Source: Media General || Note: Do not cite or republish this graph without publishing the limitations paragraph below.

Data Source: Media General || Note: Do not cite or republish this graph without publishing the limitations paragraph below.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

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.

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: Renegade98 || What was it that Buffett said 'bout swimmin' naked?

Photo Credit: Renegade98 || What was it that Buffett said ’bout swimmin’ naked?

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It’s only when the tide goes out that you learn who has been swimming naked.

— Warren Buffett, credit Old School Value

When I was 29, nearly half a life ago, Donald Trump was a struggling real estate developer. ¬†In 1990, I was still trying to develop my own views of the economy and finance. ¬†But one day heading home from work at AIG, I was listening to the business report on the radio, and I heard the announcer say that Donald Trump had said that he would be “the king of cash.” ¬†My tart comment was, “Yeah, right.”

At that point in time, I knew that a lot of different entities were in need of financing.  Though the stock market had come back from the panic of 1987, many entities had overborrowed to buy commercial real estate.  The major insurance companies of that period were deeply at fault in this as well, largely driven by the need to issue 5-year Guaranteed Investment Contracts [GICs] to rapidly growing stable value funds of defined contribution plans.  Outside of some curmudgeons in commercial mortgage lending departments, few recognized that writing 5-year mortgages with low principal amortization rates against long-lived commercial properties was a recipe for disaster.  This was especially true as lending yield spreads grew tighter and tighter.

(Aside: the real estate area of Provident Mutual avoided most of the troubles, as they sold their building that they built seven years earlier for twice what they paid to a larger competitor. ¬†They also focused their mortgage lending on small, ugly, economically necessary properties, and not large trophy properties. ¬†They were unsung heroes of the company, and their reward was elimination eight years later as a “cost saving move.” ¬†At a later point in time, I talked with the lending group at Stancorp, which had a similar philosophy, and expressed admiration for the commercial mortgage group at Provident Mutual… Stancorp saw the strength in the idea, and still follows it today as the subsidiary of a Japanese firm. ¬†But I digress…)

Many of the insurance companies making the marginal commercial mortgage loans had come to AIG seeking emergency financing. ¬†My boss at AIG got wind of the fact that I was looking elsewhere for work, and subtly regaled me of the tales of woe at many of the insurance companies with these lending issues, including one at which I had recently interviewed. ¬† ¬†(That was too coincidental for me not to note, particularly as a colleague in another division asked me how the search was going. ¬†All this from one stray comment to an actuary I met coming back from the interview…)

Back to the main topic: good investing and business rely on the concept of a margin of safety.  There will be problems in any business plan.  Who has enough wherewithal to overcome those challenges?  Plans where everything has to go right in order to succeed will most likely fail.

With Trump back in 1990, the goal was admirable — become liquid in order to purchase properties that were now at bargain prices. ¬†As was said in the Wall Street Journal back in April of 1990, the article started:

In a two-hour interview, Mr. Trump explained that he is raising cash today so he can scoop up bargains in a year or two, after the real estate market shakes out. Such an approach worked for him a decade ago when he bet big that New York City’s economy would rebound, and developed the Trump Tower, Grand Hyatt and other projects.

“What I want to do is go and bargain hunt,” he said. “I want to be king of cash.”

That’s where¬†Trump said it first. ¬†After that he received many questions from reporters and creditors, because his businesses were heavily indebted, and¬†property values were deflated, including the properties that he owned. ¬†Who wouldn’t want to be the “king of cash” then? ¬†But to be in that position would mean having sold something when times were good, then sitting on the cash. ¬†Not only is that not in Trump’s nature, it is not in the nature of most to do that. ¬†During good times, the extra cash that Buffett keeps on hand looks stupid.

Trump did not get out of the mess by raising cash, but by working out a deal with his creditors in bankruptcy. ¬†Give Trump credit, he had convinced most of his creditors that they were better off continuing to finance him rather than foreclose, because the Trump name made the properties more valuable. ¬†Had the creditors called his bluff, Trump¬†would have lost a lot, possibly to the point where we wouldn’t be hearing much about him today.

Trump escaped, but most other debtors don’t get the same treatment Trump did. ¬†The only way to survive in a credit crunch is plan ahead by getting adequate long-term financing (equity and long-term debt), and keep a “war kitty” of cash on the side.

During 2002, I had the chance to test this as a bond manager. ¬†With the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, ‚ÄúThe market is offered without bid.¬† We‚Äôve never seen it this bad.¬† What do you want to do?‚Ä̬† I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.¬† By noon, I had used up all of my liquidity, but the market was turning.¬† On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

That’s tough to do, and my client pushed me on the “extra cash sitting around.” ¬†After all, times are good, there is business to be done, and we could use the additional interest to make the estimates next quarter.

To give another example, we have the visionary businessman Elon Musk facing a¬†cash crunch¬†at Tesla¬†and¬†SolarCity. ¬†Leave aside for a moment his efforts to merge the two firms when stockholders tend to prefer “pure play” firms to conglomerates — it’s interesting to look at how two “growth companies” are facing a challenge raising funds at a time when the stock market is near all time highs.

Both Tesla and Solar City are needy companies when it comes to financing.  They need a lot of capital to grow their operations before the day comes when they are both profitable and cash flow from operations is positive.  But, so did a lot of dot-com companies in 1998-2000, of which a small number exist to this day.  Elon Musk is in a better position in that presently he can dilute issue shares of Tesla to finance matters, as well as buy 80% of the Solar City bond issue.  But it feels weird to have to finance something in less than a public way.

There are other calls on cash in the markets today — many companies are increasing dividends and buying back stock. ¬†Some are using debt to facilitate this. ¬†I look at the major oil companies and they all seem to be levering up, which is unusual given the recent trajectory of crude oil prices.

We are in the fourth phase of the credit cycle now — borrowing is growing, and profits aren’t. ¬†There’s no rule that says we have to go through a bear market in credit before that happens, but that is the ordinary¬†way that excesses get purged.

That is why I am telling you to pull back on risk, and review your portfolio for companies that need financing in the next three years or they will croak. ¬†If they don’t self finance, be wary. ¬†When things are bad only cash flow can validate an asset, not hopes of future growth.

With that, I close this article with a poem that I saw as a graduate student outside the door of the professor for whom I was a teaching assistant when I first came to UC-Davis.  I did not know that is was out on the web until today.  It deserves to be a classic:

Quoth The Banker, ‚ÄúWatch Cash Flow‚ÄĚ

Once upon a midnight dreary as I pondered weak and weary
Over many a quaint and curious volume of accounting lore,
Seeking gimmicks (without scruple) to squeeze through
Some new tax loophole,
Suddenly I heard a knock upon my door,
Only this, and nothing more.

Then I felt a queasy tingling and I heard the cash a-jingling
As a fearsome banker entered whom I’d often seen before.
His face was money-green and in his eyes there could be seen
Dollar-signs that seemed to glitter as he reckoned up the score.
‚ÄúCash flow,‚ÄĚ the banker said, and nothing more.

I had always thought it fine to show a jet black bottom line.
But the banker sounded a resounding, “No.
Your receivables are high, mounting upward toward the sky;
Write-offs loom.¬† What matters is cash flow.‚ÄĚ
He repeated, ‚ÄúWatch cash flow.‚ÄĚ

Then I tried to tell the story of our lovely inventory
Which, though large, is full of most delightful stuff.
But the banker saw its growth, and with a might oath
He waved his arms and shouted, “Stop!  Enough!
Pay the interest, and don‚Äôt give me any guff!‚ÄĚ

Next I looked for noncash items which could add ad infinitum
To replace the ever-outward flow of cash,
But to keep my statement black I’d held depreciation back,
And my banker said that I’d done something rash.
He quivered, and his teeth began to gnash.

When I asked him for a loan, he responded, with a groan,
That the interest rate would be just prime plus eight,
And to guarantee my purity he‚Äôd insist on some security‚ÄĒ
All my assets plus the scalp upon my pate.
Only this, a standard rate.

Though my bottom line is black, I am flat upon my back,
My cash flows out and customers pay slow.
The growth of my receivables is almost unbelievable:
The result is certain‚ÄĒunremitting woe!
And I hear the banker utter an ominous low mutter,
‚ÄúWatch cash flow.‚ÄĚ

Herbert S. Bailey, Jr.

Source:  The January 13, 1975, issue of Publishers Weekly, Published by R. R. Bowker, a Xerox company.  Copyright 1975 by the Xerox Corporation.  Credit also to aridni.com.

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Before I write this evening, I would like to point out¬†what is going on with Horsehead Holdings [ZINCQ]. ¬†There was an article in the New York Times on it recently. ¬†It’s an interesting situation where an equity committee exists in a bankruptcy, largely because the management team looks like it is not trying to maximize the value of the bankruptcy estate, but is perhaps instead trying to sell the company off to creditors cheaply in an effort to receive a benefit later from the new owners. ¬†Worth a look, because if the equity committee wins, it will be unusual, and if the debtors win, it very well may take value that legitimately belonged to the equity.

That said, I don’t have a strong opinion because I don’t have enough data. ¬†But I will be watching.

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I received a letter from a reader yesterday on a related topic from my most recent article.  Here it is:

Hi David,

First of all, it’s nice to find you (and Ed Yardeni and Mohamed El-Erian) working when most analysts seem to be at the beach. That said, a question:

In early ’09, as you will recall, the big banks were begging for relief from mark-to-market accounting for their holdings of mortgage-backed securities, on the grounds that these securities weren’t trading at all.

“Ridiculous!” said Jeremy Grantham. “Put 2 percent of your holding out to auction and you will learn its market value quick enough.”

At the time, I thought Grantham had a fair point. Now I’m not so sure.

What was your view on that issue? John Hussman has said repeatedly that it was the FASB’s relaxation of the mark-to-market rules that set off the dramatic resurgence in stock prices that we have seen (and which he deplores).

Was the FASB’s change of policy warranted, under the circumstances?

And should the mark-to-market rule now be restored?

Here was my reply:

Hi,

I wrote a lot about this at the time.  I remain in favor of mark-to-market accounting.  The companies that got into trouble from the effects of mark-to-market accounting had engaged in sloppy risk management practices, and got caught with their pants down.

The difficulty that most of the complaining companies had was a mix of liquid liabilities requiring prompt payment, and relatively illiquid assets that would be difficult to sell.¬† It was the classic asset-liability mismatch — long illiquid assets financed by short liquid liabilities.¬† Looks like genius during the bull phase.¬† Toxic during the bear phase.

On Grantham’s comments: my comments Saturday night are pertinent here for two reasons — anyone selling illiquid CDO tranches, subordinated mortgage bonds, etc., immediately prior to the crisis would find two things: 1) the bids were non-existent or really poor, and 2) if the trade did take place, it would be at levels that reset the pricing grid for that area of the market a LOT lower, leaving the remaining securities looking worse, and a diminution of GAAP equity.

(As an aside, the diminution of GAAP equity might affect the ability to do secondary IPOs of stock at attractive prices, but in itself it did not affect solvency of most financial firms, because statutory accounting allowed for investments to held at amortized cost.  As such the firms could be economically insolvent, but not regulatorily insolvent unless they ran out of cash, or their short-term lending lines of credit got pulled.)

Anyway, this piece is a summary of my thoughts, and provides links to other things I wrote during that era:¬†Fair Value Accounting ‚ÄĒ It Is What It Is

The regulators were pretty lenient with most of the companies involved — the creditors weren’t.¬† They enforced margin agreements, and pulled discretionary credit lines.

I’m not of Hussman’s opinion that relaxation of the mark-to-market rules had ANY effect on stock prices.¬† In general, GAAP accounting rules don’t affect stock prices, because they don’t affect free cash flow, unless the GAAP rules are embedded in credit covenants.¬† Statutory accounting does affect free cash flow, and can affect the prices of stocks.

Those are my opinions, for what they are worth.

Sincerely,

David

s-l1000

Recently I got asked for a list of investment books that I would recommend. These aren’t all pure investment books — some of them will teach you how markets operate in general, but they do so in a clever way. I have also reviewed all of them, which limited my choices a little. Most economics, finance, investment books that I have really liked I have reviewed at Aleph Blog, so that is not a big limit.

This post was also prompted by a post by another blogger of sorts publishing at LinkedIn. ¬†I liked his post in a broad sense, but felt that most books by or about traders are too hard for average people to implement. ¬†The successful traders seem to have systems that go beyond the simple systems that they write about. ¬†If that weren’t true, we’d see a lot of people prosper at trading for a time, until the trades got too crowded, and the systems failed. ¬†That’s why the books I am mentioning are longer-term investment books.

General Books on Value Investing

Don’t get me wrong. ¬†I like many books on value investing, but the first¬†three are classic. ¬†Graham is the simplest to understand, and Klarman is relatively easy as well. ¬†Like Buffett, Klarman recognizes that we live in a new world now, and the simplistic modes of value investing would work if we could find a lot of stocks as cheap as in Graham’s era — but that is no longer so. ¬†But even Ben Graham recognized that value investing needed to change at the end of his life.

Whitman takes more of a private equity approach, and aims for safe and cheap. ¬†Can you find mispriced assets inside a corporation or elsewhere where the value would be higher¬†if placed in a different context? ¬†Whitman is a natural professor on issues like these, though in practice, the¬†stocks he owned during the financial crisis were not safe enough. ¬†Many business models that were seemingly bulletproof for years were no longer so when asset prices fell hard, especially those connected to housing. ¬†This should tell us to think more broadly, and not trust rules of thumb, but instead think like Buffett, who said something like, “We’re paid to think about the things that seemingly can’t happen.”

The last book is mostly unknown, but I think it is useful.  Penman takes apart GAAP accounting to make it more useful for decision-making.  In the process, he ends up showing that very basic forms of quantitative value investing work well.

Books that will help you Understand Markets Better

The first link is two books on the life of George Soros. ¬†Soros teaches you about the nonlinearity of markets — why they overshoot and undershoot. ¬†Why is there momentum? ¬†Why is the tendency for price to converge to value weak? ¬†What do markets look and feel like as they are peaking, troughing, etc? ¬†Expectations are a huge part of the game, and they affect the behavior of your fellow market participants. ¬†Market movements as a result become self-reinforcing, until the cash flows can by no means support valuations, or are so rich that businessmen buy and hold.

Consider what things are like now as people justify high equity valuations.  At every turning point, you find people defending vociferously why the trend will go further.  Who is willing to think differently at the opportune time?

Triumph of the Optimists is another classic which should teach us to be slightly biased toward risk-taking, because it tends to win over time.  They pile up data from around 20 nations over the 20th century, and show that stock markets have done very well through a wide number of environments, beating bonds by a little and cash by a lot.

For those of us that tend to be bearish, it is a useful reminder to invest most of the time, because you will ordinarily make good money over the long haul.

Books on Managing Risk

After the financial crisis, we need to understand better what risk is. ¬†Risk is the likelihood and severity of loss, which is not constant, and cannot be easily compressed into simple figure. ¬†We need to think about risk ecologically — how is an asset priced relative to its future prospects, and is there any possibility that it is significantly misfinanced either internally or by its holders. ¬†For the latter, think of the Chinese using too much margin to carry stocks. ¬†For the former, think of Fannie Mae and Freddie Mac. ¬†They took risks that forced them into insolvency, even though over the long run they would have been solvent institutions. ¬†(You can drown in a river with an average depth of six inches. ¬†Averages reveal; they also conceal.)

Hot money has a short attention span. ¬†It needs to make money NOW, or it will leave. ¬†When an asset is owned primarily by hot money, it is an unstable situation, where the trade is “crowded.” ¬†So it was with housing-related assets and a variety of arbitrage trades in the decade of the mid-2000s. ¬†Momentum blinded people to the economic reality, and made them justify and buy into absurdly priced assets.

As for the last book, hedge funds as a group are a dominant form of hot money.  They have grown too large for the pool that they fish in, and as a result, their returns are poor as a group.  With any individual hedge fund, your mileage may vary, there are some good ones.

These books as a whole will teach you about risk in a way that helps you understand the crisis in a systemic way. ¬†Most people did not understand the situation that way before the crisis, and if you talk to most politicians and bureaucrats, they still don’t get it. ¬†A few simple changes have been made, along with a bunch of ineffectual complex changes. ¬†The financial system is a little better as a result, but could still go through a crisis like the last one — we would need a lot more development of explicit and implicit debts to get there though.

An aside: the book The Nature of Risk is simple, short and cute, and can probably reach just about anyone who can grasp the similarities between a forest ecology under threat of fire, and a financial system.

Summary

I chose some good books here, some of which are less well-known. ¬†They will help understand the markets and investing, and make you a bigger-picture thinker… which makes me think, I forgot the second level thinking of¬†The Most Important Thing, by Howard Marks. ¬†Oops, also great, and all for now.

PS — you can probably get Klarman’s book through interlibrary loan, or via some torrent on the internet. ¬†You can figure that out for yourselves. ¬†Just don’t spend the $1600 necessary to buy it — you will prove you aren’t a value investor in the process.

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

This article is another experiment. Please bear with me.

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

Q: Come on, the value of an asset must be more enduring than that. ¬†You look at the balance sheets of corporations, and they don’t list their assets at sales prices.

A: That’s for a different purpose. ¬†We can’t get the prices of all assets to trade frequently. ¬†The economic world isn’t only about trading, it is about building objects, offering services… and really, it is about making people happier through service. ¬†Because the assets don’t trade regularly, they are entered onto the balance sheet at:

  • Cost, which is sometimes adjusted for cost and other things that are time-related, and subject to writedowns.
  • The value of the asset at its most recent sale date before the date of the statement
  • An estimated value calculated from sales of assets like it, meant to reflect the likely markets at the time of the statement — what might the price be in a deal between and un-coerced buyer and seller?

Anyway, values in financial statements are only indicative of aspects of value.  Few investors use them in detail.  Even value investors who use the detailed balance sheet values in their investment decisions make extensive adjustments to them to try to make them more realistic.  Other value investors look at where the prices of similar companies that went private to try to estimate the value of public equities.

Certainly the same thing goes on with real estate. ¬†Realtors and appraisers come up with values of comparable properties, and make adjustments to try to estimate the value of the property in question. ¬†Much as realtors don’t like Zillow, it does the same thing just with a huge econometric model that factors in as much information as they have regarding the likely prices of residential real estate given the prices of the sparse number of sales that they have to work from.

Financial institutions regularly have to estimate values for variety of illiquid assets in a similar way. ¬†I’ve even been known to help with those efforts on occasion, though management teams have not always been grateful for that.

Q: What if it’s a bad day when I offer my asset for sale? ¬†Is my asset worth less simply because of transitory conditions?

A: Do you have to sell your asset that day or not?

Q: Why does that matter?

A: If you don’t need the money immediately, you could wait. ¬†You also don’t have to auction the asset if you think that hiring an expert come in and talk with a variety of motivated buyers could result in a better price after commissions. ¬†There are no guarantees of a better result there though.

The same problem exists on the stock market.  If you want the the money now, issue a market order to sell the security, and you will get something close to the best price at that moment.  That said, I never use market orders.

Q: Why don’t you use market orders?

A: I don’t want to be left at the mercy of those trading rapidly in the markets. ¬†I would rather set out a price that I think someone will transact at, and adjust it if need be. ¬†Nothing is guaranteed — a trade might not get done. ¬†But I won’t get caught in a “flash crash” type of scenario, or most other types of minor market manipulation.

Patience is a virtue in buying and selling, as is the option of walking away.  If you seem to be a forced seller, buyers will lower their bids if you seem to be desperate.  You may not notice this in liquid stocks, but in illiquid stocks and other illiquid assets, this is definitely a factor.

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That’s all for now. ¬†If anyone has any ideas on if, where, or how I should continue this piece, let me know in the comments, or send me an e-mail. ¬†Thanks for reading.

 

The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer.

The cause for tonight’s article is a piece from the Wall Street Journal,¬†Time to End Quarterly Reports, Law Firm Says. ¬†Here’s the first two sentences:

Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.

Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals.

The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy.  I disagree. There are at least four things that are false in the arguments made in the article, and in books like Saving Capitalism from Short-Termism:

  • Quarterly earnings don’t produce value in and of themselves
  • Quarterly earnings cause most corporations to ignore the long-term.
  • Ending quarterly earnings will end activism, buybacks, and dividends.
  • Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing.

Why Quarterly Earnings are Valuable

I’ve written a number of articles about quarterly earnings and estimates of those earnings:¬†Earnings Estimates as a Control Mechanism, Flawed as they are, and¬†Earnings Estimates as a Control Mechanism, Flawed as they are, Redux. ¬†The basic idea is this: quarterly earnings results give investors an idea as to whether the companies remain on their long-term growth path or not. ¬†As I wrote:

Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.  Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.  The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

Don’t think of the quarterly earnings in isolation. ¬†A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. ¬†A bad earnings number¬†lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. ¬†Vice-versa for a good number.

Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” ¬†That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down.

They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. ¬†In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings.

In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital.  When the measurement periods get too long, discipline can be lost.

Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term

Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. ¬†Even if¬†the current period’s earnings meet the estimates, the job is not done. ¬†If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. ¬†The short-term is just the beginning of the long-term. ¬†It is not either/or but both/and. ¬†A company has to try to explain to investors how it is¬†growing the value of the firm — if present targets aren’t being met, why should there be any confidence that the future will be good?

Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal.  The quarterly earnings measure whether the progress toward completing the goal is adequate or not.  Now, the measure is not perfect, but who can think of a better one?

Ending Quarterly Earnings Would Not End Activism, Buybacks, and Dividends

I can think of an area in business where earnings estimates don’t play a role — private equity. ¬†Are the owners long-term oriented? Yes. ¬†Are they short-term oriented? ¬†Yes. ¬†Is¬†capital managed tightly? ¬†Very tightly. ¬†All excess capital is dividended back — it as if activists run the firms permanently.

If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders.  Activists would still analyze companies to see if they are badly managed, and in need of change.  If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe.  Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings.

On the Use of Excess Capital

Investing, particularly for the long-term, is not risk-free.  In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete.  In such an environment, it can make a lot of sense to focus on shorter-term investments that are more certain as to the success of the project.  It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently.  Companies that shrink their balance sheets tend to outperform those that grow them.

As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors.  The same is true of large versus small investments for organic growth away from M&A.  Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing.  There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not.

In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. ¬†That’s how biotech firms work, and it is why so many of them fail. ¬†The few winners are astounding.

Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity.  All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted returns, and not wasted on speculative projects with uncertain returns.  The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive.

Remember, bad investments are just expenses in fancy garb — it just takes the accounting longer to recognize the losses. ¬†Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. ¬†Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. ¬†Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company.

Conclusion

If quarterly earnings are abolished, intelligent corporations won’t change much. ¬†Investment won’t go up much, and the time horizon of most management teams will not rise much. ¬†If you need any proof of that, look at how private equity and large mutual insurers manage their firms — they still analyze quarterly results, and are conservative in how they deploy capital.

The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors.  Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies.

Other Aleph Blog Articles for Consideration

Photo Credit: Phineas Jones || Beyond the destruction, honesty?

Photo Credit: Phineas Jones || Beyond the destruction, honesty?

Few like revenue misses, but let me point out a few significant things that investors should care about:

  • If a company misses revenue estimates around 50% of the time, that can be an indicator that it doesn’t play around with revenue recognition, which is probably the most common way of shading accounting results. ¬†Honest accounting is worth a lot in the long-run, even if the market won’t pay up for it in the short-run.
  • If a company beats revenue estimates nearly all the time, do a little digging into revenue recognition policies. ¬†Have they changed? ¬†It may be that the company is hitting on all cylinders, but that is difficult to keep up for a long time. ¬†How do accounts receivable look?
  • If a company misses revenue estimates nearly all the time, take a look at what they are saying about their marketing, and analyze the industry and competition. ¬†If it is due to the industry, that might not be so bad if you are getting the company’s shares at a cheap valuation. ¬†If it is due to other reasons, it might be time to look elsewhere…
  • If you are late in the company’s product pricing cycle, and competitors are overly aggressive, good companies may take a step back and emphasize profitable business over volume, if fixed costs aren’t too high. ¬†In a pricing war, analyze who has the capability of living through it — maybe it is time to avoid the sector, or simply own the strongest company there, as you wait for capacity to rationalize.

Regardless, it can be a good exercise to look at the current asset accruals of the non-financial companies that you own to see if they look high, because of the higher odds of an earnings disappointment if those accruals are too aggressive.  If you need a summary statistic to look at, perhaps use normalized operating accruals or the days outstanding in the cash conversion cycle for receivables plus inventories minus payables as a fraction of revenues.

That’s all for now.

For those that want the quick hit and don’t care about the underlying ideas, here is the main idea:

A vehicle holding assets may appear more liquid than the assets themselves, but that is only true in bull markets.  When bad times come, the liquidity proves elusive, particularly for large trades.

ETPs are wonderful things, but there is one thing that ETPs can’t do. ¬†They can’t change the underlying assets that they own. ¬†Merely because you have the ability to buy or sell at will does not change the performance of the assets held. ¬†Like most investment products, the amount of assets invested expands in a bull market and contracts in a bear market.

People follow trends.  As they follow trends, they tend to lose money, because they buy and sell too late.  As such, average investors in ETPs tend to lose money relative to buy and hold investors.

In this sense, liquidity is not your friend.  Just because you can trade, does not mean that you should.  Speculators tend to lose to the longer-term investors, who hold for longer periods of time.  Trading itself is a zero-sum game, but bearing risk is a positive sum game, if done with a margin of safety.

Also, if you are trying to do an institutional-size trade in an ETP, you will find that the market impact costs are significant.  Just because there is an exit door in the theater does not mean that everyone can get out instantly.

Repo Transactions

But here is my favorite bugbear in liquidity: repo transactions.  Repurchase transactions turn a long-term asset financed short into a short term asset.  Now the Fed thinks that it can control the repo market.

Honestly, the easy solution is to disallow the accounting treatment of repos, and force those who do them to display them as a long asset and a short liability.  Why?

Because in crises, the long assets are illiquid, and as such the value shrinks when liquidity is prized.  The liquid liabilities still demand to be paid at par.

The accounting change would be better than what the Fed thinks that it might do. ¬†You can’t make long-dated assets liquid. ¬†The cash flows are distant. ¬†Yes, there may be some interest payments that are near, but ultimate repayment of principal is distant.

Let me suggest a better concept of liquidity: assets are liquid to the degree that you can turn the underlying into cash.  When I say that, I do not mean trading big blocks of stock, but selling companies for cash.  That is liquidity, and as such most risky assets do not have significant liquidity, though many trade every day during bull markets.

Liquidity is a scaredy cat, it disappears when it is most needed. ¬†That happens because people think they can sell at par when they can’t.

All for now, but remember this — liquidity is a bull market phenomenon. ¬†People are far more likely to trade when they have unrealized¬†gains rather than losses.

 

Every hundred or so posts, I take a step back, and try to think about broader issues about blogging about finance.  Tonight, I want to explain to new readers what the Aleph Blog is about.

There have been many new followers added to my blog recently, ¬†through e-mail, RSS, and natively. ¬†This is because of this great article at Marketwatch, which builds off of this great article at Michael Kitces’ blog.

I am humbled to be included among Barry Ritholtz, Josh Brown, and Cullen Roche, and am genuinely surprised to be at number 4 among RIAs in social media influence.  Soli Deo Gloria.

What Does the Aleph Blog Care About?

I’m writing this primarily for new readers, because I’ve written a lot, and over a lot of areas. ¬†I write about a broader range of topics than almost all finance bloggers do because:

  • I’m both a quantitative analyst and a qualitative analyst.
  • I’m an economist that is skeptical about the current received wisdom.
  • I like reading books, so I write a lot of book reviews.
  • I’m also a skeptic regarding Modern Portfolio Theory, and would like to see it discarded from the CFA and SOA syllabuses.
  • I believe in value investing, in both the quantitative and qualitative varieties.
  • I believe that risk control is a core concept for making money — you make more money by not losing it.
  • I believe that good government policy focuses on ethics, not results. ¬†The bailouts were not fair to average Americans. ¬†What would have been fair would have been to let the bank/financial holding companies fail, while protecting the interests of depositors. ¬†The taxpayers would have been spared, and there would have been no systematic crisis had that been done.
  • I care about people not getting cheated. ¬†That includes penny stocks, structured notes, private REITs, and many other financial innovations. ¬†No one on Wall Street wants to do you a favor, so do your own research and buy what you want to own, not what someone wants to sell you.
  • Again, I don’t want to see people cheated, so I write about ¬†insurance. ¬†As a former actuary, and insurance buy-side analyst, I know a lot about insurance. ¬†I don’t know this for sure, but I think this is the blog that writes the most about insurance on the web for free. ¬†I write as one that invests in insurance stocks, and generally, I buy the stocks because I like the management teams. ¬†Ethical, hard working insurance management teams do the best.
  • Oddly, this is regarded to be a good accounting blog, because as a user of accounting statements, I write about accounting issues.
  • I am a skeptic on monetary and fiscal policy, and believe both of them tend to sacrifice the future to benefit the present. ¬†Our grandchildren will hate us. ¬† That brings up another issue: I write about the effects of demographics on the markets. ¬†In a world where populations are shrinking in developed nations, and will be shrinking globally by 2040, there are significant economic impacts. ¬†Economies don’t do well when workers are shrinking in proportion to those who are not working. ¬†(Note: include stay-at-home moms and dads in those who work. ¬†They are valuable.)
  • I care about the bond market. ¬†There aren’t that many good bond market blogs. ¬†I won’t write about it every day, but I will write about i when it is important.
  • I care about pensions. ¬†Most of the financial media knows things are screwed up there, but they do not grasp how bad the eventual outcome will likely be. ¬†This is scary stuff — choose the state you live in with care.

Now, if you want my most basic advice, visit my personal finance category.

If you want my view of what my best articles have been, visit my best articles category.

If you want to read about my “rules,” read the rules category.

Maybe you want to read some of my most popular series:

My blog is not for everyone.  I write about what I feel most strongly about each evening.  Since I have a wide array of interests, that makes for uneven reading, because not everyone cares about all the things that I do.  If that makes my readership smaller, so be it.  My blog expresses my point of view; it is not meant to be the largest website on finance.  I want to be special, even if that means small, expressing my point  of view to those who will listen.

I thank all of my readers for reading me.  I appreciate all of you, and thank you for taking the time to read me.

As one final comment, I need to say this. ¬†I note people unfollowing my blog at certain times, and I say to myself, “Oh, I haven’t been writing about his pet issue for a while.” ¬†Lo, and behold, after these people leave, I start writing about it again. ¬†That is not intentional, but it is very similar to how the market works. ¬† People buy and sell investments at the wrong times.

To all my readers, thank you for reading me. ¬†I value all of you, and though I can’t answer all e-mails, I read all e-mails.

In summary: the Aleph Blog is about ethics and competence.  I want to do what is right, and do what gives the best investment performance, in that order.