It’s earnings season again, which means you are probably staring at a company or two in your portfolio that have seen their share price take a dive after reporting “disappointing” earnings.
You are not alone.
Here was the news the other morning after Warren Buffett’s Berkshire Hathaway reported earnings:
Sounds bad right? Profit (Net Income) is down by a sizeable margin year over year for Berkshire.
Does this mean it is time to say goodbye to the all-star investor?
From those headlines it may seem so. But there is a lot more to a company’s financials than that headline earnings number. (Read to the end and find out how Buffett really measures the success of his businesses.)
Think about how we value companies today:
The headline number every quarter is EPS (Earnings Per Share).
One of the most often cited valuation metrics is based on a company’s earnings, P/E or its Price to Earnings Multiple.
Lower earnings mean higher P/E which means that company is too expensive, right? That is basic “value investing”
The most commonly cited valuation metric for the stock market as a whole is based on the 10 year average EPS of all stocks in the S&P 500. CAPE, also known as Schiller PE.
Lower earnings mean a higher CAPE value, pointing to a more expensive market and lower future returns, right? We already have many investors recommending to sell stocks because today’s CAPE value is in the mid 20’s.
Here’s a quick reminder:
Quarterly Earnings Mean Nothing.
“Charlie and I not only don’t know today what our business will earn next year – we don’t even know what they will earn next quarter.”
– Warren Buffett in his 2002 letter to shareholders
It amazes me how much we still focus on quarterly earnings at all, and specifically for a company like Berkshire, when Buffett himself has said they mean next to nothing.
At the most recent Berkshire Shareholder meeting, Buffett ran down the financial statements for Berkshire. When he got the last line, he said:
“And Net Income is $X, but of course that means nothing.”
He was actually talking about Berkshire’s ANNUAL returns, not even quarterly. This is one of the most successful investors in the world running one of the most successful companies in the world, and he is saying Net Income on his annual report means NOTHING. Is he crazy?
No. He’s right.
To understand why he feels the way he does. Let’s look into what actually goes into a company’s “Net Income” number and then what look at what Buffett looks for.
Net Income is:
Net Income is the profit (or loss) a company has after accounting for all expenses.
Every company starts with a certain amount of sales, or revenue. This is the total dollar amount of product that sold.
Then you subtract operating expenses; what it costs to make that product, what it costs to pay your employees, research and development costs, etc.
Then you subtract interest on any debt you must pay.
Then you pay taxes on what is left.
What is left is your company’s net income. This numbers gets printed in bold in newspaper headlines and online investing blogs every quarter.
So, then it goes without saying that every company should want to maximize net income, right?
Before jumping to a conclusion right away, consider this question for a minute:
What would your perfect investment be?
Buffett answered this question like this:
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter
Why didn’t Buffett just say “A company that makes a huge profit!”?
Because over time, a company that reinvests in itself at high rates of returns will compound into something much larger than a company that solely produces a large profit.
Realize that in order for the company to be able to put more money into acquisitions, capital expenditures or research and development, it will report a lower net income for that year. But this is precisely what Buffett’s idea of a perfect investment is. Buffett’s ideal company would employ as much money as possible invested back into the company to generate future growth. That perfect company could easily have no reportable earnings, because it can reinvest all cash generated by the business into other investments.
Buffett is hardly the only CEO to have thought about this.
TCI – Tele-Communications Inc
John Malone was the CEO of TCI, Tele-Communications Inc. from 1974 to 1998. Malone is profiled as one of the 8 “Outsider” CEOs in William Thorndikes’s excellent book, The Outsiders
Malone had a radical idea – minimize the company’s reported net income:
From 1989 to 1997, TCI had only two years with positive net income.
Surely shareholders must have hated him, and he was ultimately fired and replaced with someone more rational, right?
Actually, Malone remained atop TCI for 24 years before selling the company to AT&T. His performance? It’s one of the best in all of business, even better than Buffett’s.
The average compounded annual return for shareholders of TCI under Malone was an astounding 30.3%. $1 invested in TCI at the time Malone took over was worth $933 when Malone sold the company to AT&T in 1998 for $48 billion.
Malone sold the company for $48 billion, despite it having a Book Value of just $4.4 billion (TCI had $21 billion in debt as of their 1997 annual report!) and no reportable earnings.
What made TCI worth so much money if it had such a low book value and couldn’t even pull a profit?
If Net Income Doesn’t Matter – What Does?
From The Outsiders:
“Related to the central idea was Malone’s realization that maximizing earnings per share, the holy grail for most public companies at the time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.”
Malone was worried about the cash that his business generated, so that it could be reinvested into the company to create further subscriber growth.
Malone pioneered what is now referred to as EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization. It is a measurement of the money the company gets from its operations before paying interest on debt, paying taxes or taking accounting hits for depreciating assets or intangibles.
And since Malone would use so much money to buy other assets with his pre-tax money, (Malone inked 482 acquisitions, an average of one every other week, between 1973 and 1989!) I think it is safe to argue that Malone was also worried about his company’s Cash From Operations.
How much cash did TCI generate?
$1.7 billion in 1997, and it had been growing at 30%+ per year for more than a decade.
Malone was generating 40% of the company’s book value in cash every year – But a basic “value investor” would have never found it:
- If you were screening stocks based on P/E, you would have passed it by, it had no reportable income.
- If you were screening stocks based on low Price to Book ratios, you would have passed it by because it eventually traded for more than 10x book value.
Buffett talks about something similar to what Malone pioneered with his idea of “Owner Earnings”, which he defined in the appendix of his 1986 letter:
“…If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”
“Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since( c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
One could jump the gun and say that an investor can just look at a simple measurement of a company’s cash flow, but Buffett cautions against this:
“Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when ( c) exceeds (b) – GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.
All of this points up the absurdity of the “cash flow” numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract ( c) . Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids – forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all U.S. corporations were to be offered simultaneously for sale through our leading investment bankers – and if the sales brochures describing them were to be believed – governmental projections of national plant and equipment spending would have to be slashed by 90%.
“Cash Flow”, true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But “cash flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, ( c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays.
Why, then, are “cash flow” numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). When (a) – that is, GAAP earnings – looks by itself inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes for salesmen to focus on (a) + (b). But you shouldn’t add (b) without subtracting ( c) : though dentists correctly claim that if you ignore your teeth they’ll go away, the same is not true for ( c) . The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring ( c) is headed for certain trouble.”
How did Malone maximize his company’s owner’s earnings? He kept (c) to a minimum, meaning that “owner’s earnings” far exceeded any reportable earnings.
Malone was able to maintain his company’s competitive advantage, despite having to pay very little to keep up his network.
The Outsiders describes Malone’s CapEx strategy:
“Ironically, this most tech savvy of cable CEOs was typically the last to implement new technology, preferring the role of technological ‘settler’ to that of ‘pioneer’”
This gave Malone the maximum amount of money possible to acquire new companies and grow his subscriber base.
Using These Lessons to Find Your Next Investment
Buffett’s investment strategy seems so simple, and yet so many fail to come close to his returns. Some of that is because he benefits from corporate accounting, but I think just as much is because people think value investing is as easy as simply screening companies based on price to book value or price to cash flow and that’s it.
Buffett’s owners earnings concept is not “screenable”. It requires some basic knowledge to make a guess on a company’s “(c)”, that is, what the company needs to reinvest to maintain its competitive advantage. It’s an educated guess. There is no “right” number.
In an age of “big data”, where anyone can screen out cheap companies based on price-to-book or price-to-cash flow, I don’t think the way forward is to invest based solely on numbers that come from a stock screener.
Today we all expect the numbers to tell us everything. An at home, do-it-yourself investor today has access to more data today than J.P Morgan did in his time. But I don’t think that will make him more successful.
Buffett doesn’t use computers to evaluate companies. Malone at TCI used scratch pieces of paper and even back of napkins to do all the calculations required to decide if an acquisition was a good price.
I think we would all do a little better to ignore the “noise” that is a company’s quarterly income report and instead spend the time getting to understand a business.
…Oh, and by the way. Berkshire Hathaway’s Cash from Operating Activities this most recent quarter? The one with the terrible news headlines at the start of this article…
It was up from 2015, despite the 24% drop in reported profit.