Buffett’s 1986 Letter to Shareholders – Owner Earnings Demystified.

As I have mentioned before, Buffett did us all a huge favor by explaining, in depth, one of the key measurements that he uses in his valuation process, in his 1986’s Letter to Shareholders that comes annually together with Berkshire Hathaway’s financial reports.

To makes things easier to follow, I have attached the important part, together with my notes, in this link:

http://investingftw.files.wordpress.com/2012/01/buffett-1986-investingftw-notes.pdf

For years I have read dozens of different interpretations to what’s written there, and now I would like to take the time to explain, in plain English, what I consider to be one of the cornerstones of valuation: Owner Earnings.

In order to understand Owner Earnings (or simply, OE) we must delve, deep into Buffett’s explanation. It may seem like a lot, but if you want to understand it fully, that’s the only way to go.

If you haven’t before, grab yourself a cup of coffee and put some John Mayer songs to relax yourself  and get ready for some in depth analysis. This is going to be a long one.

Let’s begin.

In the beginning of the note, Buffett gives us two seemingly different income statements, and later informs us that they both belong to the same company, Scott Fetzer, one before it was bought by Berkshire (Company O) and the other the day after (Company N).

He emphasizes four different key figures, which ultimately make Company N’s show considerably smaller income. Those figures are:

1. A Special non-cash inventory cost of $4.979mil.
2. An increase in Depreciation of $5.054mil.
3. A $595k Amortization cost.
4. A non-cash inter-period allocation adjustment of $998k.

First of all, you should understand why any difference exists at all. When a company buys another company, it often pays more for the company than it’s reported ‘net worth’, meaning the sum of assets minus the sum of liabilities, or book value. The reason for this is that companies pay for intangible assets that are often not listed on the balance sheet, such as a brand name, patents, etc. As well as pay for appreciation in tangible assets that is also not listed on the balance sheet.[1]

Following the transaction, the premium paid has to be displayed on the acquired company’s balance sheet. So, in Scott Fetzer’s case, Berkshire paid a premium of $142.6mil, that now has to be listed on the balance sheet. You can treat this as some sort of update of the company’s balance sheet to current value.

So, going one by one, I’ll explain the accounting in each of the figures:

A Special non-cash inventory cost of $4.979mil:

Starting with adjusting the value of the current assets, the accounting practice is to check whether or not any of them are carried at less than current value. Because items like receivables and cash (DA. -_-) are always carried at current value, the big change comes in inventory, where an inventory that was acquired just one year ago can change dramatically in value, a change that is not presented on the balance sheet (think of last year’s computers, phones, cars).

Unless you had some training in accounting, the next part may seem complicated, so feel free to go straight to figure number 2 if needed.

Buffett allocated $37.3mil of the $142.6mil premium to increasing inventory because of an existing LIFO reserve. A LIFO reserve is the difference in the value of the inventory between FIFO accounting and LIFO accounting:

LIFO Reserve = FIFO Valuation – LIFO Valuation

So basically, Buffett adjusted the value of the inventory to the higher end of the valuation spectrum. The effect on the income statement is a little bit different – Because the income statement measures only costs that affect the same year, of the inventory increase in the balance sheet, only $4.979mil is applicable to that fiscal year.

An increase in Depreciation of $5.054mil:

Next move: Adjust fixed assets. Fixed assets are increased by $68.0mil (update to current value, as measured by the acquisition price), and that sum is depreciated in a way to reflect the real use of assets.

Another $13.0mil is deducted from deferred taxes as a tax shield – Explained later.

A $595k Amortization cost:

After all the other costs are made, the residual $24.3mil is amortized over the normal 40 years period. Which comes out at a regular cost of $607.5k, and slightly less for the mentioned year, because Scott Fetzer was acquired on January 6, resulting in a slightly lower cost for this fiscal year.

Amortization is basically depreciation for purchased companies.

A non-cash inter-period allocation adjustment of $998k:

I know Buffett lists this as too complicated, but sue me, I love complicated stuff. Again, feel free to skip it.

When an asset is purchased, the company lists a ‘tax shield’, so it won’t have to pay taxes in a case where it sells the asset in the future. The same thing happens in the case of an acquisition, because a tax shield is created on the premium the acquirer paid for the acquired assets.

Of the $13.0mil change in the balance sheet, $998k is accounted for the fiscal year (and twelve similar charges will follow in the upcoming years).

A problem, is it?

So, a problem arises. How can a company have considerably less income just because it was acquired, where there’s no economic difference? And even more, how do we overcome this?

Buffett suggests Owner Earnings as the solution. The idea is to replace the Net Income with a figure that will be more guarded from non-economic changes.

Owner Earnings = Net Income plus Depreciation, Depletion, Amortization and Certain other non-cash charges such as Company N’s items (1) and (4) minus the average annual amount of capitalized expenditures for plant and equipment that the business requires to fully maintain its long-term competitive position and its unit volume.

Let’s go one by one:

Net income – Straight from the income statement.

Depreciation, Depletion and Amortization – This change is critical, because 95% of accounting fallacies happen with the DD&A aid.

Certain other non-cash charges, such as Company N’s items (1) and (4) – I don’t think one can determine some sort of specific rule that would suit 100% of the companies in this case, but if you must, take this as a general statement: Any permanent non-cash charge made to inventory valuation or allocation adjustments relating to tax purposes, in the case of an accounting change, such as in the case of an acquisition, is to be counted in the OE formula.

Capital Expenditures – When looking at this line, one should remember that Buffett wrote these lines before the cash flow statement was mandated in 1987. Back then he estimated the CapEx figure using the average depreciation and amortization figure as a base point, as those usually account for the company’s annual spending on manufacturing fixed assets, and mentioned that in the Scott Fetzer case, the “old” accounting gives a better estimate.

Some people think that you should estimate the maintenance CapEx and the Growth CapEx components differently, using a formula made by Prof. Greenwald of the Columbia MBA program. I think it’s a good concept (although not perfect), and in order to stay on the subject I will not go into details.

One more careful observation should be made on Buffett’s note on ‘additional working capital’. Some people take that for ‘always add changes in working capital, and so they take Free Cash Flow as a perfect substitute for Owner Earnings. I do not agree. If any permanent changes do occur, add them, but it is pretentious to think that all changes in working capital fall within this definition.

Told you it will be a long run.

So there you go, Buffett’s note explained in depth. I just wish there was someone to help me with all the confusion I had with it back when I started.

---

[1] Think of land – It is always listed at cost, but usually increase significantly in value over time.

Can the boy hit?

“Investing is like playing baseball. If you want to score runs, don’t study the scoreboard, study the playing field” ~ Warren E. Buffett

I’ve always loved baseball. Ever since I was 6 year old, playing a pretty stripped down version of the game on one of my friend’s NES console. Being a regular, winning-loving kid, the Yankees caught my eye and ever since them I counted them as my favorite.

I’m still having troubles with the word, but the heart has its’ own desires, so I remained a fan and three months ago, even accomplished a childhood dream of watching a game between them and the Oakland Athletics.

The hour is 7:25PM. I’m seating at the Yankees stadium, among 50,000 other fans. Derek Jeter, the 15 million dollar man sends a high flyer, 300ft to the right, and I catch it.

I had bruises all over my body. My shoulder and knee both hurt like hell, but I couldn’t care less. The thrill of a lifetime.

Well, all amazing stories and all, but I want to get to the point. And the point resides not with the Yankees, but with their opponents for the evening (who sadly, actually won that night). What makes them interesting is the story of their GM, Billy Beane, as portrayed in both the book and the movie, ‘Moneyball’.

If you haven’t seen the movie, do. Billy Beane changed the world of baseball by picking players in a completely different way than the one that all the big teams were following. While regular scouts searched for players with ‘promise’, Beane focused on Sabermetrics, a newly created science that advocates looking for undervalued players. Rings a bell?

In the same way as Benjamin Graham, Beane focused on getting great value for a cheap price. Actually, the baseball example is so perfect, that it’s no wonder that Warren Buffett keeps on throwing baseball metaphors at us:

“The stock market is a no-called-strike game. You don’t have to swing at everything – You can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’” ~ Warren E. Buffett

The problem, as most would notice, is deciding on the value. For beane Sabermetrics were the answer, and for us, it will be even simpler. I can promise you, the easiest thing to do is complicate things. All we want to ask is a very simple question: Can the boy hit?

The value of a company is quite simply, all the money it kept for past gains, plus whatever money it will make in the future, discounted back to today.

I hope it’s sounds as simple as I think. If not, don’t worry, I’ll spend the time explaining it. As for today, I’ll leave you with the formula:

1. Calculate owner earnings for the past 10 years.[1]
2. Figure out the past growth rate.
3. Calculate what owner earnings would look like 20 years from now if they continued the same growth, and gradually slowed down (as happens to any company who gets bigger and bigger).
4. Discount those numbers to today and add them all up.
5. Add the tangible value of the company (all the money it kept).
6. You got your number! Now don’t think you’re that smart, and lower that number even more. Things never get to be worth as much as you think (Demand a Margin of Safety).

Is the company trading at that price or lower? Good! Now you can start reading the annual reports. There’s a long list of things to look for, but keep it simple. Ask yourself: ‘Is this company well run? What are the risks?’ Do not, and I repeat, do not get emotionally involved.

Again, you have to trust me, it’s really much simpler than it looks.

---

[1] as understood from Buffett himself: Owner earnings = (a) Net Income plus (b) depreciation, depletion and amortization and certain other non-cash charges less (c) the average annual amount of capitalized expenditures.

Risk! And reward?

I guess you noticed my lack of appreciation for Wall Street, as an investor guide, market timer or a participant in general. The fact that so many different incentives affect the judgment of analysts, brokers and investment bankers make their view on the market a mere outcome in a game of who-compensates-who.

For an example, please turn your mind to the idea of Risk.

On Wallstreet, for some apparent reason, it seems there’s a strong correlation between risk and reward. Stock brokers will always give you two options: Invest in boring companies, that return a small percentage annually, or take the exciting road of investing in ‘riskier’ stocks, and thus have a chance at incredible gains, with the small chance of losing all of your money.

Why should there exist a coefficient between the two at all? Why taking more ‘risks’ comes up as more profitable in the broker’s mind? Well, the problem is that our little broker has a problem defining risk.

When you invest in a stock, you buy a small piece of a business. So, common thought will urge you to think of investment risk as the chance that the business won’t perform as expected, for some reason. Our broker thinks differently. He defines risk (or Beta, in Wall street tongue) , as the relation between the price of a stock to that of the total market. Meaning that a stock that rises 20% when the market rises 10% is riskier than another stock that only rises by 15%.

Sounds fishy, doesn’t it?

Consider an example to show the absurdity of the idea. The worst thing that can happen to a stock’s risk factor, is for the stock to rise in price while the market declines as a whole. Remember Walmart? That gained ~20% while the market crashed in 2008? Riskiest stock in the market, I presume.

Why would stock price, or its’ movements, have anything to do with risk? Oh, right, because it’s easy. Risk is a complicated issue, if you think about it from a business point of view. You have to evaluate the management’s ability, read long annual reports, determine how economic factors will affect the company, bleh. Dividing two numbers is easier. And when you need the risk figure in 99% of evaluations (pretty much the analyst’s job), the incentive is to always take the easy road.

Why linger when Ben Graham already summarized it so proficiently almost fifty years ago?

Real investment risk is measured not by the percent the stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power, economic changes or deterioration in management.

But daddy! I don’t want to invest!

I’m sorry hon’, but you absolutely must.

Why? Because of a little tiny significant bug called Inflation. In theory, inflation is the level at which the worth of our money depreciates. Speaking a little bit less formally, Inflation is the name for the fact that a bus ticket used to cost about one-third of its current price, only 15 years ago.

There’s a battle to be won!

Well, indeed there is. Inflation in the US averaged 3.5% a year over the last decade, meaning that a hundred bucks, deposited into a cash account in 2001, would be worth only 70$ today. Sad, ain’t it? To think of the effect that inflation will have over our life-savings, over the years until we retire. So the answer is yes, there is a battle to be won, and the weapon is Investing.

‘Well yeah, but how?’

Another dismal realization is needed before the light will finally appear at the end of the not-so-pleasant tunnel: Even if you took those hundred bucks, and invested them into a low-interest index fund, considering the fact that the market returned an average of 1.5% annualy, you still would have lost around 2% of your money’s worth every single year. And if you have been following my recent posts, investing in mutual funds instead wouldn’t have given you much better results.

There is an answer, however, if you would take your time to read just a couple more lines. It is a not-so-popular form of investing called Value Investing. It’s a simple idea: Look for bargains, buy them, and then sell them for much more. While I will take my time writing more posts explaining the method in-depth, I will leave you with this: Ever heard of Warren Buffett? Earning 23% annually for most of the last century? or Seth Klarman, who turned 100 million dollars of his investors capital into 6.4 billion in 20 years? Or maybe even Joel Greenblatt, whose staggering results are even too good to be mentioned? All students of Benjamin Graham’s school of value investing.

Look it up. It’ll be worth your while. (Or better yet, look out for my next post…)

Mutual funds: A one way road to underperforming the market. Part IV

A fund’s manager guide to success: Marketing, marketing, marketing!

The  prominent want to increase managed capital, as motivated by the incentives applied, cause more harm than one can expect. While marketing is a key aspect of the financial success of any firm in general, it’s extremely important for investment companies. For reasons easy to understand, asking people for their savings tends to be much harder than selling any other product or service. For that reason money managers are trained to sell from the very beginning. More so, investment companies in Israel don’t even accept newcomers to positions in anything but their marketing departments. Even the lawyers of the firms have been trained in marketing and hold lists of clients! The newcomers must first learn to perform the difficult task of selling mutual funds before they ever get a chance to study any material meant to turn a newbie into the future excellent money manager. More so, usually employees advance in the business not by being excellent analysts, but by having proved marketing capabilities through building a large clientele. Even the money manager position, which its name suggests of mainly choosing investments, consists of mostly meeting with big-fish potential clients.

While one can argue in favor of this concept, on the basis that money managers, whom have a direct contact with clients will have an amplified want and need to achieve above market returns, it is usually not so, as those clients usually require a great deal of time, demanding explanations for bad results or guarantees for future good ones. In fact, the manager’ schedule suffers from what economists call ‘The free rider problem’. The manager’s time acts as a public good, as it is accessible equally and freely to any client alike. The outcome is total abuse of the manager’s time, making it almost impossible for him to spend the time needed for investment picking. Actually, most clients would be a lot better off if they never called their money manager. Ever.

Thus, the actual investment process is usually limited to a small amount of managers’ time, making it harder to find those treasure stocks or bonds. More so, while clients are drawn to mutual fund for the promise of professional management, their own pressure, drawn from the fear of losing their savings, is causing inefficiency within the manager’s decision-making process.

Mutual funds: A one way road to underperforming the market. Part III

Economics (and anything really) is a game of incentives

In economics, an incentive is defined as any factor (financial or non-financial) that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. More simply put, incentives are the fuel that guides our economic reality. When we are paid on commission, we work harder; if the price of gasoline goes up, we drive less; if it becomes common knowledge that programmers earn high salaries, more people will study computer-science. This was one of Adam Smith’s insights in The Wealth of Nations: “It’s not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”[1] In the study of business, ample focus has been put on the relationships between owners and managers. Long has it been proven that matching an owner’s goal with that of a manager by imposing adequate incentives increases results in a wide range of business ventures, if the incentives are imposed correctly. For that same reason options and stock compensation packages were created; to give managers the desire to increase profits over time by admitting them with the appropriate stimulus. But, things don’t tend to be so simple. If not presented correctly, incentives tend to have unwanted results. Options and Share compensation proved it with the emergence of countless fraud cases during the burst of the high-tech bubble in 2001. The same compensation that was aimed at matching incentives for owners and managers, really just gave managers ample reason to commit a various of different scandalous methods designed to amplify share prices in the short-term, while almost guaranteeing a disastrous future for the stock owners.

In the capital management field, money managers are presumably motivated both by the ongoing challenge of achieving good investment results and by the personal financial success that accrues to participants in a profitable money management business. Unfortunately for investment clients, these objectives frequently are at odds. As mentioned earlier, money managers are still compensated not according to the results they achieve, but as a percentage of the total assets under management. The incentive is to expand managed assets in order to generate more fees and not to improve results.[2] Regulation in this aspect has done nothing to change this.

The Investment Company Act of 1940, which was created for the sole purpose of protecting the public’s hard-earned money failed at its most basic goal, as it did nothing to change the most basic rules of the game.

---

[1] Naked Economics: Undressing the dismal Science, p. 35

[2] Margin of Safety, p. 50

Mutual funds: A one way road to underperforming the market. Part II

Background – From crashes to riches

Although various forms of investment companies have existed since 1822, they were usually the private business of the highest order of society. Things took a wild turn during the market boom and crash of the 1920s, when the public mind was set on the ample need for high quality money management. The answer came in the form of open-end mutual funds.

The concept seemed simple – The fund issues shares to the public, which can be bought or redeemed daily at the current value of the fund’s portfolio. Professional money managers actively manage the capital invested in the fund, promising better than average results for their trusting clients. In return, the fund takes revenue as an annual percentage of total assets under
management. The promise for gains took strength from the outcome of numerous fraud and misconduct cases that swarmed the public eye during the 1929’ crisis – The Investment Company Act of 1940.[1] The law imposed uniform standards of fiduciary behavior to the investment firms, and offered tax relieves to the different forms of mutual and pension funds. The law also distinguished mutual funds from competing investing firms by allowing them to market themselves, while forbidding hedge funds and other forms of lucrative investing companies from doing so. Success soon followed. As fear is a powerful motivator, Millions of Americans, who suffered through the great depression and now had two options: Don’t invest at all, and watch inflation slowly reduce the value of their savings, or invest themselves, and be subject to potential market collapse, were presented with a third option: Have a credited professional manage their investments. The promise of safety proved wonders, and following the legislation, more than 450 million dollars flowed into the mutual fund business.

Today, 44% of American households own mutual funds, totaling 11.8 trillion dollars’ worth of assets.[2] Even though the market grew to epic proportions, there seemed to have been no changes since the very beginning. The firms’ revenue still came from the same source, i.e. a percentage of AUM. As I will show later on, this simple concept of income is the trigger to all chaos reining the financial management business. A Wide range of incentives influence money managers; the last of them is for high profits for their clients.

---

[1] The Rise of Mutual Funds, p. 31

[2] 2011 Investment Company Fact Book, p. 128