For the right reasons, there is traditionally a lot of emphasis on Buffett’s investment and management style from the letters. Unfortunately, unless you are managing a fund or business empire worth billions – which most of us aren’t (and if you are, we should have coffee some time) – such lessons are hardly applicable to the needs of a common investor. Here, we focus on 3 insights which are more technical in nature and by that virtue, more relevant for small time investors and analysts.
Different balance sheet yardstick for companies with float
If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities are treated as equals, however, under GAAP.
We have talked about alternative perspectives of working capital and I believe this is a very good crystallization of what we have already mentioned. We cannot measure companies with float potential by our conventional balance sheet metrics. There are only a handful of businesses with strong float potential – insurance, big retail companies (eg. NTUC), retirement funds (eg. CPF). The strength of the float potential largely depends on their length. There are many companies which have a float so to speak, lottery companies and certain payroll processing companies. However, the length of their floats is typically too short to be of as significant use.
Failings of EBITDA – depreciation can be a very real expense
Last year, for example, BNSF’s interest coverage was more than 8:1. (Our definition of coverage is pre-tax earnings/interest, not EBITDA/interest, a commonly used measure we view as seriously flawed.)
EBITDA/Interest is a very commonly used measure in finance. I myself use it as well so I was very surprised at how strongly Buffett felt. Why does he prefer pre-tax earnings/interest? The answer can be found in a later part of the letter.
I won’t explain all of the adjustments – some are tiny and arcane – but serious investors should understand the disparate nature of intangible assets. Some truly deplete over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. The concept of making charges against other intangibles, such as the amortization of customer relationships, however, arises through purchase-accounting rules and clearly does not reflect reality. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated – even though from an investor’s viewpoint they could not be more different.
Indeed, the learning point for me would that while amortisation and depreciation are non-cash expenses, it does not mean that they are unreal expenses to be disregarded totally. Consider an asset heavy manufacturing firm where the wear and tear of machinery is a very real operating expense. With an EBITDA of 8, interest expenses of 1 and depreciation of 8, it will have a conventional interest coverage ratio of 8x which seems healthy but it can barely cover its operating expenses. Sure, because it is a non-cash expense the company might just chug along fine for a couple of years, but depreciation becomes a very real cash expense when the machines have to be renewed. An investor should discern between real and unreal expenses before using a metric like EBITDA/Interest, or any metric involving EBITDA for that matter. This might have implications on our favoured EV/EBITDA as well.
The illusion of earnings per share
The drill for conglomerate CEOs then was simple: By personality, promotion or dubious accounting – and often by all three – these managers drove a fledgling conglomerate’s stock to, say, 20 times earnings and then issued shares as fast as possible to acquire another business selling at ten-or-so times earnings. They immediately applied “pooling” accounting to the acquisition, which – with not a dime’s worth of change in the underlying businesses – automatically increased per-share earnings, and used the rise as proof of managerial genius. They next explained to investors that this sort of talent justified the maintenance, or even the enhancement, of the acquirer’s p/e multiple. And, finally, they promised to endlessly repeat this procedure and thereby create ever-increasing per-share earnings.
A refresher on the illusion of EPS. A new insight is that using shares to fund acquisitions is a red flag to such ‘managerial ingenuity’. This was also what some IT companies did in the last Internet Bubble Boom where their stocks were trading at insanely high multiples. Companies which accepted such shares as a form of payment were left with pittance after the crash.
