February 1, 2010
Reported Earnings versus "Owner Earnings"
Over the years, I have frequently emphasized that stocks are not a claim on "forward operating earnings." They are not even a claim on reported net earnings (and should not be valued as a blind multiple to a single year's results in any event). They are a claim on a very long-term stream of future cash flows that will actually be delivered to investors as dividends, or retained on their behalf as an increment to the book value of the company.
The differences between these various measures of corporate performance are striking. If it seems like this point is simply academic, ask Warren Buffett (who refers to those actual, deliverable cash flows as "owner earnings"). Every year, the first page of Berkshire Hathaway's Annual Report contains a table of the company's year-by-year performance. The table does not report the stock price performance of Berkshire Hathaway. Rather, it shows the annual growth in the company's book value, compared with the total return for the S&P 500. Since Berkshire does not pay dividends, the growth in book value captures "owner earnings," which Buffett clearly views as a sufficient statistic for his investment performance. Of course, the long-term growth in book value has been closely linked to the long-term performance of the company's stock.
While stocks are often recommended to investors based on analyst estimates of the operating earnings expected over the coming year, it is important to recognize that these estimates are invariably lowered over the course of the year - even up to the day before actual earnings reports are released. So an "earnings surprise" is typically defined as the difference between reported operating earnings and the consensus estimate immediately preceding that report. Moreover, operating earnings omit a multitude of charges, including so-called "extraordinary" and "non-recurring" losses, even when these charges are clearly ordinary and recurring aspects of the business. Reported net earnings do reflect those losses, however, it turns out that even net earnings are optimistic.
Over time, one would expect that reported net earnings should be either be dispersed as dividends, or retained by companies as an addition to the company's book value. Since depreciation charges are already deducted from net earnings, the portion that is not paid out as dividends and is retained by the company should show up over time as a net increase in book value. In practice, this often doesn't happen, in part because companies grant options to their employees and executives, and even under updated FASB rules, only the estimated option value at the time of the grant (not the ultimate exercise value) is deducted. So when companies execute stock buybacks to offset the dilution from these grants, the true cost of the option grant never gets recorded as a charge to earnings. This has been a particularly significant factor since the mid-1990's.
The chart below presents these various measures of corporate performance for the S&P 500 Index. Expected or "forward" operating earnings are the year-ahead forecasts made by Wall Street analysts. Dividends and increments to book value are the "owner earnings" that are actually delivered to investors after repeated charge-offs and option-related dilution.
Historically, the actual reported net earnings of the S&P 500 have averaged only about 72% of one-year forward operating earnings estimates by Wall Street analysts. The sum of dividends and increments to book value have been even lower, averaging just 60% of forward earnings estimates (and representing only about 84% of the net earnings reported to investors). The remaining portion of "earnings" reported to investors goes the way of the Dodo.
Importantly, the ability of companies to increase book value over time has been a critical determinant of long-term earnings growth, and is likely to be even more important in an economy where debt financing is increasingly constrained. The long-term relationship between earnings and book value is very clear, with actual reported earnings fluctuating reliably around a cyclical norm of about 13.6% of book value. Economic booms can certainly boost return on equity (earnings / book value), and recessions can depress return on equity, but over the full economic cycle, it is dangerous to assume that these temporary departures from the norm will be sustained for long.
The relationship between full-cycle earnings and book value is useful, because it provides another convenient metric of normalized market valuation. Below is a chart of the S&P 500 to that "normalized" earnings figure of 13.6% of book. Notice that prior to the market valuation bubble that began in the mid-1990's, the historical norm for this metric was an average of 14. The two historical extremes prior to 1995 included multiples approaching 19 times normalized earnings, achieved in December 1972 and again in August 1987, both before major market declines. At the January 2010 market high, the multiple matched those prior peaks.
As is true for a variety of similar measures of normalized value, the valuation levels we observe today are comparable with the highest levels achieved in history, except for the bubble period since the mid-1990's. As that bubble period has been associated with dismal subsequent returns overall, it is clear that post-1995 valuations should not be included in the calculation of valuation norms - at least not if we expect those valuation norms to be informative about the level from which acceptable long-term market returns can be expected. (We've seen some otherwise good analysts fold bubble valuation multiples into the calculation of historical valuation "norms", which is not particularly insightful).
Presently, stocks remain richly valued on the basis of normalized earnings, book values, dividends, revenues and other metrics. Investors now rely on the renewed attainment of bubble valuations in order to achieve acceptable returns.
If you keep one thing in mind during the current earnings season, it should be that operating earnings significantly overestimate what Warren Buffett would refer to as "owner earnings" - the actual amounts that are paid out or retained for the benefit of shareholders. Again, stocks are nothing but a claim to the long-term stream of cash flows that will actually be delivered to investors over time. Everything else is hype, smoke and mirrors.
Note - In the charts above, some values prior to 1980 (specifically operating earnings estimates) are fitted values following the method described in Long-Term Evidence on the Fed Model and Operating P/E Ratios.
A Glimmer of Hope
In light of the issues I noted in last week's commentary (A Blueprint for Financial Reform), it is encouraging to note that the winds seem to be shifting from a bailout mentality to a more appropriate receivership/conservatorship approach to failing financial institutions. Whether we have time to implement regulatory changes before the impact of the second wave of mortgage problems begins to bite is an open question. My own view is that it is important to get this done prior to first quarter pre-announcements (when the prospective impact of bringing off-balance sheet entities into corporate reports will be felt, as well as early delinquency and foreclosure effects from second-wave mortgage resets). This essentially gives policy-makers until about mid-March to set some new rules.
The following is an excerpt from an Op-Ed that was published over the weekend (1/30/10) in the New York Times, by former Fed Chairman Paul Volcker.
"What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.
"To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new 'resolution authority.' Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.
"To help facilitate that process, the concept of a 'living will' has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts.
"To put it simply, in no sense would these capital market institutions be deemed 'too big to fail.' What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail."
As of last week, the Market Climate for stocks was characterized by unfavorable valuations and deteriorating market action - still overbought on an intermediate-term basis, but oversold on a short-term basis. The market has broken both trend support and a sideways "line" of support around the 1100 level on the S&P 500, and it is often the case that the market will make one or more recovery attempts toward prior support even if further downside is likely. That's certainly not something we would speculate about, because the broader context is that we are coming off of an "overvalued, overbought, overbullish, yields-rising" conformation that has a tendency to produce nasty, abrupt declines seemingly out of nowhere.
Overall, our holdings in the Strategic Growth Fund are fully hedged either with long put / short call options, or put options that are either at or in-the-money (our response to recent weakness was to cover a small portion of our short call options as the corresponding long put options moved into the money). If we observe a recovery rally but of poor quality on the basis of price-volume behavior, breadth, and other internals, we would be inclined to move back to a full hedge (long put / short call using index options) against the entire portfolio. Overall, we have very little sensitivity to market fluctuations here, but would expect to benefit slightly from fresh market strength. On the basis of our measures of valuation and market action, the case for risk taking here remains weak, despite the modest decline from the January highs.
In bonds, the Market Climate remained characterized last week by relatively neutral yield levels and moderately negative yield pressures. We continue to observe some new upward pressure on credit spreads and credit default swap yields, which suggests some early concern about risk. That concern has benefited the U.S. dollar and Treasury bonds, while pressuring commodities, which is unsurprising. My impression is that we have further to go in this new phase of credit concerns, of course, but we also expect to adopt a constructive tendency toward buying commodities (as well as inflation-protected securities) on weakness in the event that these concerns become full-blown. The larger and longer-term macroeconomic concern remains the risk of substantial inflation in the second half of this decade. For now, the Strategic Total Return Fund continues to carry an average duration of about 4-years, largely in straight Treasuries, with about 10% of assets divided between utility shares, precious metals shares and foreign currencies. I expect that that "alternative" classification will expand on significant commodity weakness, particularly if we observe fresh credit deterioration.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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