Charlie Munger - Projections do more harm than good

Reading Tea Leaves

" I have no use whatsoever for projections or forecasts.  They create an illusion of apparent precision. The more meticulous they are, the more concerned you should be.  We never look at projections but we care very much about, and look very deeply, at track records.  If a company has a lousy track record but a very bright future, we will miss the opportunity,"  explained Warren Buffett.

Charlie Munger, added that in his opinion projections do more harm than good.  "They are put together by people who have an interest in a particular outcome, have a subconscious bias, and its apparent precision makes it fallacious.  They remind me of Mark Twain's saying, 'A mine is a hole in the ground owned by a liar.'  Projections in America are often a lie, although not an intentional one, but the worst kind because the forecaster often believes them himself."

Here is how Graham and Dodd looked at projections.  "While a trend shown in the past is a fact, a 'future trend' is only an assumption.  The past, or even careful projections, can be seen as only a 'rough index' to the future."

More than five decades have passed since those words were said, and Buffett still agrees.

How Value Investor identifies Earnings, Sales and Future Growth

The real goal of the value investor is to identify companies with solid financial base that are growing at a faster rate (in terms of sales and earnings) than both their competitors and the economy in general.

All things being equal, share price is likely to increase in value at about the same rate that sales grow.

For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.  

Within a portfolio, look for an overall sales growth rate of at least 10% annually.

Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.

But investors should be wary

• when a company's earnings and sales are erratic without explanation or 
• when sales and earnings are slowly sinking and the company is not taking corrective action.

Dilution of Earnings

When considering a company's earnings per share history, make certain the numbers are adjusted for changes in capitalization; that is, work from fully diluted numbers. 

Be sure that all shares that have been authorized for issuance by the board of directors are added into the number of shares outstanding.    Newly issued shares, split shares, and shelf registration (shares sitting in the company's vault but not yet issued) must be put in the pot.

This admonition applies not only to the most current earnings but to any earnings from the past that are used for comparison.  The easiest way to make the adjustment when new shares are authorized is to work backward.  Compute earlier earnings as if the new shares, rights, warrants, privileges, options, and so on already have been exercised.  Corresponding changes should be made to book value and current asset value per share.

Fortunately, most companies include adjustments for shareholders in their financial statements, reporting figures on a fully diluted basis.  But sometimes not.  This is why shareholders must be wide awake when comparing earnings from one year to another, always work from fully diluted earnings.

Retained Earnings are central to the process of investment growth

A company adds up its income, subtracts its expenses, and pays any dividends due; what is left becomes retained earnings.  These are undistributed profits.

Undistributed profits or retained earnings are central to the process of investment growth.

The net worth of the company builds up through the reinvestment of undistributed earnings.

Corporate raiders in particular love to find a company with a lot of cash reserves accumulated from retained earnings.

There is a legitimate dispute over how much retained earnings are adequate, and at what level a company should let loose of some cash and distribute it to shareholders.

Overall, retained earnings like the payment of dividends, deliver a powerful message:  the company generates more cash than it needs for the operation of the business.

That's exactly what a good investment should do.  

These earnings, over and above total expenses and taxes, drive the share price higher.

Common stocks have one important investment characteristic and one important speculative characteristic.  

• Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings.
• The speculative feature is no mystery.  It is the tendency toward excessive and irrational price fluctuations as investors (in Graham's words) "give way to hope, fear, and greed."

Inherent Permanence of Earning Power - The Income that Keeps Coming In

If past earnings are to have any meaning to investors, there must be an inherent permanence to the earning power.  

Earnings may be cyclical, or even inconsistent, and still have some permanence.

• Many automobile companies have notoriously cyclical results; yet they have managed to keep up an ongoing business over many years.

Benjamin Graham considered a company to have stable earnings when:

1. earnings doubled in the most recent 10 years, and,
2. earnings declined by no more than 5% no more than twice in the past 10 years.

Another approach to measuring stability is to compare one period of earnings with an earlier period.  

• Stability is assessed by the trend of per-share earnings over a ten-year period, compared to the average of the most recent three years.  
• No decline represents 100% stability.

For example:  Company A earnings per share nearly doubled in the 10-year period 1984 -1994:

• 5.22  (1984); 6.25; 6.31;.5.90; 5.08; 1.36; 0.30; -2.7, 1.38, 6.77; and 10.1 (1994)
• 10-year average = $4.95
• 3-year average = $6.08
• 1994 book value = $46.65 per share
• 1995 trading range = $38.25 to $58.13 per share

Income Statement in Perspective

When problems exist in an income statement, they tend to distort earnings only in a single year, or over a short period of time.

To even out these short-term distortions, use average share price, annual earnings, and other numbers over a span of 7 to 10 years.

"Averaging" establishes typical numbers for the company.  The longer the time included in the average, the better.

Flash Profits: One-time event that impacts earnings

Any one-time event that impacts earnings, such as a gain from the sale of an asset or a one-time loss resulting from a catastrophic event or the write-off of a potential debt, should be lifted out of the earnings figures and set to one side.

These occurrences should be recognized for what they are and judged accordingly.  They are in no way indicative of the outlook for future earnings.

A one-time sale of assets tends to make overall corporate profits look better in the year it occurs.  Yet the sale decreases the total assets of the company.  There is no real gain.

In an established, well-managed company, daily operations finance themselves with cyclical shortfalls covered by short-term borrowing, so never should a one-time gain be used to cover ordinary expenses.  

There is no real gain from the one-time sale of assets unless the money is used for one of the following:

• Restore the asset base
• Reduce debt
• Contribute substantially to future earnings.

Taking a Hit - Accounting Write Off or Write Down

Corporate accountants write off or write down items under several sets of circumstances.

• They may write a debt off the books that they are convinced will never be collected.
• They may mark down the value of an asset that is no longer worth what it once was.

Excessive write-offs in one year can, in some circumstances, lead to greater than normal profits in the next.  It is an old management trick to take all write-offs or write-down during a period when earnings aren't looking so good anyway.  

• The company decides to load all the bad news into one accounting period rather than several fairly bad ones, but the contrast between the bad quarter or year and the subsequent good one appears dramatic.
• This jump in earnings thrills the investing public (the company did lousy last year, but look how it's come around!)  But again, the better earnings may turn out to be a  brief aberration.  The following year the company's earnings fall back into the old ways.

Yet done frankly and for the right reasons, write-downs may lead to real and long-lasting improvement in earnings.  

• They make a difference when the company is saying:  "This was a problem; we've faced up to it.  The adjustment will allow the income statement to accurately reflect the condition of our company in the years ahead."

For alert investors, losses or gains that result from a single episode can be a boon.

• If other investors overreact to the news in either a positive or negative way, it may create a chance to buy or sell at an advantageous price.

Divine Dividends

Dividends represent nothing more than the investor's share of earnings that will be received immediately (rather than through reinvestment and future growth of the stock).

Dividends are one of the quickest and healthiest ways that earnings can make their way into shareholders' pockets.

Graham argued that intelligent investors would rather have dividends in their pockets (even if investors use them to buy more of the same stock) than risk waiting for possible future growth.  Furthermore, he insisted, it is management's responsibility to pay dividends.

For long-term investors who follow a "buy and hold" strategy, dividends are the only way to collect on investment gains.

In addition to representing money in the bank, dividends are, to many investors, a reliable indicator of future growth.  

Values are determined roughly by earnings available for dividends.  This relation among earnings, dividends and values survives.

A long history of dividend payments and regular dividend increases also indicates a substantial company with limited risk.  

Additionally, a rise in the dividend is tangible confirmation of the confidence of management in good times ahead.  A cut in the dividend is a red flag indicating trouble on the track.

Not all corporate income need be paid in dividends.  Depending on the industry and how much capital is required to keep the business growing, the appropriate payout may be as much as 80% or as little as 50% of net earnings.  

When studying the dividend payout of a company, calculate both average earnings and average dividends over a 10-year period.  From those two averages you can determine the average payout.  

Earnings fluctuate, but dividends tend to remain stable or,  in the best companies, to rise gradually.


One way of determining if a stock is overvalued or undervalued is to compare its dividend yield with that of similar companies.

• Safety, growth, and other factors being equal, the stock with the highest dividend and the lowest share price is the best bargain.
• As a further check of value, investors should compare the stock's dividend yield with that of the whole stock market dividend yield.

Rationale for Withholding Dividends

If a company isn't paying dividends it should, like Berkshire Hathaway, be doing something profitable with its earnings.  

It is acceptable to withhold dividends for the following reasons:

• To strengthen the company's working capital
• To increase productive capacity
• To reduce debt.

Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons.  It is easier to keep the cash on hand to bail management out of bad times or bad decisions.  Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income.  Consequently, other investors get no income.

Dividends in Jeopardy

Dividends may be put in jeopardy in two ways:

• When a company's earnings per share is less than its dividend per share
• When debt is excessive.

A company's average earnings (over several years) should be sufficient to cover its average dividend.  Though earnings per share can fall below dividend per share from time to time with reserves making up the difference, the condition can persist for only so long.  

A company with substantial earnings rarely becomes insolvent because of bank loans.  But when a company is under pressure, lenders may require a suspension of dividends as a form of financial discipline.

Companies amassing huge cash reserves should use these intelligently

Companies with large cash reserves can use these for the direct benefit of their shareholders by giving dividends or can deploy these to grow their businesses in the future.

Benjamin Graham was critical of amassing huge cash reserves within a business unless the company had a genuine future use for the funds.  

A certain calculable amount of reserves are necessary to:

• finance growth, 
• guard against bad luck or down cycles, 
• cover the settlement of a lawsuit, or 
• eventually replace some important asset. 

Graham argued, there is a limit to that need.  

The purpose of business is to earn profits for its owners.  Owners are entitled to access to profits.  

If earnings are retained, Graham persisted in his argument, they had better be used intelligently.

Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons.  It is easier to keep the cash on hand to bail management out of bad times or bad decisions.  Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income.  Consequently, other investors get no income.

Probably the greatest retainer of earnings of all time is Berkshire Hathaway, which keeps and reinvests all its earnings.  Berkshire's 23% return on shareholder equity is almost double that of American industry, and Buffett says he will continue to hoard earnings so as long as a dollar of retained earnings translates to no less than a dollar of increased shareholder value.  In his case, investors are inclined to let him have his way.


Comment:
It is not uncommon to encounter a company with huge cash reserves in their businesses earning only  fixed deposit interest rates for many years.  Shareholders should play their active role as business owners through raising the relevant questions to the management in the annual general meeting, to use these cash reserves intelligently.

In recent years, strong cash reserves have provoked takeover bids from corporate raiders.  Are they liberators of cash for shareholders or are they destroyers of business, interested only in their own personal enrichment?  These raiders often planned to use cash reserves to help finance their purchase, a tactic that often sucks the strength from a company.  The management may defend the cash reserve was needed for various reasons, for example, the company needed the cash to cover the next down cycle of the manufacturing business.  Corporate raiders love to find and are attracted to a company with huge cash reserves.