Actionable Investor Wisdom: Berkshire Hathaway 2015

As a dedicated attendee of the Berkshire Hathaway meeting, I believe the best part of the Berkshire Hathaway meeting is the numerous ideas and principles that carryover to everyday investors. This year, there were a number of valuable lessons and insightful, under the radar comments that will help investors make more money with much less stress. Below is my summary of the can’t-miss lessons investors should take away from the meeting.

No Single Model to Evaluate Businesses

Warren and Charlie forcefully dispelled the myth that there is a secret formula for buying great companies. Investors try to hunt for shortcuts, but were disappointed to hear that there is no easy solution. Charlie and Warren look for businesses that they can reasonably assess over the next 5 years with honest management teams.

The best comments described how they accept/reject opportunities. Their approach was not to look for positive attributes but to look for negative attributes and eliminate those companies. This path leaves only a small number of investable options. Don’t begin the search by focusing on great attributes, but first look for red flags that can eliminate and narrow down choices.

On Investment Success

One of Charlie’s best one-liners: “If people weren’t so often wrong, we wouldn’t be so rich.” It’s a blunt reminder about what drives success and failure in investing. There is nothing arbitrary about losing money. Warren and Charlie highlighted the unintuitive fact that their success is more about removing mistakes from their decisions than trying to know everything.

Investor’s decisions would be much improved by focusing on avoiding the same mistakes that Berkshire avoids: buying story stocks, trading too much, avoiding leveraged companies, etc. It’s simply easier and more profitable to avoid bad decisions, than it is to make good decisions.

Macro Worries

Charlie mentioned they have almost never turned down a deal due to macro factors. They discussed that what they pay adjusts based on the environment, but they don’t let macro factors override the ability to buy a great business at a fair price. As Charlie said, “When you start making predictions you start thinking you know something.”

Investors need to avoid the habit of fooling themselves. In addition, investors spend an inordinate amount of time thinking and worrying about macro conditions. They are much better served by focusing on dependable companies at attractive prices. I’ve seen an exceptional amount of investor money lost by macro-influenced mistakes.

Ego

Charlie: “Ego makes people do dumb things.” Ego causes several problems to investors, including not admitting mistakes and overconfidence. Warren and Charlie admitted several times on stage that they “don’t know” and had no trouble avoiding this trap. Investors need to stop chasing ego-induced decisions that dominate much of the professional and retail investment markets.

Multitasking

Charlie: “I have to think hard about one thing and the concept of multitasking doesn’t appeal to me.” He described how he doesn’t get how people can manage three things at once. This lesson certainly applies to everyday life, and it’s reassuring that the best investors still focus on one task at a time.

There is a complete misconception that successful investing is based on the hyperactive overloading of your brain. Tune out distractions and focus on the long-term fundamentals underlying opportunities.

Leverage

Both Warren and Charlie were asked about adding financial leverage to the business. They responded that they could have, but they “prefer not to sweat at night.” Berkshire Hathaway has done exceptionally well without additional leverage. Both prefer to sleep well rather than maximize potential returns.

A critical concept to investors who are always trying to juice investment returns. It works for a while, but comes at a significant future cost. The cost is not apparent today but will arise when an inevitable crisis hits. Leverage is often added near market peaks since emotions and confidence are high, leading to catastrophic investment losses when prices fall. Investors can easily build great portfolios without the burden of leverage.

I encourage all investors to attend the Berkshire Hathaway meeting at least once in their lifetime. Written notes can’t describe the clarity, simplicity, and humor in how they communicate their lessons. The meetings have tended to get better each year, as Warren and Charlie seemed to have let their guard down and enjoy delivering blunt and honest responses. Contact me for additional notes and advice from the meeting or other Berkshire-related questions.

Are You One of Jamie Dimon’s Lazy Shareholders?

JP Morgan’s CEO Jamie Dimon was spot on after pointing out the laziness of shareholders who blindly followed consultants Glass Lewis and ISS by voting against Dimon’s pay package.

Here’s Dimon via USA Today:          

“God knows how any of you can place your vote based on ISS or Glass Lewis, If you do that, you are just irresponsible, I'm sorry. And you probably aren't a very good investor, either. And you do. Believe me. I know some of you here do it because you’re lazy."

Now a few of ISS and Glass Lewis’s claims have some merit. JPM’s compensation disclosure is far from perfect, which unfortunately is par for the course in the proxy world.

The general level of disclosure in public company proxies is lacking. Bonuses are often based on vague goals, unverifiable metrics, or “adjusted” figures that usually skew to the benefit of management. It’s impossible for any diligent shareholder to have a complete picture of exactly how a board of directors rewards management.

However, the really appalling issue, as Dimon highlighted, is the widespread laziness of investors who are unable or unwilling to read a proxy and decide for themselves.

It’s a concerning trend that investors (the actual business owners) outsource the responsibility of proxy evaluation. Understanding the motivations and incentives of management and board behavior is a critical driver of investment success. Even a ballpark analysis of comp/bonus trends reveals egregious actions and disturbing board behavior. Missing these red flags has destroyed massive amounts of shareholder value.

Proxies are not a tough read for sophisticated investors. Yet some of the biggest (and supposedly sophisticated) investors can’t manage the ability to spend time reading the proxy. It boils down to an abdication of responsibility. It’s now the norm for investors outsource their thinking, creating a population of helpless investors who can’t form an independent opinion.

By deflecting responsibility towards sell-side research, ratings agencies, and corporate guidance, investors fall for the temptation of intellectual shortcuts rather than commit to hard thinking.

The overwhelming propensity of investors is to follow the herd and abandon any ability to think for themselves. The constant reliance on outside help lures investors into confusing information gathering with genuine analysis. The proxy issue is a symptom of a much larger problem: investors who have bigger and more confident opinions on investments they know less and less about. Institutional investors need to commit to full, independent, and thorough due diligence that is respectfully due to their clients.

A Guide To Profit From Market Panics

3 practical steps to profit from market volatility

Most investors hate volatile markets. The best investors exploit volatile markets. Where do you fall? If you witnessed the markets on Aug 24th, you saw extreme price swings not seen since the financial crisis. How is it possible to see huge, high-quality companies trade down 20% and then finish up on the day? The culprits are the massive amount of algorithmic trading and momentum driven investors who try to “get out” before other investors and exacerbate price pressure by adding to the selling. So how can an investor, with little knowledge of the market, end up on the profitable side of market volatility?

Have cash ready to deploy

Nothing is better for capitalizing on volatility than cash reserves ready to be put to work. Not only does cash hold its value during the turmoil, investors don’t have to contemplate what to sell. What’s a good cash level to hold? The best cash amount is a residual level based on the valuations of the equity and fixed income securities in your portfolio and opportunities in the market. 5-20% of your portfolio is a good guide, with more cash as markets get more expensive. Although investors hate getting paid nothing on cash, capturing excess returns during market distress more than compensates for the non-existent yields.

Have a list of quality securities ready to buy 

In times of panic, investors don’t have time to thoroughly research potential investments. The news flow and market movements causes focus to disappear. The solution is to have a portfolio of companies or securities ready to purchase at the right price. All that is missing is a better price, which will occur when volatility strikes. By having this list ready, investors can quickly decide and execute orders without any doubts about the companies they are buying. Best of all, high quality companies get pulled down with the rest of the market. No need to chase highly leveraged, near bankrupt companies. As seen on Aug 24th, companies like GE and Pepsi were pushed down over 20%.

Patience

The biggest problem for investors is the desire to be fully invested at all times because the pain of “doing nothing” is too great. Add in the fact that cash pays nothing today, and you get investors chasing yield all over the market-often in sectors and companies they don’t understand. Great investors have an inordinate amount of patience and conviction in their methodology and knowledge of financial markets. They know crises are hard to predict, but happen in a somewhat regular pattern. Of all three ideas, patience is the most importance. Without it, great ideas and concepts will never be put to work at the right time.

I’ve consistently heard clients talk about market volatility and extreme price moves as if it’s a huge negative. It is if you are unprepared. Great investors see dislocations as an opportunity. Investors have been indoctrinated to worry and pay close attention to short-term volatility, instead of focusing on long-term business returns. Smart investors hope for days like Aug 24th, when unintelligent computer trading and irrational investors rush for the market exit. Those who view volatility as a huge risk instead of opportunity have seriously handicapped their investment portfolio.

Investing By Subtraction

"What does you in is not failure to apply some high level, intricate, complicated technique. It’s overlooking the basics. Not keeping your eye on the ball.”1 - Eliezer Yudkowsky

When investors must confront unexpected problems, their first reaction is to consider new investments, strategies, or funds to deal with the pressing issues. The typical assumption is that something must be missing and by finding that magical investment addition, the new portfolio will be once again be fortified against future problems.

This thought process leads to big problems. Portfolio performance is often handicapped by adding new investments. It’s a human flaw to think that every problem is solved by adding something. It’s often found in medicine (if you are sick add medication), regulation (if there is a problem, add more laws), education (if student outcomes are poor add more testing and requirements).

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”       - Charlie Munger

People fail to consider that problem removal should be the first solution. Investment failures often originate from within! Portfolios often improve by subtractinginvestments, funds, or strategies, not by adding them. Investor allocations have become so heavy with funds layered upon funds, even a sophisticated investor is powerless to make intelligent decisions. Complexity is not sophisticated, simplification is sophisticated.

Less is more: paradox of choice. Large selection leads to inner paralysis. The more choice you have, the more unsure and therefore dissatisfied you are afterward. In this age of unlimited variety, good enough is the new optimum. Learn to love a good choice. – Rolf Dobelli, The Art of Thinking Clearly

The Art of Investing is Knowing What to Remove

Because investors have been taught that it’s useless to think about investment fundamentals and price vs. value, they resort to a shotgun approach of funds and strategies. They succumb to the myth that owning a cluster of random products is diversified and that alone will protect themselves against bad outcomes. Unfortunately, this assumption fails in most instances.

“Sophisticated or complex methods do not necessarily provide more accurate forecasts than simpler ones.”2 – Robin Hogarth

High Correlations

Investors fail to realize their exposure to tight correlations. Most portfolios have tremendous overlap in crowded trades because investors choose to be willfully ignorant of the investments they own.

Labels and Categories are Misleading

Investors rely on superficial categories that fail to explain true exposures. A European company may have 80% of its sales and profits from outside the Eurozone, yet it would be considered 100% European exposure. It’s a common shortcut among investors and advisors because they are too lazy to examine the underlying investments. Labels such as low-risk, liquid, and stable are widely used but often fail to reflect the underlying risks.

Lack of Insight and Understanding

Finally, when a crisis or financial panic ensues, investors have no idea what kind of quality they own. Or know good managers vs. bad managers. Or what investments are undervalued vs. going to zero. And so on…

“In this age of information abundance and overload, those who get ahead will be the folks who figure out what to leave out, so they can concentrate on what’sreally important to them. Nothing is more paralyzing than the idea of limitless possibilities. The idea that you can do anything is absolutely terrifying.”- Austin Kleon, Steal Like an Artist

Investors fool themselves into a false sense of comfort during calm times, only to be exposed and their confidence decimated when the markets get ugly. By reducing investment complexity down to a manageable level, investors will actually understand their true risk exposures. In a world of multi-tasking and unnecessary complexity, simplification is often the antidote to excessive choice and complications. Investors have been taught that diversification works, while making no distinction between the triumph of intelligent diversification and the failure of mindless diversification.

5 Ways Bruce Lee Can Make You A Better Investor

A number of worldly subjects enhance investing wisdom, but the lessons and histories of martial arts provide exceptional value for investors. One of the most famous martial artists, Bruce Lee, was an accomplished author and teacher in addition to his devastating martial art skills. His book, the Tao of Jeet Kune Do, is necessary reading for martial artists and investors. The foundation of the martial arts share many attributes with investing. By taking time to study Lee, you will find an intriguing and effective way to protect your investment portfolio.

I have realized that most important lessons come from outside the “core” disciplines of investing or finance. In fact, I can’t think of many great ideas that originate from the core fields. Instead, subjects such as philosophy, psychology, war/military, and the hard sciences provide real investing lessons. However, only those investors who look introspectively at their mindset and the nature of investing will apply these principles at the right moments.

There are many lessons from Bruce Lee, but the following five ideas will give you an introduction to the parallels between martial arts and investing.

Insight #1

While being trained, the student is to be active and dynamic in every way. But in actual combat, his mind must be calm and not disturbed at all. He must feel as if nothing critical is happening. When he advances, his steps should be light and secure, his eyes fixed and glaring insanely at the enemy. His behavior should not be in any way different from his everyday behavior; no change taking place in his expression, nothing betraying the fact that he engaged in mortal combat. –Bruce Lee

During calm times, you should run through worst-case scenarios, alternate options, and build plans to deal with the uncertain future. Complacent markets provide the time to be “active and dynamic” when running through all the possible ways things can go wrong. It’s a perfect time to simulate all the possible “what if” scenarios that could occur. Rigorous investment preparation starts when things are peaceful, not during crises.

When a crisis actually occurs, you must heed Bruce Lee’s advice and act as if nothing critical is happening. Use these moments to execute the preconceived plan, without manic-depressive behaviors that occupy most investors. If you find yourself desperate to create a plan during a panic, you are not only late but likely to make emotionally charged and disastrous decisions.

For example, if an outside observer saw you during a market panic, would they be able to tell if there is a crisis occurring? Over-reacting and dramatizing market downturns is not a badge of honor – it’s a sign of poor preparation and lack of emotional control. Prepare for downturns when times are calm and the outlook is positive, because you need to keep your head for the rough times that are likely to follow.

Insight #2

Instead of facing combat in its suchness, then, most systems of martial art accumulate a “fancy mess” that distorts and cramps their practitioners and distracts them from the actual reality of combat, which is simple and direct. Instead of going immediately to the heart of things, flowery forms (organized despair) and artificial techniques are ritualistically practiced to simulate actual combat. Thus, instead of “being” in combat, these practitioners are “doing” something “about” combat. –Bruce Lee

In investing’s simplest form, you give up cash today with some uncertain but expected return of cash in the future. That’s it. For some investments, the cash flows my occur regularly and perhaps somewhat predictably; for others it may be a decade before the cash flow received exceeds the cash invested. Neither option is necessarily good or bad – it all depends on what you pay for those cash flows and the riskiness of the cash flows.

Problems begin with investor’s unstable attitudes and poor understanding of the market. Investing has become so complicated and convoluted – constant monitoring of the U.S. and foreign news flow, Federal Reserve actions, Greece problems, short-term volatility, market volume analysis, trend following, technical analysis, earnings estimates, and so on. None of these factors provide any real help for the investor.

What Bruce Lee called a “fancy mess” – distortions that distracts practitioners from the actual reality of combat, is the same problem facing investors: distractions and illusions about what really drives the actual reality of investing.

Successful investing strips away the noise and distractions of the financial industry and redirects focus toward the core principles of what are you paying for a set of cash flows and the riskiness of those cash flows. Everything else is largely a distraction – built in some way to make you act contrary to your nature.

As Bruce Lee stated, “Jeet Kune Do [Lee’s Martial Art] does not beat around the bush. It does not take winding detours. It follows a straight line to the objective. Simplicity is the shortest distance between two points.”

Avoid investing’s “winding detours” - excessive trading, emotional turmoil, fruitless agonizing over noise, pointless ruminations, etc.

To paraphrase Bruce Lee, most investors are not investing, they are “doing” something “about” investing. As Lee mentioned, they have “a blind devotion to the systematic uselessness of practicing routines or stunts that lead nowhere.” So replace superficial activity with real work on the fundamentals of the investment. Make this clear in your mind– are you really investing, or are you dancing around the edges of investing?

Insight #3

Stylists, instead of looking directly into the fact, cling to forms (theories) and go on entangling themselves further and further, finally putting themselves into an inextricable snare. – Bruce Lee

Investors’ greatest problems arise when they are convinced they “know” what’s going on and fail to adjust beliefs when presented with new facts. No one is immune to this problem. Ironically, sophisticated and intelligent investors have a greater chance of falling for these biases.

Investors have a hard time accepting the failure of their prior beliefs and theories, especially those held for a long time or those that were developed internally. Ego protection is a problem in martial arts and it’s a problem in investing - it’s a problem for life in general. The unwillingness to kill your sacred beliefs leads to disaster.

Bruce Lee stated, “As martial artists continue to pursue a path of blind acceptance and unwavering confidence, they trap themselves in an ‘inextricable snare’.”

Investors often have the same mindset. I regularly witness bad beliefs. Some investors fall in love with certain asset classes (gold, T-bills, stocks) or pet theories (the U.S. dollar is worthless, capitalism is evil).The problem isn’t that they hold incorrect views, it’s their absolute conviction that they are right that is the major problem.

Insight #4

“Understanding requires not just a moment of perception, but a continuous awareness, a continuous state of inquiry without conclusion.”- Bruce Lee

Premature closure of one’s mind and acceptance of things as true/false is a handicap – not a blessing. Since people’s minds are resolved to remove ambiguity, we create stories to make sense of this world. Your ultimate desire to have mental closure over their investments is a short-term emotional fix that will lead to longer term damage. You must accept that the world is uncertain and highly unpredictable – your beliefs today are likely to be proven wrong in the future. But this should not be viewed as a negative – it’s simply reality and part of our human nature. Acceptance of this fact leads to a tremendous amount of peace and contentment when you abandon the belief that you have to know everything. Instead, you remain in a “continuous state of inquiry” – always ready to update your beliefs and never hesitant to admit your errors.

Insight #5

The second-hand artist blindly follows his sensei or sifu accepts his pattern. As a result, his action and, more importantly, his thinking become mechanical. His responses become automatic, according to set patterns, making him narrow and limited. – Bruce Lee

One of the most influential investors is Charlie Munger. His ideas surrounding mental models has been a beacon of light in an industry polluted with bad ideas and self-serving activities. Bruce Lee also reinforces the Munger’s warning on the limitations of blindly following one ideology, theory, or pattern.

Investors, like martial artists, need to continually expand their circle of competence and actively seek out new theories that disprove their current beliefs. In combat, failure to embrace better methods leads to death. In investing, failure to embrace better methods of analysis and knowledge lead to portfolio destruction. Investors who resolve that they “know enough” and don’t need to learn will succumb to obsolescence and decay.

Summary

1. Have a contrarian mindset - skeptical/questioning during bull markets; calm and decisive during bear markets.
2. Focus on investing’s core principles – stay away from superficial and “flowery” activity.
3. Avoid investing dogma – continuous challenging of your beliefs and desire to seek disconfirming evidence.
4. Accept the never-ending learning process with investing – you will never get to 100% certainty and comfort.

The Resilient Investor: 10 Habits of Mentally Tough Investors

Great investors develop mental toughness through proper mindset and habits. These are 10 guiding principles to condition the mind for investment success. 

1. They Don’t Worry About Issues Outside Their Control 

Much of investing and life is outside your control. Wise investors learn to recognize what they can control and what they can’t. The things that can’t be controlled are ignored. 

2. They Don’t Obsess Over Volatility

It’s a fact: every day markets go up and down. Trying to obsessively negate volatility usually worsens it. The value of every asset you own, including your own human capital, moves up and down every day. Only you don’t see it, so you normally don’t worry about it. Do the same for random market fluctuations. 

3. They Don’t Judge Success by Short-Term Results

Great things take time – going through medical school, becoming a professional athlete, or mastering chess. Investing is no different. The quick wins in investing are usually random and short-lived. Luck rules in the short term, process rules in the long term.

4. They Don’t Blindly Follow Popular Wisdom

Great ideas develop from an independent and thoughtful analysis – and may or may not conform to the crowd. While the crowd is often right, it spectacularly fails when you need it the most. The crowd is not the judge of a good vs. bad decision. Facts and reason are the judge.

5. They Don’t Abandon Their Strategy

All strategies temporarily fail at some time. Even the winningest coaches and athletes have losing seasons and rough periods. Thoughtful investing plans go through the same ups and downs. Investors constantly chase what is working today, only to get in at the peak and bail at the bottom.

6. They Don’t Feel the Market Owes Them Anything

Whatever insight or idea you believe is the next big thing is not as good as you think it is. At best it’s probably mediocre and at worst it’s a disaster. The market does not exist to guarantee a happy retirement. It doesn’t always work out. It doesn’t care how hard you work. Investing success is dependent on accepting that you are entirely responsible for your success or failure.

7. They Don’t Compare Results to Other Investors

There will always be investors richer than you so get over it. When most investors talk about their big winners they are either lying or selectively forgetting about all losers they’ve had. Comparisons to others only inflame ego and emotionally destructive decisions.

8. They Don’t Have Absolute Confidence

Great investors have an understated confidence: confident in their long-term process, humble in their short-term forecasts and market predictions.

9. They Don’t Stress Over Continuously Changing Conditions

As the saying goes, the only constant is change. Great investors embrace unpredictability, amateur investors are paralyzed by it. Success comes not from anticipating change, but adapting to change.

10. They Don’t Live in the Past

Of course the past is obvious in hindsight. Great investors accept their mistakes, omissions, and failures. The past is a sunk cost. All that matters is you learn from the past and then move forward. Focus on today and your plan going forward.

How Investors Should Navigate the Non-GAAP Earnings Confusion

There has been a recent surge in the controversy surrounding non-GAAP earnings. While the debate continues on the proper use of non-GAAP metrics, investors can’t expect outside help and need to take control of their own understanding and interpretation of non-GAAP adjustments. Investors can’t rely on “guidance” from companies or regulators.

The problems run deeper than the GAAP vs. non-GAAP debate. The actual problem is investor’s lack of commitment to a thorough, fundamental understanding of the company. Without adequate understanding, investors will never be able to tell non-GAAP truth from fiction.  There is never a hard and fast set of rules to determine the validity of GAAP exceptions. Like any set of standards, there are exceptions and situations that don’t fit the model. The extreme doubters of GAAP or non-GAAP miss the point: no system is perfect. It’s the investor’s responsibility to determine the best representation of economic reality. Blind devotion to SEC guidance, FASB standards, or company management is a dangerous path.

This article will help guide investors into asking the right questions involving non-GAAP metrics. This advice cannot replace actual analysis, but will give investors a better framework for thinking about these issues.

3 Rules to Remember

1. Always reconcile each adjustment using the GAAP to non-GAAP reconciliation

Regardless of a company’s adjustments, investors should always reconcile to GAAP earnings. This figure, required by the SEC, allows investors to see a clean breakdown of non-GAAP adjustments. Unfortunately, that’s the easy part. The hard part is understanding what items are legitimate and which are not. Analyze every line item on an individual basis to determine its validity. One or two adjustments account for most of the deviations from GAAP. Unfortunately, there are no clear cut answers on which expenses are legitimate and which are egregious. Materiality depends on the company and industry dynamics. The only way to know is to dive deep into the business and financial statements.

1. Pull up and compare reconciliations for the past 5 years

Don’t limit your analysis to the current year. Compare what “recurring”, non-recurring expenses have been consistent over many years. Repeated appearance is clear evidence that these charges are recurring in nature, even as management argues “one-off” or too volatile/unpredictable. In fact, a quick glance at successive reconciliations should show no yearly correlations between line items. Also, understand that the absence of repeated charges doesn’t mean one-time charges are legitimate. Evaluate every adjustment on its own merit.

1. Match the reconciliation to the business model

Serial acquirers should not have their acquisition-related charges excluded. Acquisitions are part of their strategy and the associated expenses are legitimate and recurring. Major problems develop when analysts and management teams guide to high top and bottom line growth without the necessary acquisition spending to support that growth. It’s unfortunate that overconfident/aggressive companies and investors permit this mismatch to make valuation, free cash flow, and EPS more impressive. Some quick investor math on the implied ROICs would show an unsustainable level of ROIC into the future.

A Cheat Sheet for Common Adjustments

I’ve tried to make the case that the legitimacy of non-GAAP measures is dependent on the individual company, the business model, the competitive environment, the management team, etc. There is no one-size-fits-all approach. While that will bother investors who want an easy answer, it’s reality. For those investors who want a quick guide to thinking and interpreting non-GAAP measures, I have compiled a quick guide of questions to ask on each topic.

Reorganization/Transition/Restructuring Expenses

Look for a continued history of these charges. The “serial restructuring” company should be obvious by the year after year disclosure of the same items. Again, the investor’s familiarity with the company and management team will drive the analysis. Restructuring charges were expenses that should have been realized all along in the past. Instead, companies get to kitchen sink these expenses as one-time items. Investors should normalize past profitability by blending the charge through past income statements to get a better gauge of historic profitability. This will lead investors to a better understanding of economic profitability, rather than just ignoring the charges.

Investors need to be realistic in their margin assumptions going forward. While most investors and management teams love to project a never-ending upward trajectory of margin expansion, reality and competition will dictate otherwise. Today, assume that the company you are looking at will likely have their “restructuring moment” sometime in the future, so adjust your understanding and valuation today to avoid getting blindsided in the future.

Options Expense

Why the options debate continues is beyond me. When you give away a claim or an option on company’s equity, that’s an expense. The argument for comparability has no merit in my mind. If one company is giving away more equity than another, the analysis/valuation should reflect that. Ignoring options expense only drives understanding further away from the truth. Because analysts want their models to be nice and clean, it leads to analysis that is borderline worthless.

Consider this example: if company A is paying its employee’s salaries at 2x the level of company B, should analysts back out the “extra” salary for comparability sake? I don’t think so. If a company chooses to pay more or issue more options, reflect that in their numbers.

Foreign Exchange

Companies with significant foreign operations (over 30% of revenue) should treat F/X movements as natural, recurring expenses/benefits. I understand the desire for comparability, but simply ignoring these movements is ignoring reality. Instead, use the company’s disclosures to set a framework for understanding the economic exposure. Given the rapid devaluation in Venezuela, Brazil, Russia, etc, it’s paramount to understand that these losses are more often than not real, economic expense, not just some accounting fiction.

In general, ignoring volatile f/x movements because they don’t model well will just create more unpleasant surprises for the investors in the future. What matters for investors are the long-term economic results, and if f/x movements are continually part of those results, then include them.

Amortization of Intangible Assets– Customer Relationships/Lists, Patents/Technology, Brands/Trademarks

Amortization of Intangibles is often a large component of non-GAAP earnings and the key is to separate and evaluate each intangible.

Patents and technology intangibles are typically always a true expense. The value of these assets declines as competing technologies render the current assets obsolete over time. Often, in a much quicker timeframe than the actual amortization period. Exercise extreme caution if a company claims their technology assets don’t depreciate or need reinvestment.

On the flipside, brands are almost always indefinite and don’t need separate reinvestment as ongoing marketing expense and normal reinvestment will support the intangible value into the future.

The same is true with customer relationships. A company will never have to have an annual budget item for customer relationships to maintain that asset. There is one caveat to ignoring brand and customer intangibles expense. Investors must ensure the business is adequately reinvesting in itself to make the case that brand and customer intangibles don’t need expensing. If the business is underinvesting, the intangibles will lose their value.

Debt Tender/Retirement

Usually, debt retirement is a one-time event since I rarely see consistent debt retirement in material amounts. The key is to look into the future and try to anticipate these costs in advance and work them into your analysis. If it appears that a debt exchange or swap will have material consequences, it’s better to know about it before than after. Again, not a meaningful issue.

Litigation Expense

Depends on the litigious nature of the industry and legal history of the company. For example, constant litigation has hammered big banks since the financial crises. Are these expenses recurring in nature? In banking, I believe they are recurring, but not to the extent of the past five years. Investors would be wise to assume some normal, ongoing expense into the future. The seeds of the next legal war are being planted today, so reserve for them today.

In addition, some companies have one-time, but massive penalties. BP comes to mind. How should investors handle that expense? I would again advise incorporating some reserve expense for future disasters in future cash flows since energy E&P is an unpredictable and volatile endeavor. Of course, this is not an exact science so it will be a subjective guess. But it’s more preferable than ignoring these realities and assuming the good times will last.

Asset/Goodwill Impairments

There are two lines of thinking I use as I approach an impairment situation. First, an impairment is nothing more than the final admission and confirmation that a company overpaid on an asset or acquisition in the past. It’s simple. They paid too much. Companies will argue that any specific impairment charge will not continue in the future. I agree with them. However, the key is that a company with repeated asset write-downs will likely continue making bad acquisitions and will suffer future impairments. Of course, no company will ever admit to that.

Depreciation

In 99.9% of cases, depreciation is a real expense.  If a company is reconciling to EBITDA, that’s fine. The issues with EBITDA are another topic. But if a company is adding back depreciation expense to net income, that’s a red flag. The common exception is excess depreciation on assets that have longer useful lives than GAAP dictates. This is rare in my experience. However, company managements will often claim longer useful lives than normal, knowing that the future costs and reinvestment won’t hit until the future. MLP’s are a great example of trying to push the belief that maintenance capex and associated depreciation is much lower than GAAP suggests. There may be some exceptions, but that’s usually pure marketing spin.

Acquisition-related costs

Look over the past 5 to 10 years and see if the company is a serial acquirer. If they are, include acquisition costs in earnings. It’s a core part of their strategy, and the costs need to be counted. Check to see if it is a “one-off” acquisition that was not made in place of real capex. Acquisitions are often another form of capex needed by companies to remain competitive; however, most analysts treat them as incremental, instead of replacement investment. How do you tell the difference? Look at the competitive nature of the industry and barriers to entry. Most companies need to continually reinvest just to stay in place. If this is the case, an acquisition is likely a “replacement” style expenditure. In addition, if the growth and earnings expectations of the company is dependent on future acquisitions, the future costs need to be included in company valuation.

Gain/Loss on Sale of Assets

This is one charge that is more likely to be non-recurring since so few companies consistently buy and sell assets on a regular basis. Most of these adjustments have less impact than some other big adjustments, and as long as companies are treating both gains and losses in the same manner, there isn’t an issue.

Severance Charges

Just like restructuring charges, these are more recurring in nature than one-off. Many companies I analyze follow a predictable pattern of overexpansion during the good times followed by restructuring/realignment/right-sizing charges in the downtime. So when times are good, especially for cyclical companies like mining and energy, understand those results are likely biased too high. Don’t believe the “this is permanently higher” marketing. Investors should focus on a “normalized” earnings approach, as cyclical companies like mining, agriculture, and energy always correct.

Conclusion

Non-GAAP metrics are useful because they enable better fundamental understanding of the core business. It’s the investor’s job to figure out what is legitimate vs. non-legitimate. It’s not the fault of GAAP, FASB, the SEC, or any other regulatory body. They are doing the best they can to create principles and rules to fit all companies. Quite a tough task. The incessant bashing on the faults of GAAP is misplaced; it’s just the reality of trying to fit diverse companies into one system. Non-GAAP earnings are not bad, and neither are most managements. What’s bad is investor’s blind acceptance of other’s ideas without doing the necessary work themselves.