Jason Zweig, in an introduction to his 2003 revised edition of Benjamin Graham’s “The Intelligent Investor,” summarizes Graham’s core principles one of which is: “A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.” This, unfortunate sound bite is often misconstrued. It calls to attention the distinction between the value of a real-world business and the here-and-now price of its publicly traded stock. It does not counsel investors in the public stock market to ignore their status as such and analyze the situation as if they really and truly own the business. (Note: I’ve been thinking for a long time about posting on this topic, but my doing so now is inspired by objections expressed by a PR person working on behalf of Kimco (KIM), a REIT I recently panned.)
What Do You Own? The Formalities
Let’s work up to this by starting with the basics: Every business is owned by somebody.
The simplest approach is the sole proprietorship, where the business is owned by the founder or, perhaps, somebody who bought (or inherited) from the founder. The next level up is partnership, which facilitates larger enterprises by having more than one contributor of equity capital and, (hopefully) the benefits of diversification beyond a single controlling-decision maker. Neither of these organization forms would, however, be able to support our modern market economy or anything close to it. For that, we need scale, continuity and liquidity; the corporation, which is like a partnership on steroids. Even a tiny one- or two-person corporation is a step up from a partnership since the corporation is a separate entity, an intangible person so to speak, which means it need not experience an ownership crisis any time an owner wants or needs to leave the business or a new one wants in. Shares are sold and the business continues.
We in the stock market are dealing with the biggest variety of corporation, the publicly held corporation, which often has thousands, hundreds of thousands or maybe millions of owners/shareholders who contributed capital directly (through the IPO) or bought from others who did.
This facilitates the capital formation, continuity and liquidity our modern economy needs. But it does something else. It separates owners from the business.
- The rights of a public shareholder are very limited when it comes to control (they can vote for or against directors, but absent exceptional circumstances, nothing more; directors hire officers who hire other employees, and officers and employees are ultimately answerable to directors not shareholders).
- There are also extreme limitations when it comes to even getting information about the business. Shareholders are constrained by what the companies disclose, and disclosure is very regulated in terms of what gets revealed, when it gets revealed, and to whom it gets revealed (to everybody at the same time or nobody.
- The rights to share in profits (get dividends) are strong in the sense that all shareholders are equal in this regard, but weak in that public shareholders have no control, or even formal input into decisions as to wether or to what extent profits will be paid as dividends or reinvested back into the same business or even into completely different ventures.
In terms of legal formalities, the Graham quip is of course, absolutely correct. Shareholders in the public markets (the audience he and other teachers, writers and commentators address) do have ownership interests in actual businesses.
But as every lawyer and law student has known for centuries, when the form differs from substance, substance wins.
What Do You REALLY Own? The Substance
In substance, shareholders in the public markets are not owners of partial interests in businesses. If you do not have unlimited access to information and some measure of meaningful control, you are not an owner in the way regular people, non lawyers, think of the word.
- To be a business owner in substance as well as in form, one would have to own a sole proprietorship.
- To be partial business owner in substance as well as form, one would have to:
- Participate in a partnership (and not a mega-MLP that feels like a public corporation, but a true partnership (where you know your partners, their families, etc.) or
- Participate in a closely-held corporation, which has just a few shareholders and is more like a partnership with extra paperwork than the sort of corporation whose stock you’d trade on NYSE or NASD.
There’s A Lot To The Tickers/Electronic Blips We Own
The notion that we buy tickers/electronic blips rather than part ownership of real businesses sounds off-putting, or even offensive, at first glance because it seems to mean we own nothing worthwhile. That is not so.
When we own a thing, we own not just its label but also its characteristics. When we own a house for example, we also own the rooms, the lot at the specific location, and so forth, and houses can differ quite a bit based on their respective characteristics. Similarly, our ownership of a car can be described (and valued) in terms of its features.
The same holds true if we own shares identified by the ticker XYZ.
Our ownership includes all the characteristics associated with the XYZ, including everything in the financial statements filed by the company and everything we know about the company form other sources, such as verbal content supplied by the company or things we discover through other sources. Such ownership interests are valued by the market’s assessment of their worth. Earnings of $1.40 per share that are expected to grow 11% annually may be valued very differently from earnings of $2.20 per share that are forecasted to shrink at an annual rate of 5%. Characteristics that impact the stability of the earnings stream (that balance sheet, industry and business characteristics, and so forth) and the credibility of expectations we form about the future are likewise relevant to valuing XYZ.
This, by the way, is an important reason why rules-based investing (screening, ranking) appeals to me as much as it does. It focuses all of my efforts on information that is actually knowable and which is intricately intertwined with the substance of what I actually own. That’s why I shed no tears for managers who bemoan Wall Street’s excess attention to numbers (notwithstanding that I often differ with Wall Street as to which numbers are most critical and how to interpret them). If companies want public shareholders to appreciate the full scope of what they do and what they are, then they should lobby for rules that require much broader disclosure and shareholder control. (As if! They already whine about what they have to do now and are more likely to argue if anything for further restrictions against public shareholders.)
Anyway, the type of ownership we in the public markets have does not give any of us the right to tell Microsoft (MSFT) how it should approach hardware, tell Netflix (NFLX) what new shows to develop, tell JetBlue (JBLU) how much it should charge for travel, tell Walmart (WMT) how much of a dividend it should pay, tell GE (GE) how it should restructure its business portfolio, etc. Nor does it give any of us the right to call anyone in management and ask questions that would require disclosure of information not simultaneously given to everybody else unless one wants residency in the ultimate public housing system (a Federal prison)
We have the right to vote in shareholder elections, and even run for the board. But seriously, I mean really, I expect I don’t have to explain how (aside from rare proxy fights) trivial this in the ordinary course of affairs in the real world.
We also have the right to exit any company in which we’re not happy be selling shares with a few mouse clicks. But this most certainly does not support a notion that we should be seeing our investments as part ownership of businesses. The put-up-with-it-or-sell situation is not at all consistent with bona fide substantive ownership.
Therefore, the ability to evaluate publicly available information to develop reasonable assumptions about value isn’t just a thing. To shareholders in the public markets, its everything. It’s the only thing.
What’s Good, What’s Bad
From the above, and from the obvious reality that we invest based on expectations about the future, it follows that:
- Anything that helps shareholders develop reasonable expectations about the future and what a stock is worth is good.
- Anything that interferes with the ability to develop credible assumptions along those lines is bad.
The industry in which the company operates is irrelevant (a well valued stock in a dog of an industry is better for shareholders than an overhyped overpriced stock in the best industry). The quality of a company’s goods and services is irrelevant (again, I might do better buying well valued shares in a downscale outfit than overpriced shares of a top-of-the-market supplier).
Management, per se, is irrelevant but for a less obvious reason. If we lived in a world where we could competently evaluate management, then yes, this would be crucial since it can be expected to have a huge influence on the future. But we do not live in this world. Our opportunities to get to know management are at best minimal since we only interact with these people through conference calls or highly regimented (by legal, by public relations, and by investor relations filters). And even this tells us nothing about lower level or mid level rank and file folks among which are often individuals far more critical to make-or break than anyone whose names we know.
This does not mean you should never invest in hard-to-forecast situations.
The reward-risk continuum is wide and there’s room for all kinds of variations. What’s crucial, though, is that your expectations and goals be aligned with the stock’s characteristics, not just the information but also the extent to which the situation lends itself to forecasting, the extent to which the information can be evaluated and used as a basis for projecting forward. If you buy into a hard-to-evaluate situation, you are taking more risk and should be able to anticipate a higher return. If, however, you buy into a hard-to-forecast situation without realizing the nature of the risks you’re taking, that would be a problem.
Past Performance and Future Outcomes
We always start with the proposition that past performance does not assure future outcomes. This isn’t just legal boilerplate used by regulators and professionals whose conduct is subject to their jurisdiction. It’s the cold hard truth. In its most literal sense, it would suggest that all financial data (which, obviously, comes from the past) is useless and that when we invest, when we buy shares expecting returns to be achieved in the future, w’re just gambling.
Reality is not so stark.
A growing healthcare services company does not become or take on the financial characteristics of a deteriorating steelmaker overnight. Bold changes can happen, but they take time and the process of transition is typically visible, if not on day one that usually at some point thereafter. As a result, we can study data, which necessarily lives in the past, trends in the data, external business and economic factors, and blend them with common sense and come up with plausible assumptions about the direction in which things are headed. This is a combination of science and art, with a lot more art than many realize.
The Art of Forecasting
Here’s where it gets dicey and here’s where the Graham-sourced adage that a stock is ownership of a business falters.
In fact, that interpretation of Graham’s phrase would put him badly at odds with a major portion of the Graham & Dodd classic he co-authored. Large swaths of that text explain the importance of and discuss approaches to picking and choosing among the data and re-stating where need be, to correct instances in which going strictly by the book causes our analysis to be distorted by information that is not likely to characterize the future. This is the dry (very dry) voluminous less folksy part of the book that is hardly ever quoted in the guru-sphere. But it is the meat of the work. (See the Appendix below for some Graham & Dodd quote I find far more substantive than shallow tidbits that find their way into public discourse nowadays.)
A major aspect of cleaning the data, so to speak, is recognizing and eliminating non-recurring items. We also need to cleanse our analysis of the impact of aberrant time periods; Graham & Dodd demonstrated by analyzing trends after excluding the nightmare year 1932 and its why I’m leery of growth states that start or end in 2008. But there’s a lot more to it than this. If you read commentary accompanying earnings reports or listen to conference calls, you’ll encounter a lot of conversation that aims to ferret out unusual, and likely non-repeating, factors that influenced the standard numbers.
The effort to inquire even into sustainability/predictability reaches into the financial statements themselves and the data derived from them. Fro example, it’s why non-cash items such as depreciation and amortization are used. Depreciation is scorned upon by many under the “cash is king” mantra, but actually, its highly useful. If a company with $100 in annual revenue and $10 in annual profit spends $500 to build a factory that will produce a lot and generate considerable new profits for the next 20 years, it serves nobody’s interest to dismiss the company as a loser because it loses $490 million in the year it builds the factory, nor would an investor be well served to get giddy and buy at a stratospheric P/E the next year because profit supposedly soared from, say, minus $490 to plus $20. Many accounting rules are designed to help investors by trying to match expenditures against the revenues with which they are associated, even if spending occurs in one period but the associated revenues are spread over many periods. It’s not perfect because we can’t achieve perfection in projecting the size or length of future revenue stream. But reasonable assumptions serve us far better than sticking our heads in the ground and not even trying.
But however desirable such accruals are, there is a point at which enough is enough. Because accruals necessarily involve management judgment, we have to be alert to signs they may be excessive; the possibility that they might be used to make the situation look good rather than to objectively cope with assumptions about the business. This is the essence of earnings quality. Poor quality earnings are earnings that may be impacted by too many accruals. The tug of war is between economic sensibility and excess fanciness. Whichever way we lean in a particular case, we (investors and analysts) do as we do in order to get better visibility as to the probable future. Going back to depreciation, yes, it’s a useful and informative non-cash item .But we can’t ever ignore its economic meaning and although depreciation itself involves no cash, there should be more-or-less equivalent cash expenditures that carry a different label, and if not, that gives rise to hard questions. So if, for example, a company is citing depreciation as a reason why its dividend can substantially exceed earnings, then we have to wonder what other spending needs are being left unmet.
Coping With Complexity
Some sets of financials are more complex than others. There are many who would be happy to make you feel small and inadequate, if you struggle with complexity. That’s wrong; very, very wrong. Complexity is not your problem Complexity increases the burden of forecasting, reduces the desirability of the stock and hence is the company’s problem.
We need not always shun complexity or forecasting difficulty. Sometimes, there are good reasons for it. But if you encounter complexity or forecasting difficulty, treat the stock as guilty until proven innocent. The company, or whoever recommends a complex stock, has the burden of justifying the need for the cloudy picture. As to whether this has been successfully done, you are the sole judge and jury and there is no appeal beyond you.
This is why, when I look at REITs (Real Estate Investment Trusts), I automatically eliminate all mortgage REITs. These are not real real estate companies but wannabe less regulated banks whose fortunes will depend not only on interest-rate related factors but also on the quality of its loan portfolio. Evaluating that is out of my wheelhouse.
I had occasion recently to speak unfavorably of Kimco (KIM). The normal plain-vanilla course of business for a REIT is to own and/or manage properties and collect income from the property portfolio. Buying and selling of properties is typically part of the picture and in terms of forecast-ability, I can (and must if I want to invest here) live with that. But when buying and selling becomes atypically important in a particular REIT, my confidence in my ability to look forward declines. If I want to invest in the property-trading proficiency of a particular management team, I can do that but I would be taking a chance because unless I know the managers personally, it’s hard for me to feel more confident than I would in any mutual fund. And a mutual fund whose strategy is a moving target is not something that appeals to me. And this is unchanged by details of tax characteristics of different types of distributions. Tax consequences are highly personal and often more complex than headline rates may suggest. In terms of commentary aimed at a broad audience, I place greater emphasis to the probability of getting money and, necessarily, leave tax implications for consideration by recipients potentially in consultation with their tax advisors. (For the record, my REIT investments are held in tax deferred accounts.)
As a public shareholder, I don’t have much to go on when I decide if property trading is too much. So I really need to pay attention to what few clues I have. A huge clue is the extent to which distributions are funded, not by ordinary income but by capital gains and returns of capital. Returns of capital, if excessive relative to peers, also tells me a REIT is non-standard in other ways that lead to elevated, relative to peers, depreciation. For me to get comfortable with such an investment, the law would have to change in such a way as to allow me to seek abd obtain what is classified as “inside information.” Since I can’t get what I’d want, I don’t invest.
This is not about whether Kimco is acting legally or ethically (in fact, I presume Kimco is law-abiding snd ethical and would justifiably tell me what to do, in unprintable terms, were I stupid enough to ask for inside information.) It’s not even about whether its a good firm. It’s about whether it’s conducting and reporting its activities in a way that makes me comfortable with the attributes of what I, as a public shareholder, can own (the data profile, my ability to project the future, and the extent to which I can feel confident in my assumptions).
My aversion to complexity goes way back before I ever heard of Kimco. It goes back to my first few months as an analyst, when I got frustrated wrestling over the phone with a CFO over the company‘s income statement, threw down my pencil (that shows how long ago it was) and blurted out “Why is this so complicated? Whatever happened to sales minus costs equals profits?” The CFO had no answer. The company later faltered and went out of existence. Not long after that, I was working from a cubicle next to co-Value Line-rookie Jeff Vinik (who later managed Fidelity Magellan and now owns the NHL’s Tampa Bay Lighting team) and commiserated frequently with him over his wrangling with complicated financials issued by the then-revered piano-maker-turned-financial-conglomerate Baldwin United, which he panned harshly before the company shortly thereafter shocked the many bulls by going bankrupt. I covered conglomerates for years during which the primary investment theme was the way shareholder wealth jumped as companies slimmed down and simplified complex operating structures hated by investors.
But this isn’t about complexity always leading to disaster. It doesn’t. There are many complex companies that succeed, especially in the financial sector. As disastrous as was the piano firm turned financial conglomerate, we have a 180-degree different situation with a New England textile firm turned finance-heavy conglomerate; Berkshire Hathaway (BRK).
It’s about steering clear of situations with which I, as a public shareholder and not an insider, don’t feel confident based on the information available to me and my ability to work with it. I undoubtedly leave money on the table in some cases. In other cases, simplicity turns out right. What is always right however, is my refusal to invest in companies with risk profiles that are inconsistent with what I, given the limited information with which I work, feel comfortable.
Here are a few seldom-quoted but very important Graham & Dodd passages, all of which align the analyst with the position of a shareholder in the public markets, as opposed to the position of one who actually owns a business (in substance as well as in form).
These passages all come from Benjamin Graham and David L. Dodd, Security Analysis, Sixth Edition edited by Warren Buffett (McGraw Hill 2008):
In choosing and dealing with the materials of analysis he must consider not only inherent importance and dependability but also the question of accessibility and convenience. He must not be misled by the availability of a mass of data—e.g., in the reports of the railroads to the Interstate Commerce Commission—into making elaborate studies of nonessentials. On the other hand, he must frequently resign himself to the lack of significant information because it can be secured only by expenditure of more effort than he can spare or the problem will justify. This would be true frequently of some of the elements involved in a complete “business analysis”—as, for example, the extent to which an enterprise is dependent upon patent protection or geographical advantages or favorable labor conditions which may not endure.
Kindle Locations 1857-1864.
Broadly speaking, the quantitative factors lend themselves far better to thoroughgoing analysis than do the qualitative factors. The former are fewer in number, more easily obtainable, and much better suited to the forming of definite and dependable conclusions. Furthermore the financial results will themselves epitomize many of the qualitative elements, so that a detailed study of the latter may not add much of importance to the picture.
Kindle Locations 1878-1881.
The qualitative factors upon which most stress is laid are the nature of the business and the character of the management. These elements are exceedingly important, but they are also exceedingly difficult to deal with intelligently.
Kindle Locations 1884-1886.
Abnormally good or abnormally bad conditions do not last forever.
Kindle Location 1897.
Objective tests of managerial ability are few and far from scientific. In most cases the investor must rely upon a reputation which may or may not be deserved. The most convincing proof of capable management lies in a superior comparative record over a period of time. But this brings us back to the quantitative data.
Kindle Locations 1907-1910.
If an income statement is to be informing in any true sense, it must at least present a fair and undistorted picture of the year’s operating results. Direct misstatement of the figures in the case of publicly owned companies is a rare occurrence . . . . But from the standpoint of common-stock analysis these audited statements may require critical interpretation and adjustment . . . .
Kindle Locations 7891-7896.
IN THE LAST SIX CHAPTERS our attention was devoted to a critical examination of the income account for the purpose of arriving at a fair and informing statement of the results for the period covered. The second main question confronting the analyst is concerned with the utility of this past record as an indicator of future earnings. This is at once the most important and the least satisfactory aspect of security analysis. It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless.
Kindle Locations 9245-9249.
The concept of earning power has a definite and important place in investment theory. It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene. The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
A distinction must be drawn, however, between an average that is the mere arithmetical resultant of an assortment of disconnected figures and an average that is “normal” or “modal,” in the sense that the annual results show a definite tendency to approximate the average.
Kindle Locations 9252-9258.
[I]nstead of taking the maintenance of a favorable trend for granted—as the stock market is wont to do—the analyst must approach the matter with caution, seeking to determine the causes of the superior showing and to weigh the specific elements of strength in the company’s position against the general obstacles in the way of continued growth.
Kindle Locations 9461-9463.