Financial Shenanigans: A Deep Look At The Tricks Company Can Play With Its Accounting

The following is a talk I will present to a introductory financial accounting class. This piece is dedicated to Ms. Hopwood-Jones. 

The source for this discussion comes from a book titled "Financial Shenanigans" by Howard M. Schilit. The discussion is aimed at explaining accounting tricks public companies use to inflate their financial numbers in order to meet the expectation of analysts. Management of public companies are often pressured by analysts and investors to "make the numbers" every quarter. Therefore, some may cheat to meet a net income target for a certain quarter. A little cheating during one quarter can snowball into a lot of cheating (i.e. Enron is a famous example). How does these corporate executives cook the books? One may think they are rocket scientists but with a little accounting knowledge you learned from Ms. Hopwood-Jones's class, you too can detect accounting frauds.

Earnings[1] (Income Statement) Manipulations:

Investors often scrutinize a public company's quarterly earnings report very carefully. They often cheer when a company can meet or beat the consensus earnings (net income) estimate. If a company failed to meet the consensus estimate, the share price often declines.  How do corporate executives create "fake" earnings? They often just play around with the fundamental income statement equation as listed below.

Revenue - Expenses = Net Income

Since net income is calculated by subtracting expenses from revenue, corporate management can manipulate net income by inflating revenues or making expenses disappear.

Trick #1: Recording Revenue Too Soon

A common trick is to record revenue early before it is actually earned. In accounting, the revenue recognition rule is used to determine if revenue is actually earned (see table 1 below for more details). 

A common trick is to recognize revenues that belong to a future accounting period. For example, if company A is a magazine publisher that collected $100 for a 4-year subscription fee from a customer, how much revenue can the company recognize in year 1? The answer is only $25 because the other $75 should go into "unearned/deferred revenue" (a liability account) since the $75 does not meet the GAAP revenue recognition rule. Nonetheless, corporate executives often trick their auditors by using fancy wording to convince auditors that these 4-year subscriptions are actually 1 year subscriptions.  Therefore, it is vital for investors to read the footnotes to financial statements. Read the footnotes carefully!

One interesting method to boost revenue is by billing the customer for work not completed yet. In the real world, most transactions are not black and white as you see in accounting textbooks and revenue is often recognized over several accounting periods (construction industry is the common example). Since revenue is a credit account, they need a debit account to balance the books. Since customers generally don't pay cash unless the required work is completed, a common account to debit is account receivables. Therefore, be wary of any abnormal increases in accounts receivables or any receivable accounts. Also, if the accounts receivable turnover ratio (revenue/accounts receivables) starts to slow while revenues are still growing, it is a red flag and the company is probably inflating revenue by borrowing future revenue.

Table 1: Revenue Recognition under IFRS and US GAAP[2]

IFRS Revenue Recognition Criteria	US GAAP Revenue Recognition Criteria
(1) The amount of revenue can be measured reliably	(1) There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end
(2)  It is probable that the economic benefits associated with the transaction will flow to the entity	(2) The product has been delivered or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risk and rewards have not actually passed to the buyer
(3)  The stage of completion of transaction at the balance sheet date can be measured reliably	(3) The price is determined or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency
(4)  The costs incurred for the transaction and the costs to complete the transaction can be measured reliably	(4) The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay

Source: IASB and FASB

As shown in table 1, a company cannot recognize revenue unless the risk and rewards (economic benefits) is transferred from the seller to the buyer. A trick used in the 1990s by Sunbeam is to use a technique called "bill and hold." In essence, Sunbeam bills the customers and recognizes revenue despite the products were held in Sunbeam's warehouses. Although this trick is difficult to detect, a closer look at the revenue recognition footnote can discover aggressive revenue recognition. Below is the paragraph disclosed in Sunbeam's annual report:

"In limited circumstances, at the customers' request the company may sell seasonal products on a bill-and-hold basis provided that goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have been passed to the customer." 

With the grills sitting at Sunbeam's warehouses, there is no doubt that the economic benefits have not been passed onto the buyers despite Sunbeam tried using the words "risk of ownership and legal title have been passed to the customer." Also, customers often do not request goods on a bill-and-hold basis. Always be suspicious when the words "bill-and-hold" comes up in the financial footnotes.

Finally, another trick is to inflate revenues is to extend generous terms to buyers despite low creditworthiness, which fails criteria (4) listed in table 1 since the probability of collection is low. An acceleration of revenue along with growth in accounts or note receivable is a red flag. Although not all red flags imply revenue manipulation, investors should be careful when these red flag appear. If the company is showing abnormal growth in accounts or note receivable while also disclosing that it is extending credit to customers with generous terms, watch out!

Trick # 2: Boosting Income Using One Time Items

One-time items, also known as "extraordinary items", are often used to boost net income. By definition one-time items should occur infrequently such as gain/loss from sale of equipment[3] or damage incurred from a natural disaster.

Corporate management often tell investors to ignore one-time items because they do not reflect the continuous business operations.  They tell investors to focus on normalized income, which is often called "operating income." You will often see a corporate income statement organized as follows:

Table 2: Sample Corporate Income Statement[4]

Revenue	XXX
COGS	XXX
Gross Profit	XXX
Operating Expenses	XXX
Operating Income	XXX
One-time Items	XXX
Earnings Before Tax	XXX
Income Tax Expense	XXX
Net Income	XXX

Investors do pay more attention to operating income than the net income number. Therefore, management has the opportunity to inflate operating income by shifting positive benefits from one-time items above the operating income line and shifting normal expenses below the operating line. The former outcome can be achieved by shifting a gain from the sale of an asset above the operating income line as reduction to operating expenses. For example in 1999, IBM sold a business to AT&T but instead of disclosing the gain on the sale in the one-time items line on the income statement, IBM decided to book the $4.06 billion gain on sale as a contra expense. The effect of IBM's accounting decision significantly reduced operating expense by $4.06 billion (reducing the $18.8 billion operating expenses to only $14.7 billion!). Investors thought IBM found a magic way to reduce operating expenses and decided to give a higher valuation[5] for the stock only to find out later that those expense reductions didn't continue into future periods. Savvy investors reading the financial footnote would have noticed this trick because the company, by law, had to disclose how the sale of a business is accounted for. Companies often bury these unwanted disclosures deep in the footnotes since they know most investors never bother to read 100 pages of financial footnotes. However, it pays to goes through the footnotes of financial statements!

Another genius method is to create a continuous stream of income from the sale of an asset. Because income from a one-time sale is less impressive than a continuous stream of income, corporate management will aim to create a continuous stream of income from the sale of an asset. Let's use the traditional debits and credits to explain this trick. Assuming an asset owned by company I is valued at $1,000,000 (fair-value). Instead of selling it at $1,000,000, company I sells the asset to company M at only $800,000. However, company I requires company M to pay for future products at above market prices to make up for the $200,000 difference. Table 3 shows the correct way to account for this transaction while table 4 shows the inflated approach.

Table 3: Correct way to account the transaction by company I

Cash	$800,000
Receivable (from Company M)	$200,000
Asset Sold (Book Value)[6]		$700,000
Gain on Sale of Asset		$300,000

When the inflated prices are paid by company M in the future, the following should occur:

Cash	$200,000
Receivable (from Company M)		$200,000

Table 4: How to Create A Revenue Stream From One-Time Sale

Cash	$800,000
Asset Sold (Book Value)		$700,000
Gain on Sale of Asset		$100,000

When the inflated prices are paid by company M in the future, company I records:

Cash	$200,000
Revenue		$200,000

Magically, company I created $200,000 of revenue that should have been recorded as a gain on sale from a prior accounting period. To create a continuous revenue stream, the company could have recognized the $200,000 more slowly, such as $20,000 for 10 reporting periods.  

This example is actually real. Company I was Intel and company M was Marvell Technology and this transaction took place back in November 2006.  Again, the only way to have detected this fraud was to look in the footnotes when Marvell disclosed that it will pay above market prices for Intel's products in future periods. When analyzing any transaction, always try to understand the underlying economics and consider which accounts are affected. It's critical for investors to understand their debits and credits.

Trick #3: Shifting Current Expenses to a Later Period

Two examples will be illustrated for this trick. The first example is capitalizing expenses. In order to understand the nature of this action, let's review the fundamental accounting equation:

Assets = Liabilities + Shareholder's Equity[7]   (1)

Now we can expand equation (1) above by expanding the Shareholder's Equity section as follows:

Assets = Liabilities + Beginning Shareholder's Equity + Revenue - Expense (2)[8]

In order to decrease expenses, the asset side must increase in order for equation (2) to remain in balance. How can a company increase assets to reduce expenses? Let's step back and revisit the accounting rules for a fixed asset. When a fixed asset is purchased, is the entire amount expensed on the income statement? The answer is obviously "no" since that action would distort the trend in net income by having years with high net income when there are no purchases of fixed assets and years with low net income when there are purchases of fixed assets. Accounting rule states that a fixed assets must be capitalized (put on the balance sheet) and the cost of the asset is allocated, by reporting costs in the income statement, over its useful life. However, only assets that provide economic benefits for more than one accounting period can be capitalized. Normal operating expenses should be expensed on the income statement. Nonetheless, managers who wish to reduce expenses will often capitalize normal operating expenses in order to boost net income.

Let's use debits and credits to explain this trick. To account for $1 million of normal operating expenses, the following should be recorded:

Operating Expense	$1,000,000
Cash/Accounts Payable		$1,000,000

To defer a portion of the $1 million expense, consider what happens if the $1 million is capitalized and recognized over 2 accounting period instead of 1.

Fixed Asset	$1,000,000
Cash/Accounts Payable		$1,000,000

Depreciation Expense	$500,000
Accumulated Depreciation		$500,000

By recognizing the $1 million expense over 2 periods, net income is overstated in the 1st period by $500,000. Because the effect reverses in the 2nd period, a company that capitalize expenses is often forced to repeat the trick over and over again until it goes bust. This was the case with WorldCom in 2002.

Capitalizing expenses is a simple trick, but shrewd investors can detect this fraud by looking at the balance sheet instead of focusing exclusively on the income statement. If any fixed asset is growing out of control and there is no good explanation in the footnotes, management is probably capitalizing normal operating expenses. For those grade 12 students who understand the cash flow statement, another method to detect this fraud is look at free cash flow, which is defined as cash flow from operations minus purchases of fixed assets, a line located in the cash flow from investing section. If free cash flow declines rapidly, it is a red flag. 

Another method to defer expense is to recognize them more slowly. Recall that depreciation/amortization expense should be recognized by an amount equaling to [(cost-salvage)/useful life]  if the straight line method is used. The useful life number is often an estimate and accounting rules allow management to use its best estimate as a proxy. Therefore, management can record a lower expense by simply assuming a longer useful life of its asset. The only way to detect this fraud is to compare the useful life (estimated by cost/annual depreciation expense) one company compared to the industry average. If the assumed useful life of a particular asset is significantly higher than the industry average, the company is probably making an aggressive assumption regarding the useful life of its assets.

Trick #4: Hiding Expenses 

Similar to how a magician makes a rabbit disappear, corporate management often employ tricks to make expenses disappear. The most simple trick to hide expenses is simply failing to record accrued expenses. Let's apply what you learned in Ms. Hopwood-Jones class on accrued expenses in the following example: company X repaired a machine for company Y and bills company Y for $100. If company Y does not pay in the current accounting period, an accrued expenses must be recorded in Y's books.

Maintenance Expense	$100
Accounts Payable		$100

However, to avoid the recognition of an expense, company Y simply ignores this adjusting entry, which would boost income (by reducing expenses) for the current accounting period. Although outside investors cannot detect this fraud without looking at the internal books, the expense recognition footnote may provide clues about aggressive accounting for expenses.

Another method to hide expenses is making aggressive assumption on "soft expenses" like warranty expenses. Soft expenses often require the significant use of management's judgement in determining the amount booked in the financials. Let's illustrate with an example of warranty expense. Under GAAP,  the company must record a warranty expense for each accounting period using past experience as a proxy, similar to the accounting for bad debt.

To illustrate with an example of warranty accounting. Let's see the following entries:

Warranty Expense	$1,000
Warranty Liability		$1,000

Warranty Liability	$900
Cash		$900

The first entry records the $1,000 expense incurred while the second entry books the $900 actual claim during the period. The figures should be similar for the two entries. Nevertheless, a company wishing to reduce current expenses may book a lower warranty expense, such as booking only $500 in the prior example instead of the $1,000 justified using past experience. The easiest method to hide expenses is to assume a lower expense figure for these "soft expenses" like warranty expense or bad debt expense.  

Trick #5: Shifting Future Expenses to an Earlier Period

This trick is to incur the pain today while lowering expenses in future periods. Table 5 shows a two-step process for expense recognition for balance sheet items. By accelerating the expense recognition process, a company can recognize future expenses upfront and incur zero expense in the future. Let's illustrate with an example of an inventory write-down.

Table 5: Cost Recognition under a two-step progress

Step 1: Asset	Step 2: Expense
Prepaid Insurance	Insurance Expense
Inventory	COGS
Property, Plant & Equipment	Depreciation/Amortization Expense

Under GAAP, inventories on the balance sheet are accounted for using the LCM (lower of cost or market) approach. If the market value (market price less estimated costs incurred to sell) is lower than the book value on the balance sheet, the difference must be written down as an expense (often through COGS) on the income statement. However, the market value used in the write-down is estimated by management and they could use an unrealistically low number so the expense recognized is higher than it should be. By writing down inventories close to zero, similar to how Cisco wrote down $2.25 billion in 2001, companies can report very low COGS numbers in the future and inflate their profit margins significantly.

Another creative method to overload current expenses is to book a large "restructuring expense." This is a common trick used by companies during difficult times. By booking a large restructuring expense today, companies can release the excessive amount into net income through a reduction of operating expenses. Again, let's demonstrate with the use of debits and credits. Assuming company R decides to fire 100 workers and need to pay $10,000 to each worker as a severance expense, which will paid in a future period. The proper method to account for the transaction is shown below.

(1) Current period to recognize the expense:

Restructuring Expense (Wages)	$1,000,000
Wage Payable		$1,000,000

(2) When Severance is paid at a later period:

Wage Payable	$1,000,000
Cash		$1,000,000

However, because the $10,000 per worker is a "soft expense" estimated by management, there is a strong incentive to overestimate, such as using $20,000 per worker.

(1) Current period to recognize the expense:

Restructuring Expense (Wages)	$2,000,000
Wage Payable		$2,000,000

(2) When Severance is paid at a later period and only $1,000,000 is paid:

Wage Payable	$2,000,000
Cash		$1,000,000
Wage Expense		$1,000,000

By booking an extra $1,000,000 of restructuring expense in the current period, the company can reduce wage expense by $1,000,000 in a future period when the restructuring liability is extinguished. This is a creative method but fails to conform to the basic matching rule under GAAP.

Conclusion:

Despite real world accounting is more complicated than what you learned in Ms. Hopwood-Jones's class, I believe everyone has the necessary tools to detect accounting frauds. As stated many times in this article, the key is to read the footnotes carefully so that you can detect aggressive accounting assumptions, whether it is related to revenue, expenses or one-time items.

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[1] The word "earnings" is often used in place of "net income" when discussion financials of public traded companies (ones that trade on a public exchange such as the TSX or NYSE).

[2] When an accounting textbook uses the word "GAAP", it is referring to the old Canadian GAAP rules. IFRS, the international standard, replaced Canadian GAAP in 2011. Nonetheless, IFRS is quite different and US GAAP is closer to the old Canadian GAAP.

[3] Recall that a gain/loss is recorded from the sale of a fixed asset when the sale price is higher/lower than the net book value (historical cost - accumulated depreciation)

[4] When you read financial statements of public companies, the income statement is commonly called the "statement of operations" or "statement of earnings."

[5] Stocks valuation can be explained by the P/E ratio which is market price of stock divided by its earnings. Usually investors would use operating earnings (income) as the denominator as those earnings are continuous in nature. Therefore, IBM's action of moving a gain from sale of an asset above the operating income line inflates operating income and increase the "E" in the P/E ratio, result in a higher stock price.

[6] The net book value is credited for the sake of simplicity. In reality, the asset account (historical cost) is credited while the accumulated depreciation is debited.

[7] "Shareholder Equity" is the equivalent of "Owner's Equity" and it is used for the equity account of a public traded company

[8] Assuming no dividends (Owner's withdrawals) or share issuance (Owner's deposit)

[9] Salvage value is ignored because it usually a negligible amount

What is Value?

When the Globe & Mail inquired about my investing style, I had to choose the word "Value".  I believe a value based approach is the only sound investment approach that can achieve sound results. Although not everyone wants to be value investors, I believe every investors can benefit by learning value based investment principles. 

Value Is All About Pricing and Not Timing 

In Security Analysis, Ben Graham described two different methods for predicting future security values. One is timing and the other is pricing. In essence, timing  involves predicting future stock prices based on past information. Timing is dangerous because investors often extrapolate past trends into the future without ever questioning if the past trend can continue. The better approach is pricing, which involves the estimation of intrinsic value. The pricing approach is more dynamic and it captures the value of the underlying business through the estimation of future earnings power and cash flow

One example of timing is using past returns to predict future returns. Momentum investing, the act of buying past winners, has become very popular lately but there are numerous dangers with this approach. Investors often see the following warning on fund prospectuses: "past returns or performance is not an indication of future returns". Yet even with this warning, many investors still rush to buy momentum stocks because they believe past performance will continue. However, as Herb Stein famously observed, "if something cannot go on forever. It will stop". A $1 billion company can grow into a $10 billion company, but it may be extremely difficult to grow the same $10 billion company into a $100 billion company. Mathematically, it becomes harder and harder to grow a company at the same percentage rate because the base (in dollars) becomes larger.

The timing approach also includes market timing, the act of trying to guess future prices based on past price patterns or intuition. Again, past price patterns are not reliable indicators of the future and guessing prices based on intuition is really unintelligent speculation. There is no guarantee that prices will move in the direction predicted and those who practice this approach will often lose money on average. Market timers may have great gains once in a while but they will also have great losses. The act of making continuous "bets" on the stock market is not a sound approach of building long term wealth. 

The pricing approach is attractive because it analyzes the underlying value of the company and avoids unnecessary speculation on the future price by ignoring the stock price. Instead, investors who practice pricing are more interested in the performance of the business rather than the performance of the stock price. Unlike the timing approach, the pricing approach is sound. Practitioners under the pricing approach avoid the extreme emotions of the stock market and can be confident that value can converge near their intrinsic value estimate if they have conducted a thorough analysis.

To answer the question in the title, value is all about buying dollars for fifty cents. I will provide three sources of value in the sections below which will help readers find dollars that are selling for fifty cents because the crowd neglected to analyze the sources of value. 

Value in a Cigar-butt (Method 1): 

This was the main approach advocated in Graham's Security Analysis and The Intelligent Investor, which was referred to as the purchase of bargain issues. Buffett later named this method as the cigar-butt approach.

Under Graham's original approach, a bargain issue was a company selling below 2/3 of net-net value where net-net value is defined as working capital minus outstanding debt. Readers should note that by buying companies at 2/3 net-net value, the investor has at least a 50% margin of safety if the stock returns back to net-net value. Net-net value is extremely conservative because it only considers the liquid assets of the company while ignoring the value of all fixed assets.

Not many companies sell below net-net value presently but many obscured small-cap may fall below net-net value from time to time. These net-net stocks were very profitable because the valuations were so cheap that a small positive development can push the stock up 50% or even 100%. A diversification policy should be followed if readers want to practice buying cigar-butt companies. Many of these companies are often cheap for a reason but a broad basket of these net-net stocks yields sound results over time. Walter Schloss, who worked at Graham's firm in the 1950s, practiced cigar-butt investing for nearly five decades. He managed to earn a 15.7% compounded return (after-fees) vs. S&P500's 11.2% over 45 years. He holds about 100 stocks but they were all cheap cigar-butt stocks.

Although not many companies sell below net-net value, investors can consider buying companies selling significantly below the reproduction cost of the net assets on the balance sheet. That value can be calculated by adjusting the book value to reflect the actual cost of reproducing the various assets or liabilities. If investors can buy at 2/3 of the reproduction costs, it can be considered as a modern day cigar-butt but the classic definition offers a better margin of safety.

Value from this method is derived mainly from the assets owned by the company and the focus is solely on the balance sheet. If investors acquire cigar-butt stocks at low prices, the reversion to the correct asset value can yield handsome rewards for investors. Even though asset values can deteriorate, a low price paid and adequate diversification can often compensate for that risk. 

Value in Economic Moat and Talented Management (Method 2): 

This approach is practiced by Buffett. After Buffett met his business partner Charlie Munger in the early 1960s, he realized that there are value in intangibles like competitive advantages and talented management. Before meeting Munger, Buffett was only buying cigar-butt stocks as described in the prior section. 

Buffett's classic example of using this approach was the purchase of See's Candies in the 1970s. Berkshire bought See's at 5 times tangible book value, which would have been crazy under classic Graham rules. However, Graham's rules ignored intangibles such as the large economic moat enjoyed by See's. Economic moat was the term Buffett created to describe the competitive advantages possessed by the underlying business. 

The company was well known in California and has a well established customer base. Another feature that Buffett noticed was that See's had the ability to raise prices to combat inflation without losing customers. With a high return on capital and low sustaining capital required to run the business, See's can generate a valuable and growing cash flow stream for Buffett, which he can reinvest in other businesses or stocks for Berkshire Hathaway. 

Management was also quite talented at See's. They ran the operations extremely well and had good capital allocation skills, a trait highly valued by Buffett.  Most corporate CEOs often have poor capital allocation skills, which can destroy shareholder value because they squander a large amount of capital on exorbitant acquisitions or low return projects. Both initiatives can increase reported earnings but not underlying value. See's management ran the operations with minimum reinvestment and were modest in their spending plans. 

Although See's was a private transaction, investors can apply the same principles in stock market investing because stocks are businesses. In fact, investors can buy a company similar to See's at a much lower price since, in theory, Buffett's price included a sizable control premium. Therefore, look for companies with strong competitive advantages such as the ability to raise prices. High return on capital and low capital reinvestment are two key characteristics of these attractive businesses. Furthermore, a strong management with good capital allocation skills can add considerable value.

Value from this method is derived mainly from the company's ability to generate consistent incremental earnings (high earnings power) and cash flow because of its competitive advantage and talented management team.

Value in Profitable Growth (Method 3): 

The right approach to growth investing is profitable growth. Under this approach, investors should purchase, at a reasonable price, firms that are expected to grow earnings faster than average and are expected to maintain or grow its return on capital. 

Profitable growth is not the same as absolute growth. Absolute growth may refer to large percentage increase in revenues or earnings over a short period of time. As a result, investors often assign generous earnings multiples on these absolute growth firms with P/E ratios north of 25. The high multiples assigned to many growth stocks are not justified because the high valuations already reflect their high growth potential. Furthermore, absolute growth can be an illusion if growth is not accompanied by increased profitability. Many investors measure profitability by earnings growth rates but ratios such as return on capital (EBIT/Total Capital) are better at assessing profitability. Earnings can grow but return on capital will decrease if management decides to conduct lower return projects in order to meet absolute earnings targets. Although earnings can grow in this manner, the incremental earnings are value destructive if return on capital drops, especially if return on capital drops below the cost of capital. Therefore, profitable growth companies increase earnings and return on capital at the same time, which result in efficient capital allocation and higher value.  

In order to assess the attractiveness of the current valuation vs. future growth potential, investors need to spend time analyzing the business and project future earnings streams under conservative assumptions. For example, growth rates should gradually diminish as the size of the firm becomes larger. Graham suggested projecting earnings 5-7 years out and apply a conservative earnings multiple less than 20 times the average projected earnings. Investors should favour growth but be wary of the price paid for growth. 

If investors find an attractive growth opportunity, ask three simple questions: (1) Does the current price reflect the growth expectations already? (2) Is the company selling below 20 times the average projected earnings? (3) Can the company grow earnings while growing or at least maintaining its return on capital? Because high growth firms tend to sell above market multiples, investors often overpay for them. Nevertheless, these profitable growth firms can offer stellar returns if they are bought at rational prices. Ten baggers, firms that increase in value by 10 times, are often profitable growth firms. 

Value from this method is derived mainly from the company's ability to maintain profitable growth over a long time period. This value can be negative if investors pay a high price for profitable growth.

Growth vs. Value Investing?

Because I discussed growth investing in the prior section, I want to give my opinion on whether value is better than growth. In my mind, there is no distinction between value and growth. In fact, growth is a component of value. Ben Graham may be known as a value investor who loves to purchase net-net stocks (stocks that trade below tangible working capital), but he also championed a growth stock approach. For those who have read the original 1949 version of The Intelligent Investor, he stated that a growth stocks add value for an intelligent investor's portfolio only if bought after a thorough analysis of its prospects 

In my opinion, the definition of growth and value used by finance professionals is wrong and misleading. A low P/E ratio, low P/B ratio, and high dividend yield are not strict yardsticks for value as commonly defined in financial literature. A stock can be a value stock despite having a high P/E ratio, high P/B ratio and low dividend yield. When Buffett bought Coca-cola in 1988, the stock's P/E ratio was in the high teens and P/B ratio was well over 5. The stock was nonetheless a value stock in Buffett's view because its future earnings power justified a high intrinsic value. On the other hand, a stock with low P/E, low P/B and high dividend yield may not be a value stock because its future earnings power is in a structural decline. A low P/E ratio may be misleading because the "E" in that ratio can decline rapidly in the future. Similarly, a low P/B ratio may be misleading because the "B" in that ratio is too high. Future operating losses can lower the "B" and the low P/B ratio will vanish. 

By the same token, a growth stock is often defined as one that has increased earnings or sales at a high rate in the past few years. Investors often make the mistake that past growth is an indication of future growth.  Also, investors are misled by absolute growth numbers. Growth can be value destructive if the incremental earnings is created by reinvesting more capital at a lower rate of return.

In short, if I was asked whether I prefer value or growth, I would answer value. However, I don't think there is a difference between value and growth. Growth is a component of value and can be extremely valuable if investors can identify profitable growth at reasonable prices (as discussed in section above). Even though I detest the standard definition of value investing, investors who buy stocks with low P/E, low P/B and high dividend yields should experience better investment results than those who buy high P/E, high P/B and low dividend yield stocks. 

The Bottom Line: 

In the 1949 original edition of The Intelligent Investor, Graham famously stated that "it remains true that sound investing principles usually produce sound results." Investors should look for stocks that have the three sources of value as described in this article. Method 1 and 2 offer more safety than method 3 because method 3 requires the estimation of future earnings growth, which can be tricky for fast growing firms.

Intelligent investing is all about pricing and not about timing. Investors who want to practice timing should warned that they are speculating, which can be profitable but also risky at the same time. Intelligent investors who buy a portion of a business at a rational price should expect good results on average and minimal loss of capital. By investigating the underlying business through pricing, investors can unlock hidden values that are often overlooked by short term oriented investors.

By finding those sources of value, an investor can buy a dollar for fifty cents! 

My Thoughts on Investing

Buffett released his 2013 annual letter to shareholders just over a week ago and it contained a very interesting section on investing. After reading it, I would like to share my own thoughts on investing, which is provided in the following sections. Everything written here reflects my current investment philosophy and I want to thank famous investors such as Ben Graham, Warren Buffett, Phil Fisher, Peter Lynch, Howard Marks, Marty Whitman, and Seth Klarman for sharing their insights on investing. They shaped my thinking and provided sound guidance that all investors should follow.

Stock Investments Are Business Investments: 

"Investment is most intelligent when it is most businesslike" 

Ben Graham  

This is the same quote Buffett highlighted in his 2013 annual letter. Investors often do not think like business owners and fail to realize that the underlying security is a claim against a company. Stocks are the residual claims of underlying businesses (the value left after liabilities, such as debt,  are subtracted from assets), but investors often view them as alphabetical ticker symbols whose price moves around from 9:30 am-4:00 pm. If investors take the ticker symbols' point of view, they would be more interested in historical price movements or price volatility in order to make investment decisions. On the contrary, those who view stocks as actual businesses would be more interested in the underlying fundamentals such as future earnings/cash flows, the competitiveness of the industry the business operates in and the quality of management. Given there is constant chatter on the direction of "the market", it's difficult for today's investors to think like business owners. It's easy, or even unintentionally, to view stocks as ticker symbols in a fast moving market. However, I will illustrate with an example that shows it would be foolish to do so. 

Since Buffett used real estate examples, I will too. Imagine you are purchasing a home, what factors would you consider to evaluate your purchase decision? Some factors may include the location of the home, the number of bedrooms/washrooms, the square footage of the house, the furnishings and the proximity to public transit or schools. If your real estate broker told you that those factors are useless and you should only consider historical prices or price volatility, you would think he/she is from la-la land. It's plain silly to buy a home because the price is in "an uptrend". What's even sillier is if the real estate broker tells homeowners that they should buy homes that exhibit less price volatility, which is the definition of a safer investment under Modern Portfolio Theory. Why waste time analyzing past home prices or price volatility when it is better to focus on the fundamentals such as location and the quality of the individual houses.  If you buy a home in an excellent location and growing neighborhood, it's a no-brainer that the price would rise over time. While some home buyers might consider price trends or price volatility (especially during the height of housing bubbles like 2006 in US), the majority of home buyers only consider the underlying fundamentals when considering a prospective home purchase, without any thoughts on future prices or future price volatility. Hence, stock investors should act more like owners when considering prospective purchases similar to how they evaluate their home purchases. 

When evaluating stocks, thinking like an owner means evaluating the future productivity of the assets owned by the business. It's important to predict future earnings and cash flows instead of future stock price movements. Similarly, it's important to evaluate the competitiveness of the industry the business operate in instead of the current stock market condition. And finally, it's important to evaluate the integrity of the managers running the company instead of the speed your broker can provide in order to trade the company's stock. True owners would only consider the former statements while ignoring the latter ones. In theory, it is easy to see why evaluating fundamentals is important but it's more difficult to put into practice especially when investors are emphasizing short term performance. To quote Yogi Berra, "In theory, there is no difference between theory and practice. But in practice there is."  

How to View Market Prices (Correctly): 

In Buffett's opinion, there should only be 2 courses on equity investments: (1) How to value a business and (2) How to view market prices. I already discussed (1) in my prior article so I will focus solely on (2) in this section.  

Before I begin the discussion, let's focus on a few every-day examples. If you drive everyday and do not own a gas station, do you hope for higher or lower gasoline prices? Given the answer should be obvious, let's consider another example: if you are regular grocery shopper, do you hope for higher or lower produce prices? For both questions, the rational and obvious answer is lower prices. Now comes the final exam: If you are a saver who is not close to retirement (by at least 10 years), do you hope for higher or lower stock market. As Buffett pointed this out in his 1997 annual letter, most investors fail to answer correctly although there is no difference between this question and the preceding questions. Some may point out that savers should hope for higher markets because they will have more money to spend during retirement. However, I explicitly stated that the savers are not even close to retirement. Savers, who still have a stable income stream and wish to invest for the future, should hope for a bear market (lower market prices) so more stocks could be purchased on a bargain basis. If everyone rushes into retailer stores when there is a 50% sale, it is very confusing to see why the same group of individuals would rush out of the stock market when there is a 50% sale (2002 or 2009 sounds familiar?). There is no difference between shopping in the mall and shopping in the stock market. Doubling down is not a bad strategy. In fact, Fairfax Financial, ran by value investor Prem Watsa, uses the strategy of doubling down when buying and doubling up when selling (buying more when prices fall and selling more when prices rise). As Ben Graham reminds investors, "buy stocks the way you buy grocery, not the way you buy perfume" or in my own translation, "buy stocks the way you buy your own personal items, not the way you buy gifts for your significant other." 

I have provided  an excerpt from my prior article on Mr. Market, an allegory Ben Graham created to describe price movements in the stock market.

Mr. Market is an allegory of the stock market made up by Ben Graham, the mentor of Buffett. Mr. Market is a fellow who comes to you daily to quote prices of many businesses and he is happy to buy your interest in those businesses or sell his interest at the price he quoted. Mr. Market is very emotional. He sometimes quotes a ridiculously high price because he only sees the positive sides of those businesses. He sometimes also quotes a ridiculously low price because he thinks the business is worthless.

Warren Buffett reminds investors of two important facts about Mr. Market investors need to know and remember at all times:

1) You don't have to transact with him every day. Only do so if you can take advantage of his quotes. If he quotes a low price, you buy from him. If he quotes a high price, you sell to him. Most of time, it is simply better just to IGNORE him.

2) It is Mr.Market's pocketbook (pocketbook describes the book traders used to keep track of their stock inventory back in Graham's days), not his opinions that should interest you. Many investors think Mr. Market is correct on the valuation of businesses and follow his opinions.

Let's revisit the real estate example again. If you bought a house and your neighbor offers an exorbitant price to purchase your house, what would you do? Sell your house to him of course! It would be silly to suddenly become more enthusiastic about the value of your house and reject his offer. However, in the stock market, investors do the exact opposite. When Mr. Market offers a ridiculous valuation, they would suddenly believe their stocks are worth more and hold them tenaciously despite clear signs of overvaluation. The opposite is true in bear markets when investors join Mr. Market's pessimism and dump every stock holding. If you won't sell your house to a lunatic neighbor who quotes a ridiculously low price, you should not sell all your stock to Mr. Market when the stocks are clearly undervalued in a bear market. Once again, thinking like a true owner will avoid the mistake of selling undervalued companies and holding overvalued ones (note I used the word "company", not "stock"). 

Second-Level Thinking: 

This is a concept espoused by Howard Marks. In his book, The Most Important Thing, Marks described second-level thinking as deep, complex and convoluted while first level thinking as simplistic and superficial. For investors who want to achieve above average returns, their thinking should be deep and avoid common pitfalls. That deep thinking is called second-level thinking. Successful investors should be able to think at a higher level and consider all possibilities. First-level thinker, the majority of market participants, only focus on the obvious facts and fail to draw thorough conclusions. A common first level thinking is buy companies with a growing business or high earnings/sales growth. Without even considering the valuation or the competitiveness of the business, investors may lose a lot of money because of their flawed thinking. Nifty-fifty investors learned that lesson in the 1970s when they lost 90% of their money by buying stocks of the best 50 corporations. Many market participants still avoid in-depth thinking when making investment decisions. To quote Bertrand Russell, "most men rather die than think. Many do. "

Difference between first-level and second-level thinking: 

• A first-level thinker would say "the company is a great company and has a great brand; hence let's buy the stock" (Too much focus on quality). A second-level thinker would say "the company does have a good brand but it's already reflected in the share price. With its shares trading at 50 times earnings, the stock is priced for perfection. Time to sell." 
• A first-level thinker would say "the company is trading only at 8 times earnings and has a high dividend yield of 10%. Time to buy" (Too much focus on yield and low PE ratio). A second-level thinker would say "although the company trades at 8 times earnings, it's not a value buy because it faces double digit revenue decline and higher expenses over the next few years. When those two factors are considered, the stock is actually trading at 25 times earnings. With its dividend payout ratio at 90%, any large earnings decline would impair the dividend. There is no margin of safety with this investment. Sell." 

Accounting Shenanigans: 

There is an old accounting joking regarding the value of two plus two. According to the joke, the accountant's answer is "what number did you have in mind." This joke illustrates how accounting rules allow significant use of estimates. I will list two problems that investors should be aware of.

(1) Non-GAAP Measures:

I wrote an article on the problems of Non-GAAP measures but I would like to illustrates a couple of main points (readers are strongly encouraged to read my prior article). First of all, non-GAAP measures are not evil but management is starting to manipulate these measures to paint a better picture. One of the main problems is the extensive use of non-GAAP measures in earnings reports. The problem is most acute when the non-GAAP measures is spelled exactly the same as a GAAP measure. For example Operating Earnings and Cash Flow From Operations are items on GAAP financial statements. However, I have seen many companies using non-GAAP yardsticks that are exactly spelled the same as the GAAP equivalents. They only warn the reader in a tiny line on the bottom of the page that these measures are non-GAAP measures and do not conform to GAAP rules. The non-GAAP copies often ignore a few bad stuff. i.e. non-GAAP Operating Earnings may ignore a loss on a small segment and non-GAAP Cash Flow From Operations may ignore certain negative working capital changes. I'm not arguing to eliminate these non-GAAP measures but the way they are spelled deceive investors especially the amateur ones. Therefore, be on the lookout for non-GAAP copies of GAAP measures. Investors should understand how these non-GAAP measures are calculated.  Companies are required to show the adjustments in their 10-Qs and 10-Ks. 

If the non-GAAP measure paints a rosier picture of the company's finances, watch out! As social media and internet stocks keep on soaring, many analysts needed new measures to justify the high valuations. The managers and investor relations officials of those company are more than happy to help with this endeavor. One non-GAAP measure invented for this purpose is net earnings excluding stock based compensation. The rationale is these expenses are non-cash expenses and do not create a financial burden because the company simply issues the shares to pay its employees. Investors who buy this logic need an accounting 101 lesson on what is the definition of an expense. Stock based compensation is a real expense because it is an economic cost incurred through the business operation. By assuming stock based compensation isn't an expense, investors are basically assuming the employees are working for free since the majority of the compensation in these social media companies are in the form of stock, not cash. 

If [stock based compensation] aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?  Warren Buffett

Finally, because these non-GAAP measures are not regulated, companies are free to change the definition of the metric. A common trick used in the past is to change the definition so the non-GAAP measures appear healthier, i.e. changing the same-store-sales definition from measuring sales at stores that opened for at least 13 weeks to 11 weeks. Another example is to change the definition of "subscriber" to show a faster subscriber growth. To avoid scrutiny, companies will make the change when they file their 10-Qs, which is often a few days after they unofficially announce their quarterly results. Given managers know not many investors actually read 10-Qs, these non-GAAP measure changes almost go unnoticed. Therefore, I highly suggest investors to actually read 10-Qs although the information contained in it should be similar to the earnings press statement released a few days earlier. However, if you notice a definition change in one of the non-GAAP measures, re-evaluate your investment thesis immediately. A company with repeated disclosure problems is a sell candidate. 

(2) One Time Items:

One time items are notorious for their manipulative uses. Unlike revenue and expense recognition, management have more leeway regarding the classification of one time items. By re-arranging lines on the income statement, management can receive a different reaction from investors because they often look above the line, which is an industry lingo for lines above the EBIT or operating earnings line. Anything below the EBIT line, which includes charges for discontinued operations or extraordinary items, are ignored because investors consider those items unimportant. Hence, management will attempt to stuff a few small expenses in the extraordinary items line so the company can meet earnings expectations. Although investors should ignore a few large one time items, such as loss on sale of a division, they should not ignore one time items if they occur on a regular basis. 

There are many other manipulative tricks management can employ to fool investors but I included just two main issues I believe are most prominent in today's market. Management can still play some old tricks, such as inaccurate revenue recognition or improper capitalization of operating expenses so investors should still keep their eyes open. Overall, trouble can be avoided by avoiding companies with weak reporting and management. An ounce of prevention is worth a pound of cure.


On Efficient Markets: 

Many readers might have heard this joke before: an economics professor and a student are walking down the road and both see a $100 bill on the ground. The student wants to pick it up, but the professor encourage him not to. According to the professor, if that bill was real, somebody would have picked it up by now. Unfortunately for the professor, the student got $100 dollar richer by not following the rule of the efficient markets. 

As a refresher, efficient markets theory states that the market should reflect all available information. Why is the market efficient? It's partly due to the actions of market participants who constantly search for mis-pricings. The value of most assets should revert to intrinsic value immediately after  major announcements - such as earnings announcements, corporate restructurings, M&A etc.-   if there is a large number of market participants buying and selling the assets. However, there are limitations that may prevent price discovery. There could be limits on short selling and  market liquidity. Furthermore, a lack of interest among market participants to conduct price discovery operations in certain asset classes (i.e. micro or small cap stocks, distressed debt etc.) also creates inefficiencies. These price discovery limitation will prevent the certain asset classes from being efficient. 

I'm not a big fan of the efficient markets theory although I do admit that the prices of major asset classes are frequently efficient. Readers should note that I used the word "frequently" and not the word "always". From time to time, investors can discover mis-pricings even in a well-covered space such as large cap stocks. Despite over 50 sell-side analysts covering Apple, none upgraded the stock or raised their price targets when the price hit $400 last April. The stock outperformed the S&P500 by a whopping 35% in the next 8 month. Even the price of a company with a $500 billion market cap can be inefficient. Markets are not comprised of machines but of people. The efficient market theory assumed all investors are rational and analyze the facts correctly. However, investor's rational judgments are often overruled by the emotions of fear and greed. They don't incorporate all the available information in their decisions and often make mental short-cuts. As Dale Carnegie famously said, "We [humans] are not creatures of logic, we are creatures of emotion."

Therefore, I believe markets will be inefficient from time to time and will offer mouth-watering opportunities for investors. Although I detest the efficient market theory, I encourage professors and academics to keep promoting the theory. The Buffett quote below explains why.

"We are enormously indebted to those academics [who promote efficient markets theory]; what could be more advantageous in an intellectual contest - whether it be bridge, chess or stock valuation- than to have the opponents who have been taught that thinking is a waste of energy" Warren Buffett 

Diversification or Diworsification: 

Should investors place all their eggs in one basket or spread the eggs among many baskets? The answer should depend on whether you have the knowledge and will to spend the time to search for investment opportunities. For most non-professional investors, I would highly recommend an extreme diversification policy. This involves buying ETFs - like the SPY, XIU, IWM etc-  that hold over hundreds of stocks. Because non-professional investors do not have the knowledge or will to select undervalued stocks, spreading out the bet is a wise choice.

However, for those who have the knowledge and are willing to take the time to select undervalued securities, I believe an extreme diversification policy is foolish. If investors mirror the approach of the mutual funds, they would find themselves owning over 100 stocks. If they own over 100 stocks, how would they know what companies they actually own? Imagine a man telling his wife that he wishes to diversify his marriage by marrying more women. If he really found the woman of his dream, why would he want to diversify? The logic is simple and it should be extended to investing. If investors found a few excellent companies, they should concentrate their positions.  Although it is dangerous to own only a few stocks, I would suggest owning 10-30 stocks in a portfolio. Studies have shown that the co-variance (measurement of correlation between the stocks in a portfolio) significantly decreases after the number of stocks increases from 1 to 10. The decrease from 10 stocks to 30 is very marginal and the decrease beyond the 30th stock is so small that it isn't even worth it. 

Diworsification is a word made up by famous investor Peter Lynch who condemns the practice of diversification. Owning too many stocks is akin to owning an index fund except the transaction cost is much higher. (why try so hard just to be average?) A concentrated portfolio may actually decrease risk because investors would exercise more prudence when they select their stocks. Pick a stock just like how you would pick your future spouse. In the final analysis, diversification can be summarized nicely with a Buffett quote, "diversification is a protection against ignorance."

To Sum it Up: 

Investment is most intelligent when it is most business like. It's worthy to repeat that phase because investors can achieve higher returns by thinking like an owner.

By thinking like an owner, investors would:

• Have the proper attitude towards market price fluctuations
• Think at higher levels regarding factors that influence the underlying businesses instead of factors that influence market prices
• Understand that markets are not always efficient and those who have a superior insight of the underlying business can achieve abnormal returns
• Understand the importance of a concentrated portfolio and realize that diversification is really diworsification 

For New Readers: Must Read Investing Articles

For new readers, I linked 6 articles on investing I wrote a while ago that I think many should take a look.

Investing Article Series:
Article 1: What is Investing
Article 2: Intelligent Investing for Average Investor
Article 3: Accounting Frauds
Article 4: Investor Psychology
Article 5: My Thoughts on Value Investing (The Must Read if the reader needs the best pick)
Article 6: What is Value

Other Recommended Articles:
Investment Risk
Share Buybacks
Share Splits
My Seeking Alpha Article on 5 Important Points (Not part of this blog but I feel it's a very good article to read for any investor)

My list of book recommendation can be found here.

Investment Risks

There is an old adage in investing that states the more risk one takes, the more return one should expect. Many investors understand that there is a positive relationship between risk and return.  Therefore, to achieve excellent investment returns, one must also take on a lot of risks. It may be important to step back and actually ask the  important question: What is risk?

There are many proposed definition for a very simple question. In this article, I will explore the conventional definition of risk and contrast that definition to what I believe is the real definition of risk in investing.

Risk Is Not Measured By Volatility Or Beta:

Any student studying finance in the classroom will learn that risk is captured by numbers such as standard deviation or variance, which measure an asset's volatility. The wider the price range of a security is, the riskier the security is assumed to be.

I see many problems with using volatility as a risk measure

• Volatility can only reveal how crazy the price of a security moved, but it does not measure the probability of a loss or the possibility of a negative outcome
• Volatility measures both bad and good outcomes when only the unfavourable outcomes should be the focus. For an investor with a long position, an extreme price move to the upside is a favorable outcome, not a unfavourable outcome
• Volatility is calculated using past data and is backward looking. Many investors use historical volatility as a measure of risk. However, past data is a poor indicator of the future because financial markets usually moves in cycles. Periods of low volatility is usually followed by periods of high volatility. For example, volatility during 2005-2007 was extremely low. However, investors were incorrect to assume low volatility would continue in 2008. Although investors often extrapolate past data to predict the future, they should not forget that investing is a forward looking game. An investor who invest based on past data (like historical volatility) is similar to a driver who drives a car by looking at the rear-view mirrors. Warren Buffett made an excellent point that if history was the road to riches, then the Forbes's list of Billionaires should be all librarians.

Another measure for risk is beta, which is the correlation between the security and the market. In equities, the market is represented by the S&P500 index. A stock with a high beta is considered more riskier than one with low beta. Similar to volatility, beta also has serious flaws as shown below:

• Using beta as a risk measure, a stock with a higher beta (fallen more than the market) is considered riskier. However, shrewd investors like Warren Buffett argue that the opposite is true. If a stock has fallen more than the S&P500, the lower valuation of that stock makes it less riskier, not more riskier. Beta does not take into account valuation levels. A lower price raises the expected return of the stock if the fundamentals of the company is not permanently impaired. 
• Similar to volatility, beta is calculated using historical prices and is backward looking. Investors who bought financial stocks with low betas in 2007 believed they were buying quality investments with low risk. The low betas completely ignored the 30:1 leverage ratios many of those financial institutions possessed. After a 75-90% decline many of those stocks experienced, betas for those stocks increased significantly. Investors started selling these financial stocks regardless what the price was because the higher betas implied high risks. How can a stock that dropped more than 75% considered more riskier than before the large price drop?

I believe measures such as volatility and beta are commonly used by investing professionals because many investors want an exact number to indicate the riskiness of an investment. However, the future is inherently uncertain and I think it's a mistake to quantify the riskiness of an investment, especially using past performance as guidance.  In the words of Buffett, "In their [academics] hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than preciously wrong."  

In my opinion, volatility only measures how crazy the price of a security moves. Beta only measures the correlation between the security and the market index. Wider price fluctuations or higher correlations with the market does not imply higher risk.

Risk Is Not  Measured By What Mr.Market Says:

Some investors believe that an investment is considered more risky if unrealized losses continue to grow. On the other hand, unrealized gains may persuade investors that the investment is less risky because it appears the only direction the asset is heading is up. Investors should not allow Mr.Market (an allegory Ben Graham created to describe the behaviour of the financial markets) to decide which investments are riskier and which ones are not. Graham reminded investors that, "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

The old rule on Wall Street is for investors to "buy low and sell high". However, majority of investors practice the exact opposite of "buy high and sell low". Aliens from Mars may scratch their head at how dumb we humans are. However, many investors "buy high and sell low" because they sell the majority of their holdings when unrealized losses are high during bear markets and buy them back again when prices are much higher in the following bull market. Investors are convinced, due to their large unrealized losses, that prices will only continue to decline further until it hit the floor and hence conclude their stocks are risky because they are heading to zero. On the other hand, the exact opposite sentiment prevails during bull market tops: investors believe prices will climb to the sky and conclude that stocks are less risky because they can only appreciate. By associating risk with price advance or decline, investors are more likely to "buy high and sell low" instead of "buy low and sell high". Mr.Market does not tell you which investments are risky and which ones are not. Investors need to evaluate the risks themselves.

The Definition of "Risk" in Investing:

I believe the definition of risk should clearly defined as: "the possibility of a permanent loss of capital". An investment is considered risky if there is a high chance of a permanent loss of capital. The definition of permanent loss simply implies that the investor is likely to lose money because the underlying fundamentals are poor or negative outcomes are more likely to occur. The definition of risk above is appealing because it's more generic and focuses on the possibility of a permanent loss of capital, rather than temporary loss.

Assessing Risks:

When assessing the risks, it is important to consider a wide range of outcomes instead of just listing the bull case, the bear case and the base case.  Value investor Howard Marks encourages investors to evaluate risks by considering a distribution of outcomes and consider the likelihood of those outcomes being realized. In my own experience, I learned that my worst case scenarios were too optimistic and I missed important risk factors because I considered them as improbable. Instead of evaluating risk as a discrete distribution with a few cases,  investors should evaluate risk as a continuous distribution. The expected outcome of the distribution is just as important as the shape of the distribution.

It is important to assess the risks to any potential investment. Below I listed some points to assess risks for an equity investment and fixed-income investment.  

Examples of assessing risks with equity investments:

• Investors should pay attention to the valuation of the stock. High valuations, such as stocks trading at extremely high multiples, will lower the future expected return and raise the overall risk level of the investment. If an investor pays a very high multiple for a stock, the expected return will be negative.  At the height of the dot.com bubble, investors were paying 100 times earnings for many technology companies. The negative returns that followed the crash did not surprise those who paid attention to the valuation levels and recognized the risk of paying too much. 
•  For equity investors, the quality of management can have a significant impact on their investments. Buying a company with a incompetent management will significantly reduce future returns because poor capital decisions will significantly reduce earnings and cash flows, the determinants of future stock prices. Investor should assess the likelihood of poor capital allocation including the possibility of spending free cash flow on empire building or investing in low return projects instead of paying a dividend or conducting share buybacks. Warren Buffett provided a simple advice to lower management risks, "invest in companies that idiots could run, because someday one will".   
• Industry risks are also important to consider for equity investors because numerous companies are constantly challenged by newer technology. Twenty years ago, it was impossible to imagine Eastman Kodak would be forced into bankruptcy because it was a dominate player in the film industry. Investors were blinded by Kodak's past success and failed to evaluate all the negative outcomes such as the disruption of digital camera by Fuji and Canon. Again, investors were looking at the rear-view mirrors instead of looking straight through the windshield and failed to consider all the possible outcomes of investing Kodak. Failing to consider the industry risks carefully can be extremely costly. Warren Buffett reflected his mistake of investing in Berkshire Hathaway (the original textile maker) in the 1989 Berkshire Letter: "When a management with a reputation for brilliance tackles a business with a reputation for a bad economics, it is the reputation of the business that remains intact"

Examples of assessing risks with fixed-income investments:

• Fixed-income investors should also consider valuation levels, but in terms of yield spreads instead of price multiples. In 2007, the yield spreads on junk bonds relative to US treasuries was only 250 basis points. The high valuation will depress future returns and increases the overall riskiness of the investment. As junk bond investors experienced in 2008, the 250 basis point spread paid in 2007 was too rich and the yield spreads blew up to over 2000 basis points. The price investors pay is key to assess the overall riskiness of investment. The opposite was true in 2009 when spreads were above 2000 basis points on junk bonds and investors were more than compensated for the credit risks they were taking on by buying junk bonds.
• Fixed-income investors should especially pay attention to balance sheet risks because they are the first in line to receive payouts if a firm liquidates. Investors purchasing bonds issued by companies with little tangible assets has very little margin of safety. Therefore, investors should carefully assess all the asset values of the company under all possible economic conditions. If once in a century event occurs, can the liquidating value of the assets cover majority of the principal value?

Managing Risks:

Why is important to manage risks when investors are not rewarded for being prudent risk managers? It may be intuitive but investors forget that great investing records are built by avoiding large errors. That is why Warren Buffett's fundamental tenet is "Rule 1: Don't Lose Money, Rule #2: Don't forget about rule #1"

Most athletes understand that in order to win a race, they must first finish the race. The same motto of  "To finish first, you must first finish" should be followed by investors as well. If investors do not practice prudent risk management, they may face the same situation LTCM (a hedge fund that lost a significant amount of its capital) experienced in 1998. Investors should always remember that if they manage to lose almost all of their capital, there is no chance of returning to the starting point. A zero multiplied by anything is still a zero. Charlie Munger stated that Berkshire Hathaway was very successful because he and Buffett avoided "stupidity". Mitigating unnecessary risks is a brilliant method of building solid returns over the long run.

Managing risks involves having a thorough understanding of the risks involved in any investment and being able to take on risks intelligently. Investors need to understand what the real risks are. Paying too much for any investment is a big risk while higher volatility is not. Investors should recognize the possibility of a permanently loss of capital and take actions to avoid negative outcomes. This involves recognizing and controlling the risks involved with their investments.

Misconceived Risk = Opportunity:

Most successful investors understand the importance of taking advantage of misconceived risks. Because most finance professionals still measure risks in terms of betas and volatility, there will be profitable opportunities during bear markets to buy assets considered risky by most investors but the underlying investment itself is actually not risky. During bear market declines, investors will sell a stock because the volatility or beta has increased, implying the stock is now more riskier under modern finance theories. However, intelligent investors understand that large price declines, which increase volatility and beta, actually decrease risk. The lower price level enhances future expected return and offers a larger margin of safety for investors assuming the fundamentals of the stock are not permanently impaired. Valuations and fundamentals are key to assessing risks involved in any investment. The 2008 bear market presented patient investors the opportunity of a life time because the herd was judging risks in terms of volatility and price declines rather than absolute valuations. Misconceived risks often present wonderful opportunities.

The opposite is also true in bull markets. Low volatility and large price advances creates a false sense of security among investors. After a long period of price advance, investors will forget to check the necessary blind spots and assume risk has been banished. This common misconception is very prominent during the height of bull markets such as in 2000 and 2007. Intelligent investors who understood the real risks would have sold (or even shorted) technology companies in 2000 and financial companies in 2007.

In both cases, misconceived risks by the herd creates opportunity for investors who take the time to evaluate the actual risks and understand when risk is misunderstood. Those who did their homework will be handsomely rewarded.

Miscalculated Risk = Fiasco

Mis-calculated risks can result in a disaster. The financial crisis of 2008 provides a perfect example of how risk was miscalculated. Fixed income investors believed risks could be banished by slicing mortgages and other loans into tranches. Equity investors believed risk was low because the low interest rate would support the use of leverage indefinitely. The danger of extrapolating near term trends many years into the future can be very dangerous. Investors should rely more on their common sense rather than the past to evaluate risks.

As Howard Marks puts it: "There are few things as risky as the widespread belief that there's no risk". No four words are more dangerous in investing than "this time is different". In the words of George Santayana, "Those who cannot remember the past are condemned  to repeat it"

Conclusion:

Understanding risk is important for investors because investing is a forward looking game and the future is uncertain by nature. It is important for investors to realize that the standard risk measures are deceiving and do not measure the actual risks to an investment. Howard Marks nailed the definition of risk with his own statement: " risk means uncertainty about which outcomes will occur and about the possibility of loss when the unfavourable ones do".

After reflecting on the mistakes of other famous investors and my own personal mistakes, I believe evaluating the risks to any potential investment is key to guaranteeing satisfactory results. Evaluating risks before making any investing is important. Minimizing risk will boost future returns, which contradicts the positive relationship between risk and return. Taking on more risks increases expected return, not actual returns. Expected returns is increased because taking more risks increases the possible outcomes of the investment (both good and bad), which increases the expected or average future returns. However, I prefer to increase future expected return by avoiding unfavourable outcomes and maximizing favourable outcomes.

All in all, I created my motto of "Misconceived risk = Opportunity, Miscalculated risk = fiasco" to use in my investment decisions. Bear markets presents excellent opportunities for value investors who spend time to understand the "misconceived risks" by the market and take advantage of the bargains created by these misconceived risks.  On the other hand, bull markets presents excellent opportunity for value investors to sell their holdings to market participants who miscalculated risks involved. Minimizing risks is key to maximizing future returns despite many investors still believe they can only maximize future by taking on more risks. One common risk, identified by many famous value investors, is paying too much for an asset. Therefore, to minimize the risk of overpaying, always remember Ben Graham's words of "price is what you pay, value is what you get". 

A Stock Market Bubble?

There has been a lot of talk of a stock bubble in the financial media. One of the cover story for the weekly Barron's magazine was "Bubble Trouble?" (subscription required to read). Also, there was another good WSJ story that used Robert Shiller's favoured Cyclical Adjusted P/E (CAPE) ratio to argue stock valuations are getting frothy. The CAPE, which divides the S&P500 price by a 10-year average real earnings number,  is near 25.1 compared to the 130 year average of 16.  With the S&P500 rallying over 27% this year, NASDAQ over 30% and Dow Jones Industrial 22%, it definitely looks like a stock market bubble is building. However, I should caution investors not to call a top based on the YTD performance or the fact that the S&P500 is up over 170% since its low in March, 2009. 

The Frothy Side:

Let's not forget the cause of the market rally this year. The key reason is that low interest rates, caused by ultra loose monetary policies like QE, pushed many investors up the risk curve. Some fixed income yields, namely short term treasuries, were negative after adjusting for inflation (real yield) which forced investors to seek higher yielding assets in either corporate bonds, high yields or even conservative blue chip stocks. The key measure that determined whether investors prefer bonds or stocks is spread between the earnings yield (E/P or inverse of the P/E ratio) and the bond yield. At the start of the year, the 10-year US  treasury yield was near 1.8% and the S&P500 earnings yield was 7.5% or almost 4 times higher! It's a no-brainer why stocks rallied. The fact pension funds and mutual funds had low equity exposure also fueled the equity rally as those "big players" re-entered the market. 

Despite a small correction in the summer due to the taper tantrum, stocks kept on rallying. The current earnings yield of the S&P500 is about 6% while the 10-year US treasury is yielding near 3%, which reduced the attractiveness of stocks by 50%. The S&P500 is trading at 16.5X trailing earnings and 15.1X forward earnings. Those measures are slightly higher than historical averages but well short of the P/E north of 20X in the dotcom boom and 17-18X at the height of the 2007 bull market. This means that stocks can still rally further. Mutual fund asset levels are still low compare to 2007 and many pension funds are still under-weighing equities. Therefore, don't be surprised if stocks move higher. 

However, what worries me is that the equity rally is mostly due to P/E multiple expansion. Recall changes in price is the product of changes in earnings multiplied by changes in the P/E ratio. Given the aggregate S&P500 earnings is foretasted to increase only 6% in 2013, the 27% rally in the index was caused mostly by a 20% expansion in the P/E ratio. P/E doesn't expand forever and the fact earnings growth is unlikely to pick up is a cause for concern. 

The Problem of Calling a Top: 

In December 1996, former Fed Chair Alan Greenspan made his famous "irrational exuberance" speech questioning the valuation of equities at that time. Some investors agreed with Greenspan and started shorting equities. The fact the stock market advanced 31% in 1997, 26% in 1998, and 20% in 1999 proved many of those skeptics wrong. The point I want to make here is that calling a top is extremely hard. Many should not even waste the time or effort to because it is hard to get both the timing and thesis correct. 

So, What to Do? 

Bonds are still yielding close to nothing (after adjusting for inflation) while stocks may be in bubble territory. My opinion is that stocks should be preferred to bonds.

Reasons:  

• Earnings yield of 6% is still 2 times higher than long term treasury yield and higher than most fixed income yields (including junk bonds that are yielding near 5%) 
• Stocks provide investors with great long term performance despite short term troubles. Let's not forget that in the 20th century, the Dow Jones returned 5.1% compounded annually. For those who are not aware, the market experienced several large drops greater than 50% with the Dow losing 90% from 1929-1933. That period also included 2 World Wars, the Great Depression, a Cold War, a decade of super high inflation etc. 

For the average Joe investor, a bubbly market should not deter them from a conservative dollar cost averaging strategy where one sets aside a fixed amount to put into an index fund every month or quarter. For more active investors, there are still bargain stocks available especially in the mining space. Trying to call a market top is foolish because no one has a perfect crystal ball. Investors should adhere to strict investment rules such as buying stocks at reasonable valuations (i.e. significantly below intrinsic value) in order to provide them with a margin of safety. Timing the market appears to be simple and easiest strategy to make money but its application is hard in practice. 

In short, although I worry about a stock market bubble, I'm still long stocks in my portfolio because they still provide the best risk-adjusted potential return. I use the margin of safety principle advocated by Ben Graham to help protect my downside by buying stocks with low valuations, healthy balance sheets and high future earnings power. I tried calling market tops and bottoms in the past but learned it's better to admit you can't. Many times, you get the thesis right, but the wrong timing can kill you. As Keynes famously said: "The market can stay irrational longer than you can solvent". 

Are Share Buybacks Really Meaningful?

After my article on stock splits, I believe I should discuss my thoughts on share buybacks, another important topic in corporate finance. I will write about other topics such as dividend payout policy, M&A, executive compensation etc in the future.

What are Share Buybacks?

Share buybacks, also know as share repurchases, are methods of returning cash back to shareholders. The net effect of repurchasing shares will result in less shares outstanding, which increase the ownership of shareholders who decide to maintain their stake. Companies usually purchase their shares on the open-market, although a tender offer can also be used. In Canada, an open market share buyback program is called Normal Course Issuer Bid (NCIB).

Rationale Behind Share Repurchases: Returning Free Cash Flow

Basically there are 3 main uses of free cash flow (often defined as operating cash flow minus capital expenditures): (1) pay down debt (2) make an acquisition (3) return it back to shareholders via dividends or share buybacks. Most executives hate option 1 because they want to maintain an "optimal structure" of debt and equity. In my own opinion,  it may be prudent to reduce debt levels when excessive free cash flow exists since high cash levels usually build near the height of an economic boom, which implies a recession may be on the horizon. Reducing debt levels in good times prepares the company for bad times such as a recession or economic slowdown. Also, it leaves excessive capacity to take on more debt in recessionary times when interest rates are much lower. Option 2 was popular but CEOs are now more cautions when it comes to acquisitions especially after the disastrous outcomes of serial acquirers like Tyco, Worldcom, or Citigroup. Accounting treatment is also less favourable with FASB and IASB abolishing the pooling of interests method. Option 3 is the most commonly used method of returning free cash flow and most executives prefer stock repurchases just because it is "tax-efficient" over dividends. Although the argument is valid, purchasing shares above intrinsic value is value destroying (see example below) despite being a little tax efficient  If the shares do trade above intrinsic value and the company has excessive cash, it should consider boosting its dividend instead.

Example:

Stock X is trading at $150, has 100 million shares outstanding, and earns $500 million a year. This implies a market capitalization of $15 billion and EPS of $5. Let's assume that the true intrinsic value (hidden from the public but can be roughly estimated by the intelligent investor) is only $10 billion or $100 per share, which implies the stock is 50% overvalued. 

If the company decides to repurchase 5% of its outstanding shares (5 million shares) at $150 and still makes $500 million a year, EPS would increase from $5 to $5.26, a magical 5.2% increase. However, if the share price corrects to the actual $10 billion (in the long run, the market is a weighing machine and will be efficient) , the high purchases made at $150 are clearly value destroying. If the company did not conduct the share repurchase, intrinsic value would still be $100 per share (10 billion value divided by 100 million shares). If they did the share repurchase, they would destroy $250 million of value by buying shares for $750 million when intrinsic value of those shares is only $500 million. Thus, intrinsic value of the company after the repurchase is 9.25 billion or $97.37 per share. ([$10 billion - 0.75 billion]/ 95 million shares). Well congratulations shareholders of company X, it just destroyed $2.63 of value on a per share basis. The company may had good intentions, such as returning cash to shareholders, but buying back shares above intrinsic value is dumb. Many would argue against me by stating there is no exact method of determining the intrinsic value. Nonetheless, I believe experienced managers who is familiar with industry trends and the company's financials should have a rough idea on the company's intrinsic value. Academic studies have shown that following the insiders (after they disclose a purchase or sale) can earn abnormal returns. 

If the shares was 300% overvalued, this transaction would destroy over $11.50 of value on a per share basis. The prior examples are typical in the real world. Why? This is because corporations usually have large cash hoards in boom times or just before a recession hits, which also corresponds to when their share prices are often overvalued in the market. Many corporate executives are often pressured to return cash to shareholders and believe buybacks are the most efficient method. 

Rationale Behind Share Repurchases: Growing EPS or Offset Share Dilution 

Short term earnings accretion get the attention of analysts and the financial press, but prudent investors should look for underlying value creation, not earnings accretion. As the example above shows, there is earnings accretion with EPS growing 5.2%. However, the actual intrinsic value of the business, on a per share basis, is lower as a result of repurchasing shares above intrinsic value. 

Another common argument is that companies often issue stock options and exercising those options could dilute existing common shareholders. The problem of offsetting that dilution with share repurchases is that buying shares above intrinsic value would destroy more value than merely letting its shares outstanding increase. Let's go back to the prior example. If there is 5 million of options, the shares outstanding would increase to 105 million and EPS decreases to $4.76. Most executives doesn't like that lower EPS so they decide to repurchase shares. If the company doesn't do anything, intrinsic value reduces to $95.24 ($10 billion/ 105 million shares) or $4.76 lower. If the company decides to repurchases 5 million shares at $150 (greater than $100 intrinsic value) to offset the 5 million share dilution, intrinsic value is reduced to $92.50  ([10 billion - 750 million] / 100 million shares)  or $7.50 lower. Clearly $95.24 > $92.50, so repurchasing shares when the shares are overvalued is a dumb idea. Buying loonies for tonnies is plain silly (For non-Canadian readers, loonies = $1 while tonnies = $2) 

Share Buyback Lesson from the Oracle of Omaha:

We pay so much tuition to learn finance in University but the best source, Buffett's Annual Letters to shareholders, is available on the Berkshire Hathway's site for free. Regarding share buybacks, Buffett's clearly explained his position in his 2011 Annual Letter (see the section on "Share Repurchases" on page 6-7). Here is a quote taken from the letter:

"Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated"

Buffett explains how CEOs, even the honest and hardworking ones, fail the second test miserably. A CEO may think his company's share price is cheap no matter what price it is selling at. Even the honest executive is led to believe that returning excessive free cash flow is necessary. Buffett argues that this is not true. There is no point of a share repurchase UNLESS the you can repurchase the shares below intrinsic value, hopefully conservatively calculated as Buffett suggests. Notice Buffett never mentions earnings accretion or returning excessive free cash flow as criteria when deciding a share repurchase.

Here is another interesting thought from Buffett: "When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock UNDERPERFORMS in the market for a long time as well ." 

Wait, what? Did Buffett just say he hopes the share price would underperform the market for a long time? This is not a typo. The logic is a simple one, but often not well understood. If the share price underperforms, the company can purchase more shares and the remaining shareholders would own more of the company (and receive more share of the company's long term earnings as well). If IBM's share price remains at $200 for the next 5 years, Berkshire's 5.5% stake in the company would indirectly increase to 7% through the ~$50 billion share buyback program. But if IBM averaged $300 in the same period, then Berkshire's stake would only increase to 6.5%. The 0.5% may seem small but it makes a big difference in the long run. If net income is $20 billion for IBM per year, then Berkshire will get an additional $100 million share of that income. IBM's stock price is in fact languishing right now as expected and sell-side analysts are cutting their price targets like crazy. While analysts criticize IBM for poor share performance, Buffett must love the lower share price right now. It's hard to think long term but let's not forget the moral behind the turquoise vs. hare story. 

If the company is pursuing a large buyback program, shareholders should cheer when the stock price languishes. As Buffett says: "The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply." Very well said Mr.Buffett, I thank you for sharing this point many people miss. 

Conclusion:

To answer the question in the title, share buybacks is definitely meaningful method of returning capital to shareholder only if the company can repurchase shares under intrinsic value, conservatively calculated. Investors should be cautious when CEOs announce buybacks because their intent is to offset share dilution or increase EPS growth. If CEOs announce buybacks because they want to return free cash flow, carefully assess the company's intrinsic value. If the company's shares are trading below intrinsic value, you should applaud the move and give a big thumbs up. If it is not (especially if it is significantly above your estimate of intrinsic value), you should  re-consider your investment thesis in the company. No matter how great a business may be, investors should not invest in the company if the CEO makes poor capital allocation decisions because those decisions can lead to a lot of value destruction. (An exception would a net-net special situation but I'll again save this topic for next time)