Monday, May 18, 2009

The Best of “Woodstock for Capitalists” Part 2: Least Logical Answer

In Part 1 of this two-part series we promised the following key disclosures from the Berkshire Hathaway annual shareholders meeting:

· Best Question Not on Our List, Answered
· Best Question Not on Our List, Avoided
· Sharpest Implied Put-Down
· Mystery Revealed!
· Least Logical Answer
· Most Logical Answer
· One Industry Not to Expect Buffett to Buy Into


· The Most Philosophical Start to Any Answer at Any Annual Meeting in History, Since the Beginning of Recorded Time

So without further ado, here goes: The Least Logical Answer

The question, by one Aaron Goldzimer, was straightforward and helpfully reprinted by New York Times ace Andrew Ross Sorkin—one of three reporters asking the questions—in his DealBook blog:

“Warren, in your General Electric and Goldman Sachs investments, do you think you’ve picked attractive businesses or simply attractive securities? Ben Graham’s Security Analysis suggest that the most frightening things management can do is manage earnings, which it could be argued both of these firms do. What’s your reaction to that?”

—Andrew Ross Sorkin, DealBook, May 4, 2009

In assessing Buffett’s “reaction to that,” let’s be clear of one thing: nobody is going to make light of Warren Buffett’s capacity for logical thought.

It is, after all, the rational appraisal of investment ideas that accounts for Buffett’s quite literally unparalleled investment success—not to mention the fact that the man processes more financial information than probably any other human being on earth.

And that last clause was not a throw-away line.

We didn’t stick it in there to merely conclude the primary thought, nor was it added merely to lend weight to the statement about Buffett’s rational thought process. Buffett has very likely read and absorbed more financial information in the last 78 years than any other human being on earth.

So when Buffett kicked off his response to the question of “managed earnings” at Goldman Sachs and GE with the whopper that “A large percentage of American businesses have managed earnings,” and “I wouldn’t know anything about that” at Goldman or GE—our reaction was, well, it’s a whopper.

GE, by any standard—and Wall Street has very low standards, we know—has to be one of the most earnings-conscious companies on earth.

This doesn’t mean GE is a bad company, or that it practices accounting gimmickry outside the bounds of Generally Accepted Accounting Principles. It's just that GE plays up to Wall Street analysts the way World Cup soccer players play up to the refs—throwing themselves on the ground, grabbing a leg, writhing in pain, and then, once the yellow flag comes out, jumping up and running back to their position, smiling.

So too GE plays the Wall Street game, and anybody who’s ever listened to a GE earnings call knows it.

And surely Warren Buffett knows it.

He's certainly read the GE proxy statement, which describes how the compensation committee arrives at the GE CEO’s compensation each year—compensation that is heavily dependent on not merely return on capital and cash flow from operations, but “earnings from continuing operations” and “earnings per share from continuing operations.”

He certainly knows that GE’s 2008 earnings would have been significantly lower than reported if not for a substantial reduction in GE’s income tax rate, from 15.6% in 2007 to all of 5.5% in 2008.

He also knows that GE’s tax rate is not even remotely comparable to other well-run conglomerates such as Honeywell, at 27%, and 3M Company, at 31%.

Consequently, we rate Buffett’s answer—that he “wouldn’t know anything about” earnings management, particularly at GE—as the “Least Logical Answer” we heard all day.

Interestingly, the balance of his response—as to whether GE and Goldman were “attractive investments” or “attractive securities”—was weighed towards the latter: “We were the low bid,” Buffett said. “The terms of the deals were overwhelming.”

Indeed they were.

Up next: Most Logical Answer

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


Anonymous said...

Well he's not going to sell. In fact, he reiterated his sell thesis...if an investment represents a never-ending black hole of cash-calls, then he gets rid of it. Given that GE/GS were preferreds and can't go lower than zero, he's not going to sell. Now, if he owned a controlling stake in, say, GE, that would be a different scenario as it would pose a significant risk to the cash flows of BRK.

cheyfaith said...

Hello, Jeff. These posts on the Berkshire Hathaway annual meeting are excellent. I'm looking forward to the next several installments.

Kevin said...

A thought on "earnings management" - you need to be more precise, as there are many forms of earnings management. In one sense, I would say that all managers engage in earnings management - i.e., over the long run, their primary goal is to manage earnings by increasing them. Insofar as "earnings" (however you define it) is a valued measure of the success of a company, that is perfectly rationale and of course should be promoted (and is the reason most companies include it as a significant component in their comp programs). On the other hand, when most people talk about "earnings management," they are really talking about fraud - i.e., intentionally misleading investors - mostly through the use of accounting tricks, such as shifting earnings from one quarter to another or creating "cookie jar" reserves (both forms of smoothing). But there are a whole host of decisions that managers are required to make every quarter that affect earnings, and in some way result in "earnings management". Things like picking the right amortization or depreciation period for an asset, deciding whether an asset has been impaired, guessing whether you need to accrue for a lawsuit and how much you are going to pay your lawyers, etc. All of these require judgment and are susceptible to charges of "earnings management." So I'm not surprised Mr. Buffett responded the way he did. The question was imprecise and I'd bet a dollar he's not consulted by GE or GS on the accounting decisions they make. The important thing is to consider whether you can trust management to make consistent, rationale and honest decisions in running the business.

BTW, I'm not sure how the lower tax rate piece fits in. If GE can lower their effective tax rate to 5.5%, that represents real cash savings in the affected period - how is that "earnings management"? Even if they know their rate is going to be higher in a future period (and I have no idea if they do), should they normalize the rate of the year? THAT would be earnings management! I'm sure they went out of their way to point out that portion of quarterly earnings attributable to a decreased tax rate...

Jeff Matthews said...

Kevin: I did not mean to suggest earnings management is necessarily a euphemism for earnings manipulation.

And you are very right: all companies make judgments every quarter that affect reported earnings.

Anybody who's ever worked for a real company knows that reported EPS reflects a whole bunch of judgment calls...although most Wall Street analysts take the reported number as a gospel, set-in-stone fact, which it is not. (Just listen to a call where some analyst asks why XYZ line item "missed our model by $23,000" or something ridiculous.)

As for the question itself being "imprecise," I think Buffett knew exactly what was implied.

In any event, nobody at GE or Goldman is consulting Buffett about accounting decisions--his company owns preferred equity: there's nothing to consult about.

As for the low GE tax rate being what it is and nothing more, I wouldn't be so sanguine.

Wall Street's Finest focus on reported EPS, not pre-tax EPS. Sure, GE reports the benefit, but you won't find an analyst report that compares GE with its peers on a pre-tax EPS basis. That's the beauty of it: when you hear people talk about how cheap GE is at X-times earnings, they're not adjusting for the tax rate.

And not for nothing, the GE CEO's compensation is, as I wrote, based in part on reported earnings "from continuing operations," not pre-tax earnings.

That means after tax, and without those pesky losses from "discontinued operations."

This is World Cup Soccer, not your elementary school travel league!


Steve said...

Enjoy your blog immensely.
That said, I'm sure you know in World Cup soccer the ref pulls a yellow card, not a yellow flag.

Sierra said...

This is very informative. You managed to include good points!