Edward Quince’s Wisdom Bites: Are You Intelligent? Chapter 12

 After introducing the topic of ‘Security Analysis’, Graham moves towards a further examination of earnings. Remember there are really only three things that matter for the analyst, are there to be future earnings, when will they arrive, and how they should be capitalized.  Earnings are the lifeblood of the company and the lifeblood of an investors’ returns.  "The absolute most that the owners of a business, in aggregate, can get out of it in the end - between now and Judgment Day - is what that business earns over time."  The “in aggregate” part there is important, but I won’t harp on explaining it.

Graham has already spent plenty of time bemoaning simple extrapolations of the past and he extends that to his discourse on earnings per share, stating:”first, don’t take a single year’s earnings seriously. Second, is if you do pay attention to short-term earnings, look out for booby traps in the per-share figures. If our first warning were followed strictly, the second would be unnecessary.”

What are these “booby traps”? Graham lists a few such as: special charges, reduction in normal income tax due to past losses, the dilution factor implicit in convertibles and warrants/options, the method of depreciation, the treatment of R&D, the inventory method, etc.    Suffice to say, accounting can be tricky.

To avoid placing too much emphasis on the short-term and attempt to remove some of the noise of these “booby traps” Graham was a fan of looking at average returns over a long period of time and comparing recent earnings growth trends to the company’s previous growth trends, often 10 years earlier.  Something that is likely impossible to do for newer, early stage companies.

Zweig takes Graham’s “booby traps” and updates them for some of the traps investors face in the 21st century.

Commenting on Commentary on Chapter 12

The biggest trap that Zweig highlights is the use of “pro forma” or “as is” earnings numbers.  These measures are simply the earnings that GAAP (accounting rules) proscribe with numerous adjustments.  The idea of pro forma numbers was to ‘help’ investors by removing the short-term, non-recurring, items that were otherwise making earnings noisy.  As occurs with many decent ideas, things can get taken too far.  Zweig describes pro forma earnings as: “enabling companies to show how well they might have done if they hadn’t done as badly as they did.”

Zweig explores a few cases of ‘abuses’ in accounting to make the point that “the intelligent investor should be sure to understand what, and why, a company capitalizes.” (capitalizes means the company spends money on something but doesn’t call that spending an expense)

The key takeaway for me in this chapter is that if you plan to invest in a given stock security on the basis of what would be necessary to call your investment ‘intelligent’ or ‘enterprising’ you’ll need to do a lot of reading up on the company’s financial statements, digging into the footnotes, understanding accounting policy elections and how they might be impacting earnings.  After all, if it was easy, everyone would be doing it.

“You can get ripped off easier by a dude with a pen than you can by a dude with a gun.” - Bo Diddley