Author Archives: Adam Schwab, CFA, CFP

How Investors Should Navigate the Non-GAAP Earnings Confusion, Continued

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Adam Schwab, CFA, CFP

A Cheat Sheet for Common Non-GAAP Adjustments – Part II

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

Debt Tender/Retirement

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

Litigation Expense

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

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

Asset/Goodwill Impairments

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

Depreciation

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

Acquisition-related costs

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

Gain/Loss on Sale of Assets

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

Severance Charges

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

Conclusion

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

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.

How Investors Should Navigate the Non-GAAP Earnings Confusion, Continued

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Adam Schwab, CFA, CFP

A Cheat Sheet for Common Non-GAAP Adjustments – Part I

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

Reorganization/Transition/Restructuring Expenses

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

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

Options Expense

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

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

Foreign Exchange

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

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

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

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

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

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

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

Look for Part 3 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.

How Investors Should Navigate the Non-GAAP Earnings Confusion

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Adam Schwab, CFA, CFP

An Introduction and Three Guiding Principles

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

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

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

3 Rules to Remember

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

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

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

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

  1. Match the reconciliation to the business model

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

Look for Part 2 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.            

How a Famed Mathematician Can Make You a Better Investor

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Adam Schwab, CFA, CFP

In the pursuit of building an investment education, I have found most insightful investment principles are often discovered in other disciplines. Investment books can be great, but most just rehash the same superficial material. True investment insight flows from deep principles that originated from other academic and professional fields.

Richard Hamming was a world renowned mathematician who pioneered research in computing and physics. He worked at the famed Bell Labs, helped design atomic bombs at Los Alamos, and advocated the redesign of mathematics education. Not only were his ideas valuable in computer science and physics, they clearly crossover into the investment world.

So what insights can Hamming share with investors that will enable a successful investment strategy?

Two foundational articles provide great insights for both beginning and sophisticated investors: “You and Your Research” and “A Stroke of Genius in Striving for Greatness in All You Do”. These articles provide a solid blueprint for constructing an investment education. Here are four ideas that readers can implement today.

“Great scientists have independent thoughts…and have the courage to pursue them.”

Hamming talked about the courage young scientists had to pursue new thoughts, instead of sticking with traditional methods. Great investors follow the same path. Independent thought is the linchpin for successful investing. Unaware to most investors, the outside influences we subconsciously entertain degrade the rational and logical mind necessary for investment success.

Great investing ideas often involve courage. The best opportunities are likely out of favor and take significant diligence to understand. Independence provides the clarity to see ideas in an unbiased light.

Investors are constantly being told what to buy, what to sell, and what to worry about. Sophisticated investors are extremely selective in what ideas and opinions they let through their filter. Investing doesn’t have to be a solo act, but each investor needs to build their own foundation.

Solution: My preferred method is to learn from other experts who have exhibited independence throughout their careers. Borrow ideas to fit your situation and mindset, rather than reinventing everything yourself. Some of my favorite examples are Richard Feynman, Teddy Roosevelt, and John Boyd.

“Knowledge and productivity are like compound interest. The more you know, the more you learn; the more you learn, the more you can do; the more you can do, the more the opportunity – it is very much like compound interest…One person who manages day in and day out to get in one more hour of thinking will be tremendously more productive over a lifetime.”

Investing requires diligent and consistent effort to build the competence to judge ideas and have the courage to stick with investments when times get tough. Investors have a nasty habit of interrupting compound growth to pursue hot ideas with a catchy story. Investor’s self-sabotage causes more problems than any geopolitical crisis or recession ever will.

Solution: Leverage great investors. My top 3 are Howard Marks, Warren Buffett, and James Montier. Build off their successes by reading one of their letters daily. Consistent effort in just a short time will yield tremendous results.

“You have to neglect things if you intend to get what you want done. There is no question about this.”

Not only is this quote practical for everyday life, it is also necessary for investors. There is too much information and distractions that bombard investors. To gain the necessary investment expertise and analytical edge, all superficial noise and wasted activity must be filtered away from investor’s attention. Whether it’s endless market commentary or concerns coming out of Europe, most of what investors read and hear has no useful purpose.

Solution: Make a conscious choice to go on an information/activity diet. Free up time that can be committed to building a particular investment skill. Abandon the thought of trying to conquer everything at once. Read a 10-K/Annual Report in your favorite industry each day and watch how a singular focus can deliver rapid investment growth.

“The people who do great work with less ability but who are committed to it, get more done that those who have great skill and dabble in it, who work during the day and go home and do other things and come back and work the next day. They don’t have the deep commitment that is apparently necessary for really first class work.”

Hamming’s insight is a great reminder to investors that investing is long term commitment. Just as great authors commit to their craft, great investors need to apply consistent effort in building their mental toolkit.

Solution: Decide how passionate and committed you are to improving your investment ability. The real test will occur when boredom & repetition sets in and you face a choice: keep building your skill or give up and see your progress unwind.

Adam Schwab, CFA, CPA is a portfolio manager at Elgethun Capital Management

3 Ideas to Implement Today from Buffet’s Annual Letter

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Adam Schwab, CFA, CFP

Warren Buffet’s annual letters are usually packed with interesting insights, but for the past couple years I had been a little underwhelmed by his thoughts. This year’s letter was the exception. As I read the letter for the second time, I realized Buffet laid out exactly how an investor should construct an investment portfolio and evaluate businesses. Although investors won’t find actual recommendations, he delivers something more valuable: a framework for selecting and analyzing businesses that any serious investor can follow. If these lessons make sense to you, you will want to read the entire letter here.

It’s ironic that the lessons seem logical and obvious as he describes them, yet 90% of investors (both individual and institutional) will completely fail at following half of his advice. We can attribute that to attention spans of zero and the general get rich quick mentality. If investors can avoid those handicaps, this year’s letter was a real goldmine for investors who are looking for a sensible way to think about investing.

Although he gives his secrets away for free every year, implementation is always the hard part! I picked out a few of the best and most practical insights that you, the investor, need to follow. By shamelessly stealing Warren’s investment principles, you will be 95% of the way to an effective investment portfolio. Now, the lessons…

One: Businesses > Treasuries

Warren wasted no time describing the tremendous outperformance of U.S. businesses over US dollar denominated bonds over the past half century. As most investors flock to “safe” U.S. treasuries, Warren’s extols the impressive track record of owning American businesses over long time periods. The common perception that stocks are risky and bonds safe is completely discredited by the long term data. Of course, this is no absolute guarantee this will repeat in the future. But consider what you would rather own for the next 30 years: a sensibly priced business that can compound value at 10-15% per year or a 30 year treasury delivering 2.7%?

Investing should be thought of as buying businesses, not trading stocks. Buffet has slowly and methodically built his portfolio of great businesses without the manic-depressive emotions that occupy most investors. Your portfolio should be structured the same way. If you have the time and aptitude to evaluate businesses, wait until they go on sale, and then start building your portfolio.

Two: What Matters Most: Durable, Competitive Advantages

Buffet highlights one the best but most forgotten elements of investing. Warren and Charlie own businesses with durable competitive advantages that can compound value over time without needing excessive capital investment. Notice how he didn’t mention fast growth, growing market share, exciting technology, or world-changing products. He distills a great business into one line.

But how quickly do most investors forget what really matters! 99% of investing conversations revolve around superficial topics that are heavy in excitement but rarely touch on the elements of investment success. Do your investments satisfy this simple test? This idea is powerful because 1) it’s free and 2) most investors won’t use it! Resist the urge to fool yourself into thinking you can ignore this advice and “beat the market”. Your portfolio will thank you.

Three: Price Matters

Although Buffet expounds on the promise of great businesses, he doesn’t pay any price for them. Even Buffet admits that at close to 2x book value, Berkshire may likely see price declines in the near future. How refreshing to have a CEO give an honest assessment of the stock price! Not many CEO’s admit their companies are priced to perfection; in fact today most CEO’s are paying egregious prices for their own stock!

Great businesses still need to be bought at sensible prices! What is sensible is debatable, but if your business evaluation skills are sufficient it’s generally achievable to be roughly right on the price. Great businesses are not on sale very often, but it certainly happens. The key is buying with deployable cash to pounce on opportunities (The 2008-2010 timeframe being the last great opportunity).

Price is an area where most investors screw up. We are hardwired to buy high and sell low, and even the best businesses make poor investments when bought at the wrong times. Activity will be skewed toward inaction 90% of the time, but the other 10% will provide incredible opportunities to pick up wonderful businesses at bargain prices.

Bonus: Charlie Munger’s Thoughts

Followers of Berkshire know the wisdom of Charlie Munger. Charlie didn’t disappoint as he gave us a few pages of insight in this year’s letter. I’ll leave you with one piece of advice that applies to both investing and life. Here Charlie describes one of the many aspects of how Warren set up his system for Berkshire Hathaway:

“His first priority would be reservation of much time for quiet reading and thinking, particularly that which might advance his determined learning, no matter how old he became…”

What great advice for investors and people in general! Notice he didn’t mention checking stock prices, scheduling meetings, or email. Great investors and great ideas are not built from at frantic pace at which the market operates. The compounding of knowledge over time will pay some large dividends if you don’t interrupt the process!

There is a treasure trove of great advice from Warren and Charlie on the Internet. Let me know and I can directly point you to the best material out there.

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Adam Schwab is a portfolio manager at Elgethun Capital Management. Prior to joining Elgethun, Adam was a portfolio manager at the South Dakota Investment Council. He managed a $250 million large-cap global equity portfolio for 5 years and a $90 million SMID portfolio for 3 years. Adam is a CFA charterholder and a CPA. He has an MBA from the University of Chicago Booth School of Business and a degree in Finance from the University of South Dakota. He currently serves as a Trustee for the University of South Dakota and also serves on the boards of the Sioux Falls City Employee’s Pension Fund and Alta Trust. Outside of work, Adam has been married to his wife Sarah for 6 years. He is active in powerlifting, competitive taekwondo, and the outdoors.