WWII 069: The Retained Earnings Test, Quantitative vs Qualitative Data, John Mayer's Ten Million Dollar Watch Collection
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Main Topic: The Retained Earnings Test, Identifying Cigar Butts, Overall Market Returns
The topic of this episode is a unique metric that Warren Buffett has suggested as a way to determine management’s ability to turn retained earnings of a company into an increase in market capitalization or higher stock prices.
Companies become more valuable through three basic mechanisms, both directly related to management’s ability.
· First, companies that increase their earnings over time will be rewarded with higher stock prices.
· Second, companies that increase their dividends over time will be rewarded with a more stable stock price based on current yields.
· Third, companies that can reinvest their retained earnings at high returns on invested capital will produce still higher earnings and be rewarded by the market.
· Remember, “The market rides on earnings,” as noted by Shelby Davis Jr.
Lets define some of these terms and see how we can use these concepts to do a retained earnings test.
Retained earnings are essentially profits a company earns that are not distributed to shareholders through dividends or stock buybacks. Hence the term “retained.” Some or all of these earnings are retained as cash on the balance sheet, which then needs to be reinvested.
The process of growing earnings from operations, and investing retained earnings are two very different processes.
Operating earnings can be grown through selling more product, to more customers, at higher prices, for lower costs, in a nutshell.
Reinvesting retained earnings on the other hand, is a type of investment strategy. Do you buy another company with those retained earnings? Do you increase your R&D budget? Do you add a new product line? As opposed to incremental increases in earnings like growing operating earnings, reinvesting retained earnings may mean initial outflows of cash before you begin seeing increased earnings, often for a year or more. So reinvesting earnings may actually lead to a temporary decrease in earnings until the investments begin to pay off.
As a long-term investor, I am fine sacrificing a year or two of earnings growth to get the benefit of a good investment by a management team that will lead to decades of earnings growth.
Finding a business model, that allows for reinvestment of capital at high return rates and paring it with a management team that has both skill sets of growing operating earnings and reinvesting retained earnings can be a bonanza for investors.
Since there should be a link between growing earnings (from either process) and rising stock prices, is there a metric that we can use to show this relationship?
And the answer is…yes! We can use the change in retained earnings, over period of years, and the change in market capitalization over that same period. We call this the “Dollar Test”, in short. The test tells us how many dollars of market cap increase we get from a dollar increase in retained earnings. In a few minutes, we’ll do such a calculation as an example.
First, let’s talk about how should we interpret this interesting metric.
Since 1983, Berkshire Hathaway’s Owner’s Manual has had specific language when it comes to earnings retention. The following test appeared in the Owner’s Manual each year until 2009:
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.
We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”
Published on January 14, 2014
To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. … But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.
–Warren Buffett, 2012 annual letter to shareholders
One of the basic principles of accountability involves setting objective criteria for success or failure in advance and then periodically assessing actual results. Anyone who spends significant time examining potential investments knows that the majority of shareholder letters and annual reports tend to be filled with pages of content developed by public relations specialists rather than a frank assessment of business results delivered by the CEO.
Warren Buffett’s 2012 annual letter to shareholders is a good example of how CEOs should accept accountability. Mr. Buffett reported on Berkshire’s “subpar” year as measured by criteria he set in advance and predicted that 2013 could also be “subpar” based on the same criteria.
Although Berkshire’s stock price in 2013 was roughly even with the S&P 500 total return, it appears almost certain that Mr. Buffett will have to issue another mea culpa when Berkshire’s annual report is released at the end of next month. This is because Berkshire’s criteria is more involved than simply comparing Berkshire’s stock price performance to the S&P 500 on an annual basis. In this article, we examine the criteria and assess whether the self-criticism is warranted. Even the best standards must occasionally be revisited to ensure that the underlying assumptions made long ago are still relevant.
Berkshire’s Retained Earnings Test
The process of generating earnings and successfully reinvesting earnings are two fundamentally different tasks. Many CEOs are competent when it comes to generating earnings from the business they oversee but fail when it comes to intelligently deciding how to deploy the earnings. Since 1983, Berkshire Hathaway’s Owner’s Manual has had specific language when it comes to earnings retention. The following test appeared in the Owner’s Manual each year until 2009:
We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.
We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.
The retained earnings test was revised significantly after the 2009 annual meeting when a question regarding the original earnings test made Mr. Buffett realize that the original wording did not reflect his intentions. The current wording is as follows:
I should have written the “five-year rolling basis” sentence differently, an error I didn’t realize until I received a question about this subject at the 2009 annual meeting.
When the stock market has declined sharply over a five-year stretch, our market-price premium to book value has sometimes shrunk. And when that happens, we fail the test as I improperly formulated it. In fact, we fell far short as early as 1971-75, well before I wrote this principle in 1983.
The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.
So at a minimum, using Berkshire Hathaway’s Owner’s Manual as a guide, we want to see a company producing MORE THAN a dollar of increased market cap, for every dollar of retained earnings over a rolling period of at least five years. That means that there is more a 1 to 1 relationship between the investing activity and the reward of higher prices.
There are many companies that you do this test for, that otherwise have decent metrics, and you find that this relationship results in less than a dollar, or even a negative change in market cap. Those companies often have other things going on with them that may be depressing their stock price and you will have to explore that issue on an individual basis. In general, however, if management team can’t figure out a way to get more than a dollar in increased market cap from reinvesting a dollar of earnings, they should, essentially, not be retaining earnings at all.
Buffett’s comments also call out which metric we should use as a proxy for retained earnings, which is, book value. Why? Changes in book value capture the change in every metric and number of a company’s operating and investing activity over a period. I prefer to use specifically the change in retained earnings from the balance sheet directly.
So let’s do an example to make this test clear. We’ll use the Walt Disney Company as an example.
Looking at Disney’s balance sheet, from 2012 to 2016, retained earnings increased from $42.9B to $66B, a $23.1B change. Looking at the cover page of Disney’s 10-K filing with the SEC, Disney’s market capitalization grew from $78 Billion to $160 Billion, an increase of $82B.
We divide the $82B market cap increase by the $23.1B change in retained earnings, and we find that Disney produced $3.5 in increased market cap for every $1 in retained earnings. One of the best you will find out there.
Once you do this calculation a few times, you will find it fairly easy to replicate, and automate. It is definitely one to check out before you put your money at risk.
Ask JB: What if a company looks good quantitatively, but not qualitatively?
I am a value investor and I enjoy picking stocks and understanding businesses. Recently I was exploring the idea of quantitative value. Backtests seem to indicate that there's a clear edge over the market, but when I looked at individual holdings, all looked really unappealing qualitatively. What is your opinion on this approach?
Thanks. Appreciate your work!
JB Says: First, thanks so much for being a listener and for checking out my website. It's always nice to hear from a fellow value investor.
If I understand your question correctly, you have found ideas where the numbers look ok to you, but the qualitative, such as business model, management team, moat, etc.. does not.
A general test of whether an idea is attractive to you intellectually would be to assume that you will have to hold the investment for ten years. Imagine yourself putting your hard earned cash into it and not being able to take it out for ten years. How do you feel about it now?
The way Buffett would characterize an investment that had decent numbers and poor qualitative aspects would be a "cigar butt". He would take the last puff, then discard it. You may be seeing cigar butts. Not good for long term holdings, but generally undervalued and held until near intrinsic value, then sold.
If the company also had the qualitative aspects he was looking for, they may be long term holdings for him.
Lastly, I would say if you are not completely happy with the kind of fish you are catching, try fishing in a different pond.
Question number two
Given the high multiples in the current market (around 25 for SPY), and the GDP growth of no more than 4% for the foreseeable future, it seems like buying U.S. equities is like settling in for less than 4% earning yield and less than 4% growth, even if the multiple don't contract. I know there is a lot of "don't time the market" talk, but given the low potential return and the probability of something like a 50% bear market, wouldn't it make more sense to settle with a 3% bond of some sort or move out of the U.S. market and find more reasonably valued countries to invest?
There are several "forecasting" aspects to your question including assumptions for GDP growth, the extent of a bear market, and what the earnings yield will be. Your comment about not market timing is a really important one. One indicator you can use to determine if the market really is over-priced is using the Buffett Indicator (which will be episode 64 coming out in a few weeks). Right now, it is high, but not a extreme levels. Consider John Templeton's advice about how bull markets die: euphoria. This is the most hated bull market...maybe in history. There is far more concern than euphoria out there. None of the usual indicators of a market top are out there such as excessive IPOs. Unreasonably priced mergers, or a complete lack of value ideas.
Bonds are not a great place to put money, unless you hold the bond to maturity. Bond prices and yields have an inverse relationship. If rates rise, bond prices fall. Keep all that in mind.
Thanks again for the great questions, I'll be answering several of them in episode 69 which will be released May 30th.
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