Monday, April 1, 2019

Buffett on Expenses

From Warren Buffett's latest letter:

"...managements sometimes assert that their company's stock-based compensation shouldn't be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year's exact rearrangement won't recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.

Abraham Lincoln once posed the question: 'If you call a dog's tail a leg, how many legs does it have?' and then answered his own query: 'Four, because calling a tail a leg doesn't make it one.' Abe would have felt lonely on Wall Street.

Charlie and I do contend that our acquisition-related amortization expenses of $1.4 billion...are not a true economic cost. We add back such amortization 'costs' to GAAP earnings when we are evaluating both private businesses and marketable stocks.

In contrast, Berkshire's $8.4 billion depreciation charge understates our true economic cost. In fact, we need to spend more than this sum annually to simply remain competitive in our many operations. Beyond those 'maintenance' capital expenditures, we spend large sums in pursuit of growth. Overall, Berkshire invested a record $14.5 billion last year in plant, equipment and other fixed assets, with 89% of that spent in America.

The practice of ignoring real costs like stock-based compensation is the practice of deliberately making what's inherently challenging -- the investing process -- even more so.

Unfortunately it remains a not uncommon practice especially for businesses that rely heavily upon stock-based compensation.

Those who use earnings per share (reported or estimated) that exclude these real costs as a basis for calculating intrinsic value end up, all else equal, with an inflated assessment that value.

This conscious distortion may be a great way to feel better in the near term but it's an even better way to transfer wealth to strangers (the exiting shareholders) while, as a bonus I guess, taking on additional risk that need not be taken.

Now it's possible that, because a particular business has rapidly improving prospects, such a "gift" may be masked by the rapid increase to intrinsic business value. Yet the "gift" is still real even if buried inside the bigger story. It seems rather obvious that a more wise approach would be to admit a higher premium is being paid -- and in some cases no doubt a justifiable premium -- than to pretend the current earnings are higher than reality.

Premium prices built upon inflated earnings can, in fact, function as a gift to exiting shareholders.

Nothing wrong with generosity but I think it's fair to say there's better ways to go about being charitable.

Attempting to understand why what should be relatively informed individuals -- investors, analysts, and managements -- would accept such an alternative reality is worth the effort. There are, of course, underlying social and psychological factors at work here.

Those factors may not always be obvious or measurable but they're real and potent.

Adam

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