AMA, pt. 2

Busy week waxing poetically about bank runs. But promises are promises.

So let’s get this done…

At a very simple level, buying back stock can spark earnings per share growth because of the “per share” part.

Say LouCorp earned $1 million in quarter 1. LouCorp had 1 million shares outstanding. So LouCorp earned $1 per share in the quarter. (Full disclosure: I am definitely not recommending you buy LouCorp.)

Fast forward a year. LouCorp once again earned $1 million in the quarter. But thanks to buybacks, LouCorp now only has 750,000 shares. LouCorp earned $1.33 per share in the quarter!

On a per share basis, that’s 33% growth. THAT’S GREAT!!! Only, LouCorp didn’t actually grow at all.

A huge caveat: Sometimes, buybacks don’t even help manipulate EPS. In the scenario above, LouCorp used buybacks to reduce its share count. So at least each share is a bigger slice of the pie! Often, buybacks only offset shares issued to employees or used for acquisitions. In that case, there might not be any benefit to EPS.

If LouCorp had bought back 250,000 shares but also issued 250,000 shares to its fabulous, good-looking CEO, it could have reported flat earnings and glossed over the fact that significant amounts of capital went out the door to buyback shares.

I’m not at all against buybacks. And I don’t consider them manipulation, or at the very least I don’t assume they are manipulation. But it is important to judge each buyback based on what it does to share count, and what management’s motivation is.

To answer the other part of the question, the easiest way to manipulate earnings is to decide what goes into the number you report. Notice how many companies rely on “adjusted” earnings for the headlines.

There can be good reason to exclude certain items. If you had a real one-time event, like say a massive snowstorm that shut down a factory for weeks in the quarter, it could be relevant, and actually helpful, to give investors some color on what things were like before and after the storm to get a better feel of how the business is really doing. A lot went on during COVID that I hope never happens again but made the numbers look weird at the time. It makes sense to provide some context there.

But companies increasingly are stretching into the bizarre when it comes to adjusting earnings. So much so regulators have taken notice. The scrutiny is justified, and hopefully will at least cause CFOs to think long and hard before adjustments are made.

I’m a literary geek at heart. I got so excited when I got these two questions, and then went back and forth so much on how to answer that I eventually punted the question for a few days. Now here we are, in AMA 2, and I am still not sure.

I’m a huge Walker Percy fan. I’d highly recommend everyone read books like The Last Gentleman and Love in the Ruins. But my favorite Percy book is The Moviegoer.

Percy was obsessed with the meaning of life, or lack of one, and The Moviegoer is the story of narrator Binx Bolling’s unhappiness with his own life, his sense that there is more to life than what he sees around him, and his astonishment that everyone else seems so content to settle for the reality that is so unsatisfying to him. (Technically Binx is a stock broker, but I don’t think that qualifies it as an investing book.)

Binx describes his awareness that something is missing as “the search.” In the book he summarizes it this way:

“What is the nature of the search? You ask. The search is what anyone would undertake if he were not sunk in the everydayness of his own life. …

To become aware of the search is to be onto something. Not to be onto something is to be in despair.”

I reread The Moviegoer every year around my birthday (like I said, I’m a literary geek). I’m not nearly as fatalistic as Binx. But I’ve always loved the exploration of this concept, and the way Percy explores it (and, spoiler alert, the rather unsatisfactory way it is resolved, which is kinda the point I think?). At a base, two-cent explanation level, it is about taking the time to appreciate what is around you, to live in the moment and take time to explore the moment instead of being fixated on the past and what is to come. Or to, at the very least, realize all that is around you. Which, in theory, should make you a better investor as well.

As for the flip side of the coin, I’m going to go with Roger Lowenstein’s When Genius Failed. It is more of a business book than an investing book (frankly I don’t care for most investing books). Lowenstein was Michael Lewis before Michael Lewis, a writer with amazing skills in chronicling real life events and really getting beyond the headlines to what really happened behind the scenes. He’s got a great Buffett book too, as well as While America Aged, about the nation’s pension crisis, and Origins of the Crash about the Enron era and the whole 1990s market scene. I’d recommend all of them.

When Genius Failed is the story of Long-Term Capital Management, the original algo shop formed by some of the brightest minds in finance with a goal to end trading as we knew it. When formed in 1993 it was the biggest thing in investing. Four years later it almost brought down the market. It is an interesting investing story (as a cautionary tale of what not to do), but more importantly it is a story of human hubris.

I believe human beings rarely learn from being told, no matter how good the advice is. We mostly learn by experiencing and screwing up. (We’re quite fortunate as a species that most mistakes aren’t fatal.)

When we aren’t learning from experiencing, we learn from relatable stories. The risk of arrogance is one of the oldest stories in recorded history. It has been told time and time again. But I remember LTCM vividly as one of the first great crisis moments of my post-college life.

Seeing it play out on the pages never really impacted me as an investor in the sense that I wasn’t ever going to play the games LTCM tried to play. But it is a valuable lesson about how to live life and the dangers of overconfidence, applicable to both investing and everything else in life.

I’m not sure I qualify as a professional investor. Full disclosure, about six months ago I came close, but turned down, an offer to take on a role that would have made me far more of a professional investor. It would have taken a lot of time out of the day. I said no. Perhaps it just wasn’t the right offer.

As for skills, I think patience is a big part of it. I also have a habit where I tend to obsess about knowing every side of a story. And fill in the details when I can’t. It drives my wife nuts. We can be talking about some terrible person or someone who did a terrible thing and I’ll end up seemingly taking their side. I think the nexus of psychology and finance is probably what interests me the most. (I was probably a decade too old to find behavioral economics in college.) I like to understand what people are thinking.

I think there is some potential benefit here for an investor. Both in the sense that it probably helps me visualize not just what could go right, but what could go wrong as well. And I tend to look hard at what motivates actors, be it companies or the investors buying and selling them.

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Naming something new is such an important decision. It is, for better or worse, your brand. It is who you are. And let’s be honest. There are some really strange sounding names out there.

That said, I’m easily distracted and didn’t really want to spend too much time on it. So, no real profound reason for it. But at least three bad reasons:

1. Travis had suggested “The Boring Newsletter” or something similar. It does roll off the tongue, but if I called it Boring I was afraid I would be tempted to tunnel under Las Vegas. So that was out. Fits and Starts sounds active, so the opposite of what Travis suggested. The opposite of Travis’ gut makes sense to me.

2. I’ve so far kept a pretty good cadence, but it felt like a pretty good joke on myself about how likely I was to keep up with this and post on a regular basis.

3. Perhaps most importantly, a really cool Decemberists song had come up on my shuffle earlier in the day that day.

Perhaps related to the answer above about psychology, I don’t really rely on metrics. But I do certainly look at them.

I don’t think I have found a single metric that can be used to analyze different businesses. Forget comparing Google to Brookfield, Union Pacific, or a REIT. I’m not even sure how to really use numbers to compare Union Pacific to a REIT.

If there is any metric, it would be tied to cash. As mentioned above earnings per share doesn’t do much for me. But it is more difficult to fake cash. Take your pick. Cash conversion, cash ratio, operating cash flow per share. But again, different companies have different cash profiles, so I don’t think the comparison means much.

It isn’t a metric, but if you really want to compare businesses using numbers I would recommend running a discounted cash flow analysis. This can be complicated, though there are some pretty good simple templates online. And there is a garbage in/garbage out problem to watch for: The models are only as good as the estimates and assumptions that go into them. But it if nothing else is a good way to articulate your feelings about a business, and to think through the business. And it can help you to choose between different options. It just isn’t an easy metric you can find on Yahoo Finance.

Mostly, metrics are best for incidental comparisons between related businesses. If you want to compare Union Pacific to other railroads, or even other transportation companies, using metrics might be appropriate. But I wouldn’t recommend putting too much faith in them. And please, if you are comparing different kinds of businesses, don’t think the math will do the hard work.

Disclaimer: Fits and Starts DOES NOT provide financial advice. All content is for informational purposes only. Stocks mentioned are as reference only, and a mention should not be interpreted as a buy or sell recommendation. The author is not a registered advisor or a broker/dealer. DO YOUR OWN HOMEWORK. The information contained within is not and should not be construed as investment advice, and does not purport to be.

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