'The Intelligent Investor:' Chapter 12 Reviewed

Benjamin Graham casts a skeptical eye on a legal but misleading earnings report, and gives us a tutorial on what to watch for

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Jun 29, 2018
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Earnings get the Benjamin Graham treatment in chapter 12 of "The Intelligent Investor." More specifically, the guru wants us to understand that the earnings reported by a company should be read with a degree of disbelief.

To do this, he wades through the fine print of an earnings report for what was then known as the Aluminum Company of America, stock symbol then ALCOA. The company officially changed its name in 1998 to ALCOA Corp. (AA, Financial), the name by which it is known today.

Graham said that there are numerous ways in which per-share earnings numbers may be adulterated, including:

  • The use of special charges.
  • Reducing normal income tax deductions through past losses.
  • A dilution factor due to convertible securities or warrants.
  • Treatment of depreciation: straight-line or accelerating.
  • At what time research and development costs are charged.
  • Accounting policies to handle inventories: FIFO (first-in-first-out) and LIFO (last-in-first-out) methods of valuing inventories.

Because of such issues, Graham challenged us to determine which of the earnings figures in the table below is most relevant. And, he asked us to consider this from the perspective of a naïve investor who thinks ALCOA might be a good buy based on “primary earnings.”

He wrote, “But if our investor-speculator friend had bothered to read all the material in the footnote, he would have found that instead of one figure of earnings per share for the year 1970 there were actually four, viz.”

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Special charges

Graham noted that the earnings statement listed 88 cents per share in special charges, and asked if they should be ignored, recognized as an earnings deduction or partly recognized and partly ignored (answered later in the chapter). He also wanted to know, “How does it happen that there was a virtual epidemic of such special charge-offs appearing after the close of 1970, but not in previous years?”

He also asked readers to look at two “ingenious aspects” of the procedure ALCOA was using. One is that by anticipating future losses, it never needed to allocate those losses to any specific year. When they did occur, they were not reported because they were already taken. As he said, “Neat work, but might it not be just a little misleading?”

Then, there is the issue of future tax saving from these losses, which in turn leads to tax credit implications and eventually the integrity of the earnings.

To put the issue in context, the stock market took a “blood bath” in the first half of 1970, and poor results for the year were widely expected. Further, much better results were expected in 1971 and future years. Graham said companies such as ALCOA were taking advantage of perceptions to pad the results of coming years by taking losses when they were expected.

Now, Graham seemed ready to answer the question: Which were the true ALCOA earnings in 1970? He said the accurate answer would be $5.01 per share, after dilution, minus that portion of the 88 cents per share which may “properly” be attributed to 1970.

Unfortunately, investors do not know what that portion might be, and “hence we cannot properly state the true earnings for the year.” Management and auditors, Graham said, should have provided that information, but did not. Also, management and auditors should have provided the balance of deductions from ordinary earnings in the next few years.

Other issues

Graham dealt with the other issues in lesser detail. Some of his comments on them include:

  • The 1970 report from Trane Co. (now Trane Inc. (TT, Financial)) was used to show how depreciation can be manipulated. When the company increased its per-share earnings nearly 20% over 1969, half of the increase came from returning to straight-line depreciation rates.
  • Research and development costs: Are they charged to the year they are incurred, or are they amortized over many years?
  • FIFO refers to a distribution process which sees the goods that arrived first being taken off the books first, something we can imagine in a produce warehouse. LIFO, on the other hand, refers to products such as commodities, where the last items in are the first items to be delivered and taken off the books. Any change from one system to the other will have implications for prices, and eventually, earnings.

Should investors ignore such issues when the amounts are relatively small? Graham answered by pointing to yet another contemporary case reported in the Wall Street Journal, a case in which Dow Chemical Co. (DOW, Financial) included a 21-cent per share item in regular profits, rather than giving it “extraordinary income” status. Since millions of dollars in the aggregate were involved, profits increased by 9% rather than 4.5%.

Average earnings

To deal with the many ways in which earnings reports may be shifted or manipulated, Graham suggested the use of average earnings. Taking the mean figure for seven to 10 years, and including special charges and credits, would iron out fluctuations in company profitability and the business cycle.

If ALCOA’s earnings were averaged through the 10 years between 1961 and 1970, the mean would be $3.62. Graham said that if average earnings per share are combined with growth and stability of earnings ratings “they could give a really informing picture of the company’s past performance.”

Past growth rate

The author emphasized that a company’s growth rate must be considered. But, how do you combine that with earnings? He said:

“We suggest that the growth rate itself be calculated by comparing the average of the last three years with corresponding figures ten years earlier. (Where there is a problem of “special charges or credits” it may be dealt with on some compromise basis.)

Two-part appraisal

Graham then invited us to go back to the two-part appraisal process described in chapter 11. In the first part, analysts determine “past performance value” based solely on the past record. In the second part, an analyst worked out how the past performance value should be adjusted because of new conditions that may arise in the future.

“Such an approach might have produced a 'past-performance value' for ALCOA of 10% of the DJIA, or $84 per share relative to the closing price of 840 for the DJIA in 1970. On this basis the shares would have appeared quite attractive at their price of 57¼,” Graham wrote.

Other thoughts

Writing his commentary in 2003, after all the rot in high growth companies of the 1990s had been revealed, Jason Zweig noted, “Even Graham would have been startled by the extent to which companies and their accountants pushed the limits of propriety in the past few years.”

And, how do earnings reports look in 2018, as we near the 10th anniversary of long bull market? Your thoughts in the comments section below would be appreciated!

(This review is based on the 1973 revised edition of “The Intelligent Investor,” republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)