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Geoff Gannon
Geoff Gannon
Articles 

Want to Find Ben Graham Bargains? - Read the Footnotes

February 10, 2011
Someone who reads my blog sent me this email:

My question now is about investing internationally. I’ve been doing more of this recently, and the relative absence of good opportunities locally is pushing me even more in that direction. The trouble is, I’m not as confident in my ability to read the accounting. I occasionally come across differences in US vs international accounting standards, but the piecemeal nature of these discoveries makes me nervous. Are you aware of a good resource (preferably a book or three) for learning about the differences in accounting practices? I know there are a few textbooks on international accounting standards, but I’m not sure they’ll be useful, and they’re generally over $100 each. That's a lot to spend on something that could well be useless.

Thanks again,

Erik
The textbooks could be worthless. I wouldn’t buy them unless you have a specific company with accounting you can’t decipher. And even then just using Google for the accounting treatment that's got you perplexed is usually the better answer. You can find a wider array of descriptions for any accounting treatment - including its practical applications - on Google than you can in a textbook written by only one accounting professor who knows only one way of explaining something.

No. I'm not aware of a good book that handles this sort of thing. Generally, there are very few accounting books geared toward investors that I would recommend anyway. And this is sort of a narrow subject.

You aren't preparing the statements, so you don't necessarily need to know how to account for something. You need to know how the company accounts for something that matters. By matters I mean it is material to your investment. Whether they are over reporting or under reporting sales by 5% is never going to be material to a value investment.

The pension fund will be. The environmental clean up will be.

With liabilities like that, disclosure is more important than how they account for it. I don't take a company's word for its pension fund. I just cross out that liability, go to the pension plan note, and replace the liability with my own estimate. They may think their 50% stock 50% bond portfolio will return 7.5% a year. But I'm going to restate that liability as if the plan returns 5.5% a year.

So disclosure of facts and assumptions is often more useful than the official number they put on the books. In many cases, accounting for something in a way you don't recognize won't matter if the company explains how they accounted for it. The problem area is when you combine minimal disclosure with unfamiliar accounting. Then you're screwed.

But enough about liabilities. Most of the folks reading this are interested in stocks to buy not stocks to short. So, let's talk about the accounting that matters most for finding bargains.

Honestly, the most important accounting is amortization in the sense that any sort of unusual amortization charge in an obscure stock can create a bargain. I've mentioned the amortization of management contracts before. Since buying a company no longer creates the kind of goodwill that must be regularly amortized, but management contracts still do - you have an accounting mismatch in cases where you can find a company that structures its business purchases as management contracts.

A good example is Birner Dental Management Services (BDMS):

The Company's dental practice acquisitions involve the purchase of tangible and intangible assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase price allocation, the Company allocates the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed, based on estimated fair market values. Identifiable intangible assets include the Management Agreement. The Management Agreement represents the Company's right to manage the Offices during the 40-year term of the agreement. The assigned value of the Management Agreement is amortized using the straight-line method over a period of 25 years.
Even before you get to the footnotes, you know the company is doing something like this if you read the cash flow statement. Why is free cash flow always higher than net income at this company?

Go to the notes. In this case, the amortization of the management contracts explains the mismatch quite nicely. Now, if Birner Dental was Microsoft or Apple or something this wouldn't matter. Analysts would put out reports explaining the difference between reported earnings and free cash flow and why the company should be valued using free cash flow. But investors in obscure stocks may look at reported earnings first and never read the footnotes. The lesson is to first compare the balance sheet, statement of cash flows, and income statement. Then you hunt through the report looking for the footnotes that answer the questions you have about mismatches between the statements.

Since stocks tend to be valued according to their assets, anything that constantly alters the reported earnings of an obscure stock can create a bargain. One-time charges of this nature are pretty common. And pretty useless. It's rare that a stock's price will get cut in half just because it reports a huge one time goodwill write-down. Constant mismatches caused by unusual amortization are rare. But they're very helpful in creating bargains.

Like I said, footnotes that completely change the earnings power picture are rare. Footnotes that completely change the asset value picture are much more common.

Whether they are carrying the land at cost or appraised value or an equity method where they've used losses to bring the value down to zero - that's material if the land is big enough and the company is small enough.

Usually, your appraisal of the actual operations of any business - foreign or domestic - is going to be based on cash flows and current assets. There are different ways of accounting for those things in terms of where you place them on the statement, what you call the line, how you group things together, and things like that. But, unless this is the world's slowest turning inventory in the world's highest inflation country, you aren't going to find that the way a company accounts for current asset used in its day-to-day business is important enough to make or break an investment.

The question here is whether a bartender needs to ask for the I.D. of a 60 year old. I'm not sure he does.

You're looking for situations where the accounting only has to be roughly right for you to make a lot of money.

Now, when I say roughly right, I'm not talking fraud or massaging the numbers or something. I'm saying if your investment depends on deprecation expense being right - that's not an investment, that's a speculation.

An investment is not just something backed by accruals. An investment is something backed by cash flows, current assets, and non-current assets where there's an active market you can reference. Land can back an investment. If you can lend against it, you can count it. And, usually, if you can lend against an asset there's some way of figuring out the value of that asset. After all, borrowers need something to tell their bankers. A bank doesn't look at the cost of land on your balance sheet if you're carrying it at 1950 prices.

Under that method of accounting, my house would be carried at 5 cents on the dollar.

If you look at the earlier years of Warren Buffett - and the entire career of Ben Graham - they had to analyze stocks with less financial disclosure and less standardized accounting. The direction of GAAP has been toward less and less choices for how companies can account for something. Graham lived in a world where you could use much more conservative accounting if you wanted to. That doesn't exist today.

In fact, Graham lived in a world without cash flow statements. And he had to calculate comprehensive income himself using changes in the balance sheet reported in consecutive years.

I'm going to be posting an article today about Warren Buffett's investment in Union Street Railway. You'll notice that there was a note in the Moody's Manual saying: "Above does not include accident insurance fund, established in 1896, which had a book value on December 31, 1951 of $600,000".

That's it. In 1951, the stock was selling for $25 to $41 a share. The company only had 21,900 shares. So, that $600,000 accident insurance fund was sometimes worth more than what the stock traded for. It was a very material item. And yet it appears as a note in a Moody's Manual.

About 5 years ago, I came across this footnote:

"On January 21, 2002, the…Building and the land, which was utilized for the…operation, were independently valued...at $23,975,000. As at December 31, 2005 these assets are carried on the balance sheet at a net book value of $1,848,658....Generally accepted accounting principles…no longer allow the revaluation of capital assets on a periodic basis. However, if the balance sheet as at December 31, 2005 was adjusted to reflect the building and land at their January 2002 valuation, shareholders' equity per share would increase from $21.95 to $98.57"
The stock traded for $55 to $65 a share. And 2002 was before the real estate boom really got started. The building was subsequently valued much, much higher.

And I say it’s a footnote, but I don’t mean it’s buried on page 72 of a small print, block justified 10-K. It’s the third note. It’s on page 10. And it’s in nice, big print. The entire annual report was maybe 15 pages. And it said things on the first page that made you think you should go check into the building’s value, since it was obviously carried at the wrong dollar amount.

They didn’t come out and say the asset was carried at the wrong value on the balance sheet. But they said right up front that it was an old property. So you knew to check.

Here's another good example. It was also obvious to check the footnote here, because a property had been mentioned and yet it didn't appear under the list of the company's own properties - that suggested it was possibly accounted for differently. Which it was:

The Company is accounting for the investment under the equity method. As of December 31, 2009, the carrying value of the Company’s investment was $0. The (general partner) has reported to its limited partners that in October 2009 it received an independent appraisal report of the…property which reflects the approval to develop 2,996 residential units and 235,000 square feet of commercial and retail space. Based upon the appraised value of the…property, at December 31, 2009…strictly on a pro-rata basis, the estimated fair value of the Company's interest in the…property would be approximately $17,134,000 and…without adjustment for minority interest and lack of marketability discount.
My point is just that if you look at the homeruns Ben Graham and Warren Buffett - and even I - hit they'd be pretty similar regardless of where they were located and under what accounting method they were prepared. Cash and securities aren't hard to value if the company provides footnotes. Land can be hard to value in some foreign locations, but in the internet age - you can figure it out if you really want to.

As long as you aren't just basing your investments on financial data from a website or from the company's financial statements without reading the notes, you'll do fine. You may be off in how you account for some depreciation or matching some expense over a certain time period or something, but you shouldn't be off when it comes to cash and bonds and stock and land. You shouldn't be off when it's enough to make or break an investment.

Current assets and free cash flow are very similar under all accounting methods. Provided, of course, you aren't just grabbing the subtotals but actually reading the statement with the notes. If you're reading the whole annual report with a highlighter, pen, and paper - you'll do fine regardless of the accounting.

You can always get an academic book on some technical aspect of accounting someplace if it comes to that. If you've decided you're going to focus on one country or whatever, you might have to do that. But with websites, even that isn't necessary.

If you know how to read U.S. accounting and you know how to use Google you can invest internationally.

Just look for a margin of safety.

Look for stocks like Northern Pipeline, look for stocks like Union Street Railway, look for the stocks with the kind of notes shown here.

And focus on current assets, free cash flow, land, cash, stocks, and bonds.

You can find enough information about these things in a company's annual report to know whether you should dig deeper into their value. Then use the internet to get rough appraisals of assets like land.

If a company says they bought land in 1950 and carry it at cost - just figure out the inflation rate from 1950 to today and multiply the original cost times the inflation rate raised to the 61st power (example: $100 * 1.03^61 = $606.84).

I've seen companies carry investments in the stock of publicly traded businesses at either market value or the equity method. In both cases, you do the same thing. You highlight the name of any public company they own shares in and you go get that company's 10-K and you use the look-through method and just appraise the company for yourself.

But we aren't worried about things that move a company's intrinsic value up or down by 10%. We want things that move a company's intrinsic value up or down 30%, 50%, or 100%.

We want to find footnotes that change the whole way you look at the investment.

They're rare.

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Geoff Gannon



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Comments

rob.will
Rob.will - 8 years ago    Report SPAM
Geoff, you never cease to amaze us with your simplicity in explaining the nuances of our craft. Thank you immensely. Maybe next you can tackle some of the other accouning issues for us such as depreciation and whether or not to reproduce financial statements i.e. Applied Value Investing.

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