The Most Important Part Of Buffett’s Annual Letter
Warren Buffett's annual letter to Berkshire shareholders is a must read for any investment professional. For various reasons. Click Here to see the full letter.
From our vantage point, here is the most important part from today's report......
"Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses."
He said, for example, that Berkshire Hathaway had been restructuring since Buffett acquired it in 1965, and "we have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power."
"To say 'stock-based compensation' is not an expense is even more cavalier," he added. He provided an example of the way in which Berkshire could report "adjusted earnings" by making certain compensation costs disappear, but chooses not to.
"Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.
Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.
To say this is an epidemic on Wall Street would be an understatement. And its not only Warren Buffett. Carl Ichan has the same view. We wrote about it before. Carl Icahn: Earnings Are Shockingly Overinflated
And that is where it gets very, very bad. Carl Icahn estimates that S&P earnings are overstated to the tune of 20%. If true, that would add at least 5 points to today's P/E ratio.
So, Shiller's Adjusted S&P P/E ratio would go from 29.31 to about 35. Arguably the highest reading in its history (if we adjust for 2000 tech earnings) and about 5 points higher than 1929 record reading.
That is to say, anyone who is buying stocks at today's valuations might be certifiably insane.