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Welcome to episode 56 of the Investing for Beginners podcast. In this week’s episode we’re going to talk about something that Warren Buffett dropped in his latest shareholders letter and he was also mentioned on a video on CNBC that was released recently and this is relating to new GAAP figures that are going to potentially inflate earnings figures and we’re going to dive into that.
Andrew is going to start us off and talk a little bit about some of the background and then we’re just kind of go back and forth, so Andrew one should go ahead and start us off there big guy.
- New GAAP accounting rule will affect financial institutions, like banks, insurance companies.
- This new rule could inflate earnings for said companies.
- Isn’t the first times accounting rules have changed
- If you invest in these types of companies you need to be aware as the rule takes effect.
Andrew: yeah sounds good and like my M.O. for this podcast has been kind of to hate on CNBC. I just have to say like they put up a new video series and it’s probably the best thing on YouTube other than my own stuff obviously.
Okay great there they did like three hours with Warren Buffett on Squawk Box and edit it down and I think it’s about an hour to an hour half of the content on their YouTube channel right now and this was back in I think early February’s when they interview him mid-February is when it was released so he’s that’s straight from the Oracle himself talking about some of the stuff we saw with Bitcoin a lot of the market volatility we saw at the beginning the year and most importantly.
Which kind of from my understanding from the way I’m kind of interpreting all of this he just mentioned something as an aside and they talked about it briefly but like the whole majority of the finance industry right now is completely ignoring this and it’s going to have a big impact for a certain group of companies. And it’s relating to what they’ve referred to with these GAAP which is generally accepted accounting principles or practices. And it’s the way that these companies are having to report the financial data that’s all audited and it’s how they come up with the earnings number.
And so it’s going to be a big kind of thing and it’s all in a hand in hand with like the new tax reform stuff that we’re seeing and so it’s like this unprecedented thing and it’s definitely something we need to discuss.
We’re going to try to keep everything basic explain everything from the very top down and keep it in simple terms but it’s something that’s important to understand so we can know how to approach these type of businesses moving forward.
It’s not going to necessarily affect every single company that’s out there right now but it is something that we should definitely talk about.
I guess the first thing Dave I will ask you how would you break down some of the major aspects of this are going to be net income and marketable securities and then how those are defined so can you for the beginner that’s out there who doesn’t have an accounting background can you break down what net income is and then marketable securities after that?
Dave: okay so I’ll go ahead and take a stab at this so net income is really the easiest way to think of it is the money you make on the money, you make.
In simple terms think about your own paycheck when you bring home your paycheck and you pay all of your expenses the money you have left over there’s your net income so after you pay your rent your utilities maybe your cell phone bill maybe you got to get your dog washed or groomed any of those kinds of things that money that’s left over at the end is your net income. And that is the money that you can use to either do things you want to do or you can use it to invest or pay down debt or however you want to do it.
And so the same basic principle applies to a company so when they have their income statement that shows all the revenues that they generate from all the businesses and all the different products they may sell or services or whatever it may be that the company does. and then at the bottom of that statement is their net income so that they’re going to be taking all their expenses their operating expenses any taxes they may pay any of those kinds of things so that’s what is considered net income so I think that’s pretty simple.
Moving on from there marketable securities now this is kind of a whole jumble of stuff and the way I think of it is marketable securities are going to really think about stocks. If you’re buying stocks in the stock market or if you have tea bills, for example, you buy Treasury bonds or bills from the government those will be lumped in there which would be other types of stocks preferred stock any of those kinds of things money market accounts any of that kind of stuff is all going to be considered marketable securities.
And that is really kind of when you talk about Warren Buffett that’s really kind of his one of his big bread butter with Berkshire Hathaway.
Andrew: and so I guess that’s kind of what makes the insurance business model work, in general, is obviously they get premiums from people right and then they make sure they have enough liquidity to be able to cover any sort of catastrophe if they need to pay out somebody who makes a claim.
But what you do with the majority of that money what Warren Buffett does with Berkshire is they takes what they call the float which is kind of like that difference between premiums and claims and basically takes that money and uses it to invest in securities and that’s where the market will secure these come in and that’s how he’s been able to create fantastic amounts of wealth by using other people’s money and it’s almost I don’t want to say it a double compounding machine because I can use that metaphor too much I’m talking about dividends.
But it’s really like one of those kinds of special things that’s what businesses can do and you tend to see more in the financial industry but when a guy like Buffett can do it and he does it without taking on a lot of debt it can really create a lot of magic in the financial world.
Dave: yeah absolutely
Andrew: and so net income that’s important because that’s the big focus on Wall Street ever it’s all about the bottom line and bottom line means net income and so when analysts are doing projections when they’re looking at performance they’re looking at quarterly reports annual reports they are comparing whether the last year’s earnings look like compared to what this year’s earnings look like you know what kind of growth are we seeing year over year two years three years all that kind of stuff that’s all from that income.
What’s going to be different moving forward is we’ve defined what net income is and we define what marketable securities is part now the next thing is when you have gains and this applies to personal investments and investments made by businesses like these corporations we’re talking about.
When you have to say I buy a stock in and it goes up 25 percent on paper I have a 25 percent gain but until I sell the stock I don’t actually make 25 percent right so what that kind of I don’t know paper gain is it’s the technical term for it is unrealized gain. Basically means your portfolio is 25 percent more valuable but it’s only on the screen or only on paper that’s not real money in your pocket until you sell it. Once you sell it becomes a realized gain and it becomes real cash in your portfolio up until then it’s this hypothetical number that does make your balance higher but it’s unrealized.
This new rule for 2018 is that already businesses report what’s called unrealized gains on their marketable securities they’re doing these things they’re putting these financial numbers in there they have to report what kind of assets to have what kind of cash do I have what’s the value of that every year it’s always changing right?
Unrealized gains going be the same way the way that they’ve previously done it is they’ve always just kind of had it in its own little section and it’s always been understood as okay we have what our net income was for the year that’s how much profit we made for the year. But then on a separate kind of a side edition, we have what our income could have been having we sold our investments or marketable securities and made that extra profit right.
And so that’s always historically been as an addendum to the income statement and it’s been in a section called other comprehensive income. so now the and you’ll have to forgive me because I’m not a lawyer I’m not into the whole legal jargon stuff I’m just based on what Buffett wrote in this letter based on the way I interpreted what the document said. This is from the FASB which is the private business that creates these GAAP these accounting principles these accounting practices that all businesses need to respect when they file with the SEC.
Basically, they have to include the unrealized gains instead of just being like an addition now this is going to be part of your net income. so remember that these unrealized gains are not real gains it’s the hypothetical balance of your account and so what that’s going to do for companies like Berkshire and companies that have large amounts of marketable securities is when this goes into effect which is fiscal year’s starting in 2019 they’re going to have seen a big bump in that income if they have a lot of unrealized gains and for Berkshire that is definitely the case.
Buffett explained that they’re going to get thirty billion more in net income strictly based off this little accounting requirement right so I made a spreadsheet I’ll talk about that a little bit later but basically you’re talking about a 67 percent gain in that income. Which is it’s not necessarily real right if we’re talking about unrealized gain this is not Berkshire didn’t buy a stock for have a gain sell the stock and now have cash in their pockets. This is just a stock they’ve owned for however long and it’s appreciated because we’re in a bull market so now they’re there and realize gain is higher now it’s pushing it’s going to push their net income higher.
The problem that Dave and I see with this which we talked a little bit about off air is that now you’re going to have net incomes that don’t correlate with what the real operating business really is.
At times that’s what can happen they can potentially cause a lot of problems and so I’d love if we dug into that next Dave and kind of explain why this could potentially be problematic for these type of businesses that owned a lot of marketable securities that either have a lot of unrealized gains or have little unrealized gains or even negative unrealized losses and that can affect how other people are analyzing these stocks.
Dave: well yeah as we were talking enough off-air the thing that kind of jumped out at me was let’s think about excuse me let’s think about if the market goes into a bear market and companies start losing not losing money but the stock market goes down. And we’re really talking about financial institutions things like insurance companies banks investment banks things of that nature and then let’s just pick on JP Morgan for example.
Let’s say that JP Morgan in a downturn in the stock market is still a profitable company however because of these new rules with their marketable securities and showing a potential loss in the stocks because the stock market has taken a downturn. Keep in mind again still this is money that has not been lost or gained because they haven’t sold or bought in any securities but all of a sudden now because of this rule this company could be showing negative earnings and what will happen is the news will not tell you the whole story.
They’ll just say hey JP Morgan is losing money you need to death doom and despair because that’s what they do and people will freak and they’ll go running to the bank to take all their money out of the bank because the news is telling them that JP Morgan is losing money which people will equate to going out of business.
That’s not the case the case is that because of this rule that those marketable securities are affecting their net income but its not real money again its unrealized which mean is not taken place yet now.
This doesn’t take let’s say that JP Morgan all of a sudden starts selling all those stocks at a loss which Jamie Dimon is not going to do it as a very smart guy he’s not going to do something like that. but if that does happen then yeah that could be a but my fear is that this rule is going to inflate or deflate companies that are really not being inflated or deflated because of a I hate to use the word fictional but it kind of is.
It’s a fictional number it’s not a create a real number in it I want to back up for just a second as Andrew and I were talking about this today I did a little bit of digging on the Internet the GAAP accounting rule started in 1936 and this was all enacted because of what happened with the Great Depression back in the 20s.
Back in the day, there was no government oversight on companies so they could do whatever they wanted on their accounting. they could mix and match and manipulate numbers all kinds of crazy stuff and so people lost their shirts because of the company’s being unethical about their reporting their actual numbers and so this this FASP was created to help they started and they created these GAAP rules to try to make all these companies have to report things legitimately.
Now there are companies that will do non-GAAP and GAAP rules on their balance I’m sorry on the balance sheets on their financial statements and that always makes me leery because there is no on a non-GAAP there’s no there’s no oversight on how they can adjust the numbers.
And that makes it very very scary to me and so when we’re talking about this rule that’s being enacted and again as Andrew said it really has not been talked about hardly at all. There’s been an article on market watch CNBC mentioned it and Warren Buffett has mentioned it.
Now you can bet your bottom dollar that he’s going to be talking about this at his annual meeting and there’s probably going to be quite a bit more conversation after that about this but it’s at this time there is not much being discussed about this.
Now, this doesn’t really necessarily affect a company that doesn’t have a lot of marketable securities we’re really talking about companies that have big numbers and Warren Buffett was very against this.
Because he even said in his interviewed that I was watching today that the it makes his number look larger than it really is and he didn’t his head it’s not real and I guess that was kind of what I was really taking out of what we were talking about earlier what are your thoughts Andrew?
Andrew: yeah I completely agree in them I’m glad you mentioned that this isn’t going to affect companies that don’t have marketable securities.
Keep in mind that we talked about the insurance business and financial big financial institutions and so those are the ones that generally have a lot of marketable securities. A lot of the companies you know when you think about how they store their assets it tends to be in the traditional sense. They’ll have plants property equipment inventory and then obviously cash.
Cash is king and that’s shared and it’s very parallel in a lot of different companies some businesses will do a lot marketable securities and they’ll kind of invest in the stock market with their cash in this way what I saw is.
Basically the kind of companies that you’re going to want to look for if this if you’re looking at these type of companies then this is going to be the rule that’s going to affect how you want to analyze them.
find any stock in the financial industry I went on finviz today and did like a S&P; 500 and the industry financial that pulled up 98 stocks so of these 98 stocks you’re going to want to check if one of your stocks falls into that industry check in their income statement check the comprehensive income check their unrealized gains portion in there and make sure that if that number is large or small how is that going to affect it even in the short term we’re talking about these rules go on effect 2019.
And I still think it’s early as far as I ran the spreadsheet and I looked at these 98 companies and I wanted to see what are they showing right now as far as unrealized gains what is their net income so this is for 2017 numbers. What’s the percentage in there and then is there any price in Wall Street yet right because you can only imagine if Buffett’s Berkshire is going to see a 67 percent increase in their net income based purely on an accounting rule.
Well doesn’t it make sense that the share price is going to have a similar jump because a lot of a lot of people are going to be so focused on just the earnings growth and the year-over-year growth like they already are?
I went through and looked at a lot of these businesses and a lot of them don’t have these kind of correlations where if you see a big unrealized gain that’s about to get reflected in the net income for next year you would think that because this was announced back in January of 2018 and it was a made official sometime in February where the FASB actually made a document that has the official addendum to this.
You would think in that period of time stuff would be reflected but I haven’t personally seen it and it’s not all doom and gloom either yes it could make stuff a little bit more volatile and it’s going to change some of the perceptions on Wall Street.
But like Dave and I like to argue what happens on Wall Street doesn’t really matter that much as long as you understand what’s really happening with the operating part of the business of Wall Street wants to overreact but from your analysis that actually the operating business is fine. Then this could maybe even be an advantage to you from an information standpoint that other investors might not necessarily have.
This is all definitely good information the other thing I’ll say is I made this spreadsheet ninety-eight companies on there and I would say I don’t know if the word what’s the statistical word for this is if it’s Delta or what but I only saw 20 stocks where the difference in their unrealized gain was 10 percent or higher than what their net income was.
Meaning for example Berkshire has a 30 billion dollar expected increase on forty five billion dollars that’s sixty seven percent thirty billion is 67 percent of forty five billion. So like if there was more than a 10% difference compared to the net income. I only saw that in 20 cases and if these are numbers do you want to you want to have for yourself.
I’m going to give this spreadsheet out for free to my to any anybody who’s an e letter subscriber and VTI spreadsheet client if you’re both of those I’ll give you this spreadsheet for free. I will I’ll mail it out to the list on May 1st so everybody who’s on that list at that time I’ll send the spreadsheet out to.
And basically the way I built it was unfortunately there’s every company’s financial statements different that they all generally say the same thing but it’s always worded a little bit different so it wasn’t as easy as like I look for things like if they’re talking about unrealized gains if they’re talking about investments secured these sometimes I have weird wording they called it available for sales securities or they might say net change instead of unrealized gains sometimes they call it equity investments instead of investments securities.
Those were all practically saying the same thing so I tried to pull out as best I could the numbers for these financial stocks I personally I have like about a 25 percent exposure to the financial industry on one stock one of my dividend Fortresses so you can be sure I checked that stock to make sure that whatever it’s showing for unrealized gains or unrealized losses that there wasn’t going to be like a big volatile jump. And even if there was that I was mentally prepared for it and I would know kind of how to how to view the stock moving forward.
It’s kind of a bummer for me to hear because literally two weeks ago we’re talking about how I’m so black-and-white when it comes to negative earnings here we are seeing another case where actually negative earnings could actually not be reflective of a poor business model.
Having adjusted my view on negative earnings just yet and luckily for me only one stock that I owned which would technically fall into this range and it just so happens it’s not it doesn’t have any marketable securities so it’s not an issue I’m running into now.
But this is something that definitely investors should keep in mind that particularly as the market moves and as it moves from extremes from one extreme to another you really need to dig deeper than just what’s being reported on in the media and what people are saying.
The bottom line is you need to have more than one reference point of data and you can’t rely solely on earnings growth like a lot of Wall Street likes to do.
Dave: I totally agree and I I’m excited to take a look at this spreadsheet because I do have several two or three different investments in financial institutions and as Andrew and I talked about a couple weeks ago about the negative earnings part I have a slightly different view on it.
I’m still going to have to take a look at this as well and I’m going to have to rethink how I analyze looking at the earnings of a financial institution I’m going to have to dig deeper then I might have done before. I tend to think that I look pretty deep now but I’m it’s just another thing I’m going to have to add to the my checklist.
Simply I mean that’s just basically the way I’m going to look at it is just another item to look at my checklist when I’m doing a cursory surface look at the company to see where they are and I think the spreadsheet that Andrews going to let us take a look at is going to be really helpful for me in this regard so I’m kind of excited to look for it myself personally. so thank you for sharing out with us Andrew.
Andrew: okay me I got excited building it so yeah.
Dave: I know how you love your spreadsheets.
Andrew: but seriously though if you think about it this isn’t the first time that would you call GAAP, GAAP is like made a big change back in the day I think it was the 90s they changed the way that EPS was reported earnings per share and so I don’t know feels Buffett I want to I want to say was Buffett who like really said that there was a problem with these companies because they weren’t reporting a lot of these businesses like to give RCS and stock options to their employees and that wasn’t getting reported in earnings per share reports.
They split earnings per share from just a regular earnings per share figure to basic earnings per share and diluted earnings per share and now common knowledge is to use diluted earnings per share because that’s going to take into consideration stock options that have really been granted but not necessarily vested and things of things of that nature.
We don’t know how the financial statements will look 19 years it’s possible that that there will be some standardized procedure that makes it very clear to investors or it might be more opaque we don’t know that. But regardless we’re going to be prepared right and I don’t think it’s necessarily a bad thing but it’s a potential trap that you could get a trap you can get trapped in if you’re not careful so I guess be mindful when you’re doing these things right.
Dave: yeah it could definitely trip you up if you’re not aware of it and that’s one of the things that we like to try to do is help people be more aware because the more knowledge and the more aware you are the better decisions you can make for sure.
Alright folks well that is going to wrap up our discussion on GAAP rules the new changes that are coming about with financial institutions. We hope you guys found that interesting and informational and we hope you learned a thing or two.
Without any further ado we’re going to go ahead and sign off you guys go out and find some great intrinsic value and best with the margin of safety emphasis on the safety. You guys have a great week and we will talk to you next week