IFB53: Dave and Andrew Debate Negative Net Income (Earnings)


negative net income

Welcome to Investing for Beginners podcast this is episode 53, Andrew and I are going to take a stab at talking about negative earnings. We had some interesting event happened this week in Andrew and I were having a conversation prior to coming on here today and we wanted to talk a little bit about negative earnings.

Just to kind of give you a little of a bit of a backstory, so last week Andrew sent me a text message telling me that one of the companies that he and I both own had negative earnings on their 10k and this caught me completely by surprise. That was shocking and I had no idea that if that happened and I was a little bit like wow Oh crazy and I was it kind of caught me because it I felt like it came from out of out of the blue.

And I had no idea that that this company had happened and you know I wasn’t paying that close of attention honestly and so something that really caught me off guard and as Andrew and I were talking about it it’s you know Andrew and I see eye to eye on almost everything but in this particular case we differed a little bit on our viewpoints of how we handled it and so it was kind of an interesting snapshot into how value investors think about things and it’s not always exactly the same.

And so I had a different viewpoint and Andrew had a different viewpoint I thought it would be interesting for us to talk a little bit about that tonight so Andrew why don’t you go ahead and tell your side of the story if you will and then I can tell mine.

Andrew: well what is this a divorce are we fighting hardly well let me get my lawyer and we’ll have somebody in between and they can relay this message and then you can calm down think it over maybe take a walk cool off.

Yeah but no this will be fun like you said we kind of agree on everything and it’ll be fun to have a little bit of a debate I’m not really going to call it a debate. I’m just going to present how I do it you we kind of talked before coming on them and you talked about some of the reasons why you’re doing what you’re going to do and so I see that side a lot and I think a lot of it has to do with the way we’re structuring our portfolios and the different strategies that we try to take.

For me it’s kind of simple and it’s not much to talk about I’ve talked about over and over again how the way I structure my strategy is I split my portfolio into two basic segments. I have the regular portfolio with a 25% trailing stop attached and those I tend to focus more on the margin when it comes to margin of safety rather than the safety.

In those cases I look for things that are really undervalued they tend to have a lot of negative sentiment around them when they’re so steeply undervalued. So might have to you know buck the trend but also have chances for quick gains. Or you know a stock that has really high growth but because of that they don’t pay much of a dividend or don’t have any dividend growth.

You know I still always buy stocks with dividends but that could be the case as well and that would be a regular position for me. And then obviously I have the dividend Fortresses which are companies that I look for that are growing their dividend looked to grow them for a very long time and obviously still trade the good price and a good safety when it comes to margin of safety with more emphasis on the safety.

Though what one of the rules that I implement and so this is generally just for the dividend fortress sell but this particular position is it’s applying to this position as well and it’s one with a 25% trailing stop. So definitely it’s important to have strict rules for where you’re going to sell.

I think that’s key number one and number two is when you set these rules do not make exceptions so in my case once I once Dave told me the justifications for why he’s not going to sell the stock I started to feel bad because there’s a really good chance that the company is going to continue on just fine and maybe selling the stock is going to be a mistake. And if you look at the stock chart the markets kind of pricing it in or anything they’re not too worried about what’s going to happen and you’ll figure out why in a second.

You know it’s definitely a bummer and it’s opportunity for me to really feel like I’m missing out and part of setting the sell strategy in the beginning and understanding that this is where you’re going to go is you need to be consistent with it and follow through whether how painful it is or how nice it might seem.

So my hard fast rules for a dividend fortress and this also applies to my regular holdings is if it has negative earnings I’m going to sell no matter what. I talked about this in episode 48 but I did research on bankruptcies and I did the most recent 30 biggest bankruptcies spanned all the way back to the early 2000s. and the out of all the financials putting all the major ones that I always like to look at revenue, earnings, assets, liabilities, equity, cash at the end of the year the biggest thing that was all consistent between those was negative earnings.

More companies had negative earnings than not and so in the case of the companies that did go bankrupt it was more of a 50% chance that a company would have negative earnings now that’s not to say that every company in the stock market if they have negative earnings it’s a 50 50 percent chance they’re going to go bankrupt obviously that’s not true.

They have what five hundred companies in the S&P; 500 and you’re talking about maybe 30 of them that went bankrupt it’s not a big percentage it’s not nearly close to 50 percent. However this is just my approach and this is something I observed and being so focused on trying to avoid any sort of value trap or risk of bankruptcy that’s why I don’t that’s why I always sell out negative earnings and that’s what I’m going to do for this stock.

The second one is if a company stops paying a dividend completely and again this goes back to my investing strategy my principles the things that I’ve pounded on the table over and over and over again in this podcasts about how to me an investment is something that pays you an income. and the best way to get compound interest is to reinvest that income and how if a stock isn’t paying you a dividend it’s not paying you an income so how can it really be an investment and it turns more towards a speculation and you need the market to agree with you in order to make money.

So that’s where I stand with dividends and that’s why any position I hold that stops paying the dividend will be sold right away. The third and final and this one’s not as black and white as the first two and that’s a very large increase in debt to equity. So where I said with the bankruptcy research about negative earnings there was also a big similarity in debt to equity. It wasn’t as common as negative earnings but I did see some sort of correlation meaning the companies that did go bankrupt tended to have higher debt to equities than normal.

In many cases you saw sharp increases in the final years that these companies went bankrupt so another trend I observed and so something that I will be keeping the mind in the situation as of yet. Not an easy thing because you know to say debt to equity rising sharply that can be very vague and I didn’t put a number to it I didn’t see any relationship between how it rose and which companies went bankrupt and all those sorts of things.

But that’s one where it’s going to have to be a little bit more intuitive if I might say like last week using more of the art part of value investing rather than the science. And so those are kind of like my three big sell points other than a trailing stop for the regular portfolio.

And so those are really the only cases where I’m saying in either section of my portfolio when it comes to the different fortress’s I want to hold those forever if I can. Continue to reinvest those dividends and maybe even live off those dividends one day.

As it continues to climb I’m just going to continue to hold when it comes to the regular ones you know those might climb up really high people might say well why don’t you take some profits sure I’ll take some profits but let’s let it ride all the way up and then the trailing stop will automatically get me out after a good amount of profits.

That’s the logic behind why I’m going to sell that’s my thinking and that’s my viewpoint that’s my sell strategy and it’s what I continue to do moving forward. I think it would be fun to kind play back this episode maybe refer to it in a year after the stocks doubled and Dave you can laugh in my face I missed out on this opportunity.

But you know I have no problem with it and honestly it’s as emotional to me as like getting a piece of paper and putting some scissors through and just cutting it like I got a nice portfolio I got a lot positions and you kind of have to be called cold-blooded when it comes to cutting them off and so that’s what I’m going to do in this situation.

But it’s a great story and a valuable lesson in there too and there’s a lot of value investors and people who listen to the podcast who don’t necessarily have the same strategy that I do or the same approach or the same kind of values or principles or viewpoints when it comes to investing.

And that’s what we’re Dave’s going to come in and really tell us you know what’s going on and when negative earnings are okay and when they’re not.

Dave: well they’re definitely not but this I mean they’re not and you know the thing is that I agree with everything that Andrew said you know his view and his philosophy on when to sell a stock are rock-solid and those are absolutely perfect examples of when you should sell a stock.

In this particular case it just I had to know why because it’s a company that I’ve had and I really believe in and I think the management is great and I think their products are great and it’s done really well for me since I bought it and I just really caught me off guard and so I had to investigate I couldn’t just take it on face value that hey this company had negative earnings I’m going to sell.

I had to know why and because it just didn’t seem didn’t seem logical to me and so the company in in that we’re talking about is Corning this is the ticker for it is GLW and I’ve held it for I believe four years now and it was a company that Andrew held as well but as you heard he is selling it so he felt comfortable revealing that to people.

So the so kind of the back story of Corning if you’re a familiar with the company which probably most of you are not because it’s definitely a boring company. It’s not exciting not sexy by any stretch of the imagination they make glass. so that may not sound like super exciting and it’s really kind of not but they make glass for phones iPhones for example they also make them for cars and then they use it for a lot of other different things and the company’s been around since the 1800s and they’ve done very well.

It’s never been a high-flyer it’s never been super sexy stock but it’s been very consistent and it pays a dividend and they’ve been increasing the dividend since I’ve held it.

Kind of what happened was Andrew sent me the text message like I mentioned and so as soon as I got the text message you know he and I went back and forth a little bit and I thought you know what I’m going to look it up myself.

I went on the SEC gov and looked up the 10k which was just released it was released a little bit about three weeks ago and so I thought I am going to go look it up and find out why did this happen because it’s going to stay in there that’s one of the beauties of the 10k is they have to reveal all this to us the investors the people that pay their salaries.

I looked it up and I started reading and I started reading and I you know I came across before I found out the reason why the first thing I saw was the main reason why they had negative earnings was they had a huge tax hit and it took me a few minutes to kind of discover why that happened but before I get there I just I started checking other things along the way of looking in the 10k for the exact reason why this negative earnings happened.

So when I looked at their revenues they were right in line with what they were the year before and the year before and the year before. they were up about 8% and which is great and then I looked at you know all their other costs that they had everything was right in line, their debt had not risen hardly at all and still everything just kind of fell in line.

I mean when I looked at the revenue for all the different departments that they had it was all in line with what they had had the year before and the year before in a year before. The costs were on line as well there wasn’t any huge spike in anything other than this tax liability that that hit. I looked at their balance sheet everything was exactly the same as it was before there was no major changes in anything.

Their assets were roughly the same their liabilities were roughly the same so again they kept coming back to what happened where did this come from and it’s just it look if I didn’t see that negative tax hit I wouldn’t have it would have been a normal 10k for them it would have been you know a positive earnings growth positive revenue growth positive making money everything would have been perfect.

And the other thing that I noticed in kind of Andrew was talking about dividend cuts they actually raised their dividend again so they’ve had positive dividend growth over the last four years and so you know all those things would lead me to think well this is a great company. But there’s this one negative thing that was dragging it down causing it to have negative earnings.

The other thing that I did in addition to reading through the 10k and this took me about half an hour or so to kind of read through everything and kind of get an idea of what was going on. I also looked at their stock chart which I never ever do but I just thought you know just for giggles I’m just going to go back and look and see if the stock market is really reacted to this kind of negative news with their 10k.

And it had budged hardly at all it you know I’ve gone down you know maybe 20 cents you know over the course of the time and that’s also with the market kind of being super volatile for these last couple months so that to me was like well that doesn’t really make a lot of sense so if Wall Street’s not freaking out about this then why am I freaking out about this.

Then I started reading more into the 10k and reading more into the 10k and I finally came to the part where the management was explaining what happened and basically what it boiled down to is you may or may not know this but the president just recently revamped our tax code which also affected corporations. and his intention was doing that was bringing trying to allow these companies to keep their businesses here in the United States so that we have jobs and they can pay taxes here in the States and everything.

But the other thing was he wanted to repatriate a lot of money that was being held overseas. You’ve probably heard that Apple had I don’t know 350 million dollars overseas it was being held in Ireland and they were not reluctant to bring it back because they didn’t want to get a 38% tax hit which don’t blame them.

Anyway so part of all this part of his reasoning for doing that was to try to bring some of this cash back so it could be reinvested in the company here in the United States and grow jobs and you know all that kind of fun stuff.

Corning, most of their business has done overseas they do they have plants in Korea and in Japan and so in the course of my investigation I discovered that they chose they chose to leave the money overseas and they took a penalty. because they did that they took a penalty of upwards of 2.1 million dollars which was a huge hit to their bottom line which caused the negative earnings and the reason why they chose to do that is because the majority of their money is in foreign currency and to convert it and bring it back to the United States would have been a bigger tax well a bigger loss the van if they’d just taken it the one-time tax penalty that the government slapped on them for making that decision.

And they didn’t have a lot of time to make this decision because it was this tax law was enacted early wait November early December so they didn’t have a lot of time to make a decision on this but that’s what they chose to do.

You could disagree or agree with them that’s really kind of up to you but to me when I just saw that it was just a one-time tax hit that they made a choice a business decision to not you know lose more money I thought that was a good decision and so that’s why I chose not to at this point to sell the company.

Now with the cut with the stock price you know the bottom falling out it gives me time to breathe and think about what it is I want to do with this and like I was telling Andrew before we came on the air was you know when the next quarter is 10 Q comes out you bet your butt I’m going to look at that and make sure that everything else that I was looking at for the 10k winds up exactly the way I should.

And if it does then to me then that’s just a blip on the radar and I’m just going to keep going forward it could be you know something as simple as you know something negative happening like you know Steve Jobs dying for Apple. or you know I’m not going to compare that but it’s a negative it was certainly negative news when that happened Apple. But the company has rebounded quite nicely since then.

I guess my point being with all this is that you know Andrew mentioned early about the fear of missing out and that’s definitely in play with things like this and I admire Andrew for sticking to his guns even when I pointed out to him hey this is why this has happened. He said to me it doesn’t matter this is one of my rules I got I got a stick with it you know and I agree with him he should stick with and that’s one of my rules too but I also wanted to know why and based on what I know I made a decision not to sell it.

Because I think it’s I have time and that’s the other thing is when the stock market is freaking out and that’s one of the great things about what we’re doing here is you could this is I thought was a good teachable moment to look at taking the time to not just reacting to something and overreacting. I’m not saying Andrew overreacted that’s far from it. But what I am saying is is that whenever you have to make a decision about whether you want to buy or sell a company you need to think you need to think about it you need to breathe and take a deep breath and not react to what you see negative on CNBC or MSNBC about something horrible thing happening.

Looking at the numbers and looking at the productivity of the company nothing has changed about Corning you know since the news that I got from Andrew it’s still all running exactly the same and so that’s why I chose not to sell the company at this time.

Andrew: can you talk about some of the specific metrics that you saw that you particularly liked that made the earnings hit not you know I’m saying like then that means what to look at?

Dave: yes, so I looked at the I looked at the net earnings I also looked at each particular segment Corning has five different segments that they break their business down into and I looked at the sales growth for all of those and they’re all they’re all increasing like they were the year before. I also looked at the you know yes the P/E ratio was negative because it you know has a negative earnings but their shareholder equity had not changed.

I also looked at their debt to equity ratio had gone up slightly but that’s because they took on some assets they are they bought some stuff basically went a little bit of shopping spree during the course of the year and bought a few things. But they were buying assets that are going to help them down the road.

The other I didn’t do like a return on equity or a return on assets or anything of that nature I didn’t I didn’t go to those realms I just basically looked at the income statement the cash flow statement and the balance sheet. I looked at all three of those documents and then I just compared those numbers every single number on there from the year before.

I looked at any sort of hedging that they do Corning does hedging for the currency to try to help mitigate any conversion losses they may have from a foreign currency to the US dollar. And those were all right in line with everything that they were doing before. I looked at all their assets and I looked at all the liabilities and every single item line by line by line was right on line with everything else that had been the year before the year before in the year before.

I didn’t just look at the 10k for 2017 I also went back and looked at the 10k for 2016 and 15 so I could kind of go farther back to make sure that I was you know pulling data in from more than just a three-year snapshot. I was trying to look at about eight or nine years’ worth of numbers and everything was growing just like it had been for the last eight or nine years.

Every single line item so you know working at the income statement looking at the you know earnings before interest in taxes was exactly where it should have been without those tax hit. Now obviously after the tax hit on the earnings you know on the interest income statement I’m sorry there was obviously a negative number there because that’s obviously a big number to take out of your bottom line. And that’s really those who you know those were the numbers that I was looking at but again to come back to it I look at all three financial statements and to make sure that everything that I was looking at was exactly there.

And then there’s a section in the 10k where there’s a kind of a management’s discussion where they were Wendell Weeks who is the CEO of the company that’s his opportunity to talk to me and tell me what’s going on with a company and that was that was in the first paragraph that’s exactly what he said was that about the tax hit and why they did it and why their decision to make to make this one-time decision.

Everything else was right in line with what they were talking about so does that help answer your question?

Andrew: it does yeah I’m glad you brought up earnings before interest in taxes. That’s a ratio we don’t really talk about much but EBIT.

It’s one that’s widely used in Finance and Accounting especially and that’s like the perfect situation to look at a ratio like that because you’re ignoring the tax is making sure the core part of the business is solid making sure you know the business models there it’s not because if I get declining in demand it’s not like customers don’t want their products anymore or businesses don’t want to buy from them.

That’s it’s strictly because of taxes and so will exactly everything you talked about looking through the various years and also metric like EBIT or revenue that’s that can be a great way to make sure the core part of the business is still intact and what they’re saying in the annual report is in fact true and not just you know smoke coming out of them.

Now this might be a little bit unfair of a question since you haven’t had time to prepare but I noticed when you bought the stock it was at $16.36 today it’s at $29.53 as of the Thursday we’re recording this you have this all posted which we don’t talk about your site enough but its intrinsicvalueformula.com and you have like a heading that’s called stock picks so we kind of had this discussion about Corning now and obviously is bullish as far as like a holding perspective do you.

Would you say the logic changes for prospective investor who might be looking at this company from scratch is the argument the same or different when it comes to looking at Corning where it’s at today?

Dave: well that’s more of a that’s more of a question of whether you think the entrance if it’s still below its intrinsic value and that is a question that honestly I have not really delved into because I bought the stock at like you said 16.56 and I’ve held it to where it is now.

At the time I felt like it was undervalued when I bought it do I feel like it’s undervalued now I probably would say yes but that’s without me doing any sort of research or really digging into where I think it could go. I know through reading the 10 K’s through the last four years since I bought the company and reading farther back they have plans of course and they have ideas of things that they want to do to try to grow their revenue.

They’re a fairly conservative company they’re not a big high flyer they’re not flashy they’re not going out and trying to use their money to make big splashes and buy other companies that could maybe help grow them faster.

Because they’ve been around for a long time I think they’re just more comfortable doing conservative things which I like you know I like boring and especially when it comes to stock market and I like boring. Maybe not so much with my sandwich but yeah definitely with my stock picks.

But you know so what if somebody was walking in today and they saw the negative earnings on there I probably would it for me I would hold off. it would definitely be something that if I was investigating it and I was doing the research that I would do to buy a company and I saw something like that it would give me pause for sure and I would probably hold off until I would see the next earnings report from them.

Not so much that I’m looking for the bottom line in earnings report but more to make sure that everything else that I’ve been looking at is going to be continuing to grow. That all their segments are all still firing you know everything that they’re doing is continuing to work and that you know to reassure me that this tax hit is a one-time thing.

And you know we may talk about this in three months and I may find out that I was wrong and you know that’s wouldn’t be the first time and it won’t be the last. and if it is then I’ll sell the company you know it’s just it’s that simple lets you know but I think you know based on what I saw it looks to me like it was a blip on the radar it was a one-time thing.

and that’s you know kind of coming back to the art of value investing I trust the CEO of the company everything that I’ve read about him and everything they have read and I’ve listened to his calls. He seems like a genuine guy he comes across to me when I’ve seen interviews with him as a genuine guy and so I think I trust him at this point he’s not giving me any reason not to and so at this point when he says to me this is a one-time thing I believed him.

I could be wrong and like I said it won’t be the first time won’t be the last but at this point I believe him so the answer your question I would probably hesitate to buy the company at this point just because I want to make sure before I pull the trigger that this negative earnings is not a blip on the radar.

Andrew: I hundred percent agree with you I want to make sure you know we talked about the sell side of this and cover the buy side as well it’s like you know what’s waiting the next year is the stock price really going to climb up that much higher after the company comes out of negative earnings and if it does you know well it’s it’s not the end of the world.

I think better to for them to confirm the fact that you thought that this was just a blimp rather than you know the risk versus reward I think is it’s kind of skewed when you’re looking at entering a new position like that yeah and I wouldn’t think that Ruth that that’s a bit different than some other businesses that might be out there at the time.

Dave: yeah I would agree with that I think looking at any sort of company whether it’s you know think about Corning is that you know I mentioned this kind of when we first started talking they’re boring and it’s not a sexy company there’s not a you know if you go to Seeking Alpha which is one of my favorite sites you don’t find a lot of people writing about the company and that’s usually a sign that it’s not exciting because it doesn’t generate a lot of buzz about it.

If you look at you know if you go back again looking at stock chart which is not something I do a lot of but if you do look at their stock chart and look at the growth of the company. Its infinitesimal you know it’s not you know it’s not one of these huge swoops up you know like a Bitcoin you know for the last six month or whatever. It’s nothing like that it’s you know like you said waiting a year I’m a company like Corning you’re not going to have the fear of missing out it’s not going to go from you know twenty nine dollars to fifty nine dollars in a year it’s just not going to happen.

When you look at a company like that it’s good to be patient you know it’s you’re not going to have those other biases kicking in when you’re looking at a company like Corning.

Alright folks well that’s going to wrap up our discussion on negative earnings today. I hope you enjoyed our little chat and hearing Andrew and I disagree on something all the shock of the horror oh my god we didn’t agree on everything. But you know Andrew didn’t have to call his lawyer and neither did I so it was it was all good so I hope you guys enjoyed our discussion.

I hope you guys enjoyed our little teaching moment and the one thing I want you to take away from this as always do your due diligence always read the 10ks they’ll you’ll find a wealth of information and there yes they can be boring but it will also help you make great decisions.

so without any further ado you guys go out there and invest with a margin of safety emphasis on the safety have a great week and we will talk to you guys next week.



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