Distinguishing Between Earnings and Earning Power

“…the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline.” ―Graham & Dodd, Security Analysis (6th Ed.)

A few thoughts from Graham & Dodd and Marty Whitman about how to think about earnings and how it may differ from earning power.

In The Aggressive Conservative Investor Marty Whitman discusses the importance and implications of distinguishing between earnings and earning power:

Given the varied economic definitions of earnings, it may be wise to distinguish between earnings and earning power. By “earnings” is meant only reported accounting earnings. On the other hand, in referring to “earning power” the stress is on wealth creation. There is no need to equate a past earnings record with earning power. There is no a priori reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.

Graham & Dodd also put down their thoughts about earning power, for instance in Security Analysis (quotation below from the sixth edition) in which they wrote:

Intrinsic Value vs. Price. From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. In all of these instances he appears to be concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price. We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value. 

Intrinsic Value and “Earning Power.” Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earning power. But the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only too forcibly that in many instances this is far from true. This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.

Example: To make this reasoning clearer, let us consider a concrete and typical example. What would we mean by the intrinsic value of J. I. Case Company common, as analyzed, say, early in 1933? The market price was $30; the asset value per share was $176; no dividend was being paid; the average earnings for ten years had been $9.50 per share; the results for 1932 had shown a deficit of $17 per share. If we followed a customary method of appraisal, we might take the average earnings per share of common for ten years, multiply this average by ten, and arrive at an intrinsic value of $95. But let us examine the individual figures which make up this ten-year average. They are as shown in the table on page 66. The average of $9.50 is obviously nothing more than an arithmetical resultant from ten unrelated figures. It can hardly be urged that this average is in any way representative of typical conditions in the past or representative of what may be expected in the future. Hence any figure of “real” or intrinsic value derived from this average must be characterized as equally accidental or artificial.

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Video: Marty Whitman Interview at WealthTrack

Below, an interview originally broadcast on October 25, 2013 with Marty Whitman from Consuelo Mack at WealthTrack.

Short description:

They just don’t get it! That’s the view of legendary deep value investor Martin Whitman, Founder and Chairman of Third Avenue Management. In this exclusive interview taped at the Museum of American Finance, Whitman takes on Congressional and Wall Street ignorance about debt, credit worthiness, and earnings. Whitman will also discuss his long term mantra, to buy “safe and cheap” stocks, and his four elements to getting growth at dirt cheap prices. (Source: WealthTrack)

Some print screens from the interview:

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Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned. 

Toby Carisle’s Deep Value Slides, Talks at Google

“It is no good getting furious if you get stuck. What I do is keep thinking about the problem but work on something else. Sometimes it is years before I see the way forward. In the case of information loss and black holes, it was 29 years.” —Stephen Hawking

Toby Carlisle—investor, blogger (at Greenbackd) and author—visited Google on November 20, 2014 for a talk about Deep Value and his new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations. The talk is about 60 minutes, and it’s well worth the time.

I watched this video yesterday night (I know it was Saturday night, but what else could you better be doing, right?) and I thought it would have been great to have the presentation slides at hand when watching the talk.

So, afterwards I fixed this for myself and I thought I’d share it with everyone out there with an interest in the subject of VALUE INVESTING and the niche DEEP VALUE INVESTING. Hope you will enjoy.

Click image below for full PDF of the presentation slides (all of them copied via print screen).

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See video below for Toby Carlisle’s Deep Value presentation at Google.

Go here to read a sample of Deep Value:

DVPR2Click here for press release from Wiley.

And finally, go here to buy this great book.

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And, last but not least. Go here to read more about the DEEP VALUE Course from CSInvesting.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Words of Investing Wisdom

“An investment in knowledge pays the best interest.” —Benjamin Franklin

Click here or image below to go to a full PDF of Value Investor Insight’s compilation Words of Investing Wisdom.

Reproduced below is the editor’s letter that you will also find in the beginning of the document above (see here).

EDITOR’S LETTER:

While we certainly believe there are core principles upon which sound investments are made, it’s equally clear that, like snowflakes, no two investing strategies are exactly alike. Equally talented and accomplished investors can view the same investment opportunity in precisely opposite ways. That’s a central reason we launched Value Investor Insight four years ago (and SuperInvestor Insight two years ago), to help inform the ongoing development of our readers’ own unique investment strategies with the experience, wisdom and ideas of a wide variety of superior investors.

The differences in strategy and style among value investors are many: Some invest primarily in small-cap stocks while others stick to large-caps; some invest overseas while others stick to U.S. markets; some run concentrated portfolios while others are more diversified; some are activists while others never are; some are long only while others actively short. The list goes on.

At the same time, there are several fundamental characteristics that value investors tend to share as well. We’ve identified an even dozen:

» They tend to buy what’s out of favor rather than what’s popular.
» They focus on intrinsic company value and buy only when there is a substantial margin of safety, rather than trying to guess where the herd will go next.
» They understand and profit from reversion to the mean rather than projecting the recent past indefinitely into the future.
» They understand that beating the market requires a portfolio that looks different from the market.
» They focus on absolute returns, rather than outperforming a benchmark, and on avoiding permanent losses.
» They typically invest with a multi-year time horizon rather than focusing on the month or quarter ahead.
» They pride themselves on in-depth and proprietary analysis in search of “variant perceptions,” rather than acting on tips or relying on Wall Street analysts.
» They spend far more time reading things like business publications and financial reports than watching the ticker or television shows about the market.
» They focus more on analyzing and understanding micro factors, such as a company’s margins and future growth prospects, and less on trying to predict the direction of interest rates, commodity prices or the overall economy.
» They cast a wide net, seeking mispriced securities across industries and types and sizes of companies rather than accepting artificial limitations on market capitalization or other criteria.
» They make their own decisions and are willing to be held accountable for them, not seeking safety in what everyone else is buying or decision-making by committee.
» They admit their mistakes and seek constantly to learn from them.

It’s in this spirit of continuous learning that we offer this collection of wisdom from the pages of each of the 46 issues of Value Investor Insight, celebrating both the similarities and differences in how the best investors apply their craft.

John Heins
Co-Editor-in-Chief

Whitney Tilson
Co-Editor-in-Chief

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.