An upcoming change to the blog: In light of a recent conversation, I finally came to my senses and realized that I need to focus on what the true earnings power of the companies I discuss happen to be rather than focusing on the GAAP numbers which can use pension adjustments, currency headwinds, one-time expenses, and depreciation/growth capital expenditures to massage the numbers that are widely circulated to investors. The problem is this—I want to look at numbers that are as untainted as possible so that I can see what a business is really doing rather than merely discussing the gilded lilly that is presented to investors.
I anticipate that this will make my future conclusions about stocks more countercultural because there will be companies reporting seemingly higher than usual P/E ratios but actually trade at much better values because there is a one-time event cluttering the figure. Bank of America is an example of such a stock right now. On a web portal, the earnings show up as $0.33 per share and a P/E ratio of 48. If that reflected the underlying profit engine of the business, that would be a big problem for people trying to get a rational price at the time you make an investment.
But once you look past the lingering costs related to the 2008 Countrywide acquisition and the ruthless cost-cutting that is resulting in one-time charges, you will see a bank that is about to make $16.4 billion in annual profit once the numbers are clean. That is $1.35 per share. That is 12x profits, which is much more interesting. And plus, given that banks live and die on interest costs, an (what I see as) inevitable rise in interest rates will accelerate the profit growth and make the $16 valuation even more attractive. Every one percentage point increase in interest rate would add $3.7 billion in net interest income to Bank of America’s balance sheet.
That said, you do need to have the value investing patience gene to do this stuff. It is not for everyone. Bank of America has rebounded nicely from the financial crisis if you bought the stock between $2 and $10 during its wild swings when the litigation damage was uncertain and the company was hurting for capital because of its low dangerously low liquidity heading pre-2008 (the figure is much, much better now with a Tier 1 Capital Ratio above 10%). But there is no guarantee when the price change will come—sometimes it takes a few years of no “everything is great, but this one thing” profit numbers before the value rises to where it needs to be.
Take BP for example. It is still trading in the $40 range. Because over 20% of the company’s profits come from Russia (which is threatening to hijack some of the ownership of BP’s rigs) and because oil profits fell considerably in the past six months and because the final litigation payout is still not determined, the price of the stock has stayed down. It takes a certain kind of confident, truly long-term (not just lip service to it) mindset to recognize that even with all of its problems, it still makes $12 billion in annual profits with lower oil prices. It has $30 billion in cash on hand—right now—to handle a worst-case legal scenario around the $20 billion range. It has 4.2 billion barrels of oil and 34.2 cubic feet of natural gas, so this is a company that won’t be going away.
And the dividend has even piled up: $1.68 in 2011, $1.98 in 2012, $2.19 in 2013, $2.34 in 2014, and a $2.40 rate going forward. By the end of this year, we are talking $10.59 in dividend payments. You’re collecting about the a quarter of your investment amount back in the form of cash dividends that you can deploy elsewhere—if you reinvest, the returns are even better because the dividend yield is high so the absolute amount of money you would have collected in the meantime would be more substantial. Given that this was a reasonable worst case scenario for BP, the fact that long-term owners have still been able to extract 25% of their investment amount is what the margin of safety is designed to accomplish. Those dividends reinvested at $40 will appear quite substantial once the price of BP’s stock becomes free from its current trappings. And if it lasts longer than you expect, you still collect a nice chunk of change.
That’s my long-winded way of saying that things are going to get even nerdier around here. I’ll be looking at health-care companies with significant accrual differences where the earnings reported to investors is significantly different (for better or worse) than the cash flows generated by the businesses. Sometimes, that means a stock with a reasonable P/E ratio is actually more expensive than you think, and other times, it will mean that something with a high P/E ratio is a better value than you’d guess. It’s going to be about focusing on what the growth engine of the company actually looks like rather than what the superficial gloss might indicate, and then comparing it to the given price to figure out whether it is a business worth our time. It will be about what the businesses you own are doing, rather than what they and the media say they are doing.