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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Freedom Fighter who wrote (632)	8/13/1998 11:54:00 PM
From: Freedom Fighter	Respond to of 1722

Reynolds, I loved your essay on GM. >The write-offs of accrued medical benefits had the effect of >reducing GM's stated book value. They also had the effect of >making GM's ROE (earnings/book value) appear larger. Further, >they made the debt/equity ratio appear larger. Therefore, this >distorts comparisons of present ratios with those of the past. You may be misunderstanding this I believe. I have thought about this subject and read on it endlessly. I just avoid the companies altogether as far as investing goes. In theory this should not have had any effect on ROE because there is a writeoff and then there is also a change in the earnings going forward which is related. So it should have gotten us to true book value and true earnings which is real ROE. This should have been a number in line with past experience since both book value and earnings were overstated in the past in a related way. And for much of history these benefits were small or non-existent so the comparisons of now to the past are meaningful in at least some way on a company to company basis. I have verified this with a CPA. The reason it works out the way it does is because the post retirement liability is a non-interest bearing liability and it was very large in many cases. If GM were to substitute real debt to eliminate it, some earnings would vanish in a hurry, borrowing costs would rise, ROE would go lower due to interest payments and the balance sheet would be a mess. GM is a super leveraged entity as it exits and that accounts for the high ROE. That accounts for some of the higher ROE in aggregate too. Post retirement liabilities are debt and companies are more leveraged than they appear. The Post Retirement liability is just not discussed in this manner. That is the problem. Remember very high debt is generally value reducing and the liability is clearly value reducing since you are not paying interest on it in its present form. I have finished the Post Retirement number for the entire Dow. The number is approximately $600 per share. Instead of about $1600, book value would be about $2200 according to the old standards. Earnings would also be somewhat higher (I have no exact figure). You have to adjust earnings also to get to ROE on an adjusted basis. Price to book is still outrageously high relative to the past and so is ROE with the adjustments. The adjustment for the S&P500 is much lower on a percentage basis. I don't have the exact number. There isn't a snowball's chance in hell is would be double. More like a 15% higher book value according to my estimate. This of course is just Post Retirement adjustments. As far as writeoffs go, if recent ones weren't real from a business persepctive then book value is understated. But then depreciation is also understated and thus earnings are overstated. If they are real then book value is real and earnings are real. If book values in the past were overstated because they didn't write things off easily then depreciation was overstated and earnings were understated. No matter hwo you slice it.... Either way you can get to the values and issues by looking at free "REAL" cash (cash flow statement) as you said and comparing it to all sorts of other things. But from that perspective profit margins are at all time highs. Now the $64,000 question. If they are sustainable you are receiving little in the way of risk premium relative to bonds. If they are not you are doomed if the market adjusts accordingly. That is the essence of the bet. One that I and most value guys refuse to make at aggregate market prices. It is simply a very poor bet to receive a little if you are right and lose a lot if you are wrong. Especially when the prices are at all time highs by every measurement that is not in dispute like simply multiple of sales. The second way you can prove that that return on capital is at all time highs is from gross margin measurements. Most companies are earning a higher amount on sales than ever before. I think you agree here and you can scan VL also to prove it. There is little dispute here. Again, if it is sustainable you are getting little premium to bonds. If not you are doomed. So again that is still the question. I choose to pass on the current odds because I believe it is a foolish bet on an aggregate market that at current levels already assumes it is permanent. To me Value is getting into a situation where if you are right you make a ton and if you are wrong you lose a little or nothing. That is the opposite of where we are now no matter how it turns out. I simple can't see most banks, brokers, retail outlets, some restaurants, many techs and numerous other industries that contain many companies with no special advantage over numerous competitors continuing to earn 20% or more on equity the way they are now and the way their stock prices reflect as permanent. Not when you can borrow at 6%-7% and issue stock discounted at low rates. Much of these returns are simply a bull market related phenomenon that will eventually disappear when the bull does or when they take advantage of the cost and return on capital spread and do it to themselves. The market is a bet with poor odds in aggregate at present. As an aside. A view a that I know you pay little attention to and place little value on. I know of not one single competent value investor without a vested interest in saying otherwise that thinks this market is a good bet. This even includes the Fed. And I know a ton of them. Wayne Crimi Value Investor Workshop members.aol.com