Don't Let Earnings Trick You

Certain aspects of long-term investing really appeal to me. First and foremost, it leaves more time for family and other non-investing related activities. When it comes to investing itself, the advantage I've seen mentioned most frequently is that it gives us the chance to learn more about the companies in which we hold shares. 

But there's another advantage that doesn't get mentioned as much: Long-term investors are left with time not just to study their companies, but also to learn how to better analyze companies. It's this aspect that I've spent much of my investment-related time on over the last few months.

I hadn't thought all that much about this advantage until last Sunday night, when I went to a surprise party for one of my relatives. During the course of the night I was asked a question that I'm asked nearly every time there's a family gathering: "Are there any stocks that you like right now?"

My first response was an unusual one (especially for me): silence. I really had to think about it. While I generally make it a practice to add shares of stock on a regular basis, I haven't bought much lately. The reason for that is simple, and it has nothing to do with the performance of the market.

When it comes to investing and the related analysis, I know that there's still a lot more that I can learn. So, part of my investing philosophy involves taking a step back from following the companies I own so that I can focus on learning more about how to analyze companies in general. As we learn more and gain more experience, our approach to investing should evolve as well.

There are two reasons I invest. The first is to better provide for my family both now and in the future. The second is to learn. I take a great sense of accomplishment from learning new things. Investing is a great tool for learning.

My approach to investing includes many tenets of the Rule Maker approach. However, there's more to it than that. I also base my approach on that outlined by Philip Fisher in his book Common Stocks and Uncommon Profits. I believe that while it's an imperfect science, valuation is an important aspect of investing, particularly when it's based on discounted cash flow analysis. While I didn't sell any of my shares in Cisco (Nasdaq: CSCO) when it was trading at levels I knew were unrealistic, my concerns over valuation kept me from adding shares to my existing position.

Those familiar with my writing can also probably guess that I like to perform pretty detailed financial statement analysis. It's this part of my approach to investing that has changed the most over the last few years. For example, when I first started investing, I didn't worry much about stock options, as I believed that they were an important employee incentive. Now that I've better educated myself on this subject I believe that companies like Cisco have issued an excessive number of options.

My thoughts about pro forma earnings have changed quite a bit as well. When in school, I learned that pro forma financial statements were provided to adjust previously reported financial statements so they could be directly compared to current results. They were most commonly used after a merger, so investors could see what the financials would have looked like if the merger had taken place at an earlier time.

Now, unfortunately, things have changed. Companies use pro forma earnings to try and make even the saddest picture look rosy.

Personally, I don't object to excluding acquisition-related items in determining pro forma earnings, as companies are generally not in the business of acquiring other companies. But, when it comes to things like the tax benefit from stock option exercise, inventory write-offs, and restructuring charges, I'm much more a skeptic than a believer.

Let's take a look at inventory. Manufacturers are in the business of making and selling goods. Cisco, for example, took a significant charge in the third quarter because it failed to identify the slowdown that was taking place in its industry. Too many raw materials were ordered and ultimately couldn't be sold. Management made an error. I don't believe this charge should be excluded from earnings.

Another company in this portfolio guilty of the same offense was Pfizer (NYSE: PFE) with its handling of the Trovan write-off last year. I don't believe such charges should be excluded from operating earnings.

The same applies to restructuring reserves. A company hires too many people and later lays off some of them because it overestimated growth, or it takes a "big bath" charge to clean up the balance sheet. Sounds to me like management messed up. I don't buy the view that such a charge doesn't arise from operations. Worst of all, companies can intentionally overestimate charges and then put them right back into operating earnings in the future, thereby giving the appearance of higher profits.

Also for consideration, there's the way that companies have been using pension surpluses built up during the market's boom times to bolster the current year's bottom line (see "Pondering Pensions"). The income related to the pension plan is not part of operating earnings and cannot be returned to shareholders, yet I challenge you to find the company that will exclude these gains from its pro forma earnings.

Many of these issues weren't in the center of my radar screen when I started investing. I knew they were there, but I didn't focus on them. By devoting a portion of my time spent on my investments to learning more about investing in general, I've learned to not follow along with the Wise and their apparent willingness to forgive the transgressions of companies in the form of pro forma earnings.

Bottom line: Go to the cash flow statement. Work with cash provided by operations. There's less possibility for manipulation there. Use free cash flow when valuing companies. That's the best way to try and get a handle on a company's value.

Until next time, be Foolish.

Phil Weiss and his family reside in northwestern New Jersey. Despite the concerns discussed above, at the time of publication he still owns shares of Cisco and Pfizer. The Motley Fool is investors writing for investors.