Quality of Earnings | Thornton O'Glove | Talks at Google

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I liked his book, but man this is some terrible investment advice.

👍︎︎ 1 👤︎︎ u/dharmon 📅︎︎ Jul 08 2016 🗫︎ replies
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SPEAKER: So Mr. O'Glove is a Wall Street veteran known for pioneering red flag deviation analyses, and he's the author of "Quality of Earnings-- The Investor's Guide to Figure Out How Much Money a Company Is Really Making." His work is amongst the must-reads by industry icons including Tom Gardner of the Motley Fool and on Cuppy's book list as one of the top financial accounting books of all time. I could go on and on about the book, but this talk is about him. Over to you, sir. Thank you so much. THORNTON L. O'GLOVE: Boy, [? Surum, ?] I really thank you for your patience. So much time putting this together. All of you taking time out from lunch to come here. My family, and when I look at some of the personages that have been here-- Barack Obama, Hillary Clinton, Nassim Taleb, "The Black Swan," it goes on and on. I sort of feel like a pygmy in their company. And as I tell you later when I get to Berkshire Hathaway, if Houdini can come back to life and wave a magic wand as a financial magician, it would be great for Warren Buffett to come out here and for me to debate Warren Buffet on what he's not going to do. We're talking about disassembling all the company. All 90 operating companies will be spun off tax-free to shareholders. The $360 billion market cap here, again, it's like waving a magic wand. It'll go up to a trillion dollars, but I'll go more into this and the mind of Warren Buffett and why he chooses this path of acquiring and continuing to conglomerate, rather than deconglomerate. And a little bit more about my background, I was born and raised in San Francisco, got a BA from San Francisco State, an MBA from the University of California-Berkeley. I was a stockbroker for a number of years. When I was a stockbroker, I used to read these prospectuses. My specialty was selling new offerings by prospectus, and the prospectus had about 120 pages of dense content. I was the only one in the office that bothered to read the prospectus. So that gave me the idea to become a security analyst, and I left the brokerage business to go two years University of California-Berkeley, and that really helped me get more of a base and so on. And then I went on to Wall Street. I worked for a couple of firms and I got the idea-- I'll tell you where I got the idea of this "Quality of Earnings" report. This book really changed my life in the future. The "Quality of Earnings" report was an institutional report for professional investors, banks, mutual funds, investment advisers. Now we'll go on to what this presentation is about. Part one, financial deviation analysis, the "Quality of Earnings" book. What I like about the book is knowing financial analysis, but it can help your mind look for financial deviations and other deviations. One of my hobbies is I can't pick up a paper without seeing either a positive or negative deviation from the norm. In part two, investing 50 years in the market, I wish I could have some of the years back what I know now about the stock market with hindsight. And this is why when I see my eye doctor, he says, you have perfect 20-20 rear vision, but not so much foresight. And talk about the best pathway, and I kind of prove this out. It's very simple. You know, I know all these investors come here, mutual funds, Howard Marks was here. They all have their own ideas how to invest and so on. And then part three is the bonanza. Only after Warren Buffett leaves the scene will the corporation change dramatically. Even though he's got it all figured out in his mind, he doesn't want it changing. But I'll explain why this is going to happen. So going on to part one now, I came across a book all the way back in the 1950s, "How to Lie With Statistics." Everyone should read this. It was written by Darrell Huff. It's sold over two million copies since the mid-'50s. It's still in print. And here's what he says. Basically, you can take this to the bank. "Rarely you live through a day without having statistics forced on you by radio, television, billboard, or newspaper. This book will keep you from being fooled. Read it and discover which statistic is the phony." And by the way, you almost cannot pick up a newspaper, and you will not see some example of rigged statistics. It may involve school grades, maybe even involve how many ships are in the US military, how many Special Forces are really in Iraq, because they don't count the number who are going to go on rotation, so they leave out 1,000. That's another way of rigging statistics. And I love this quote by Disraeli, the Victorian prime minister of England. He said, "There are three kinds of lies-- lies, damn lies, and statistics." And then the famous H.G. Wells said, "Statistical thinking one day will be as necessary for efficient citizenship as the ability to read and write." Well, that's never happened, never will happen. Always remember, whenever you look at statistics, a contract, whatever's handed you in the form of statistics, the presenter has the upper hand. Everyone has a bias. So the Department of Labor has a bias in keeping down the inflation rate. The inflation rate, they claim, is 2%. It's nowhere near 2%. I wish Janet Yellen could come here for 30 seconds, the head of the Federal Reserve, and I say, I don't think you eat food. I don't think you pay rent. You don't have any medical expense. You don't have any tuition expense, because you say the tuition's only 2%. The real rate of inflation runs 5% or 6% right now. That's the real rate. The deficit, you'll read a $500 billion deficit. The deficit's not $500 billion. The current deficit in the last 12 months is $1 trillion. It's very simple to know what the deficit is. It's the increase in government debt over a period of time. But the way the government keeps the statistics, their definition of today's deficit is one half of the true deficit. Just to give you a few more examples of this, now Nate Silver has come here to talk. This is a book that I think everyone should read, from the president of the United States on down. People in command, the head of the FBI, you name it, the higher up you are in a corporation or whatever you're doing, you should read this book, because so many signals are missed. And Nate Silver is a genius, first of all as an amateur pollster. In 2012 he's the only one that predicted every state that would vote for Obama and Romney. The only one. He was an amateur. I'm just going to read this part here briefly. You see on the board. "'The Signal and the Noise,' he examines the world of prediction." By the way, talking about the world of prediction, if you heard Nassim Taleb come here, he mocks predictors. He says they're all wearing empty suits. They don't tell you what their real track record is. And also Warren Buffett, he makes few predictions but the few he make come true. But at the annual meeting, he'll say everyone loves predictions. They like to make predictions. And the kings of old hired soothsayers to tell their fortune. Now he says, "Many predictions fail, often at great cost to society, because we have a poor understanding of probability and uncertainty." That's also what Nassim Taleb goes into. "We are wired to detect a signal and we mistake more confident predictions for more accurate ones." The noise-- there's never been more noise ever in trying to make predictions, and the reason there are so many mixed signals-- you see, the internet is great. The internet-- however, the negative on the internet is there's way too much noise. And I was just reading the "New York Post." I can't believe the statistic. They said the average worker in tech and so on spends six hours a day retrieving emails. And my son here-- who's assistant DA at the district attorney's office, he's head of the criminal division-- my guess is he spends three hours a day just on collecting emails. So what happens is you get all these emails, all this overloading information. You're searching for all this different information. There's so much texting. This is why somebody who can train themselves a la Nate Silver to look for the signals that count will be ahead of their competitors. Now what are three great missed signals among the many recently? Bernard Madoff, the greatest Ponzi scheme ever. He claimed he was managing billions of dollars, and he'd give you a 10% steady return, and people would beg him to invest. And he said, I have a-- They would say, what is your method? He would say, I have a proprietary method. If you already had money with him, he said, I'll send you a check tomorrow if you don't want me to manage your money. And if you don't like the way I can't tell you exactly how I manage all these billions of dollars to give you a 10% return no matter what the bond market does, no matter what the stock market's doing, you're getting a 10%. And that's how he got so many, you might say suckers, to invest with him. But nobody, including the SEC, and the missed signal was, who were his accountants? You've got to realize Bernard Madoff was very well known on Wall Street. He was president of the National Association of Security Dealers. He was under oversight of the SEC. They would come in, inspect his office. Some investors invested over a billion dollars with him, but none of them interviewed his accountant. And who were the accountants? Nobody in the world ever heard of these two accountants up in a strip mall, upstate New York. Nobody ever heard of them. If they investigate the accountants, then what they would have done is how on earth can this man of his stature and managing so much money have accountants nobody ever heard of? You'd almost have to have one of the big four accountants that handle most of the corporation audits. So this-- that was the real signal where he could have been apprehended years before. Now we come to Enron Corp. This is one of the biggest accounting scandals ever. You remember Enron Corp? The lights went out in California and they were gaming the system. Enron, if you wanted to invest in an energy company, that was the way of going. The company's stock skyrocket. The last year they reported earnings, they only earned $1. They were selling at 100 times earnings, which is a very high multiple. There were so many red flags. Looking through the annual report alone, there were dozens of red flags. And one red flag was off-balance-sheet entities. These are entities that are not part of the annual report that you can look at, and all the SEC had to do when they used to look at their financials, just ask for a separate income statement balance sheet of these entities, and they would have saw they were hiding the losses. They had three sets of books-- one for the shareholder, the other for the IRS, and the third set of books was these off-balance-sheet entities that became more and more notorious, and that's where the real losses. The losses in these offshore-balance-sheet entities hid the fraudulent gains. Another one, interesting. Derivatives. Nobody listened to Warren Buffett. This is a case of Warren Buffett making one of his famous predictions. In 2003, in the annual report, he said, derivatives will become weapons of mass destruction, financial mass destruction. I heard him on the Charlie Rose program. Charlie Rose said, well, how do you know so sure? Remember this is four years before the derivatives busted corporate America-- I mean busted the banks and so on. And they all had to be saved by the government. He said, I bought general reinsurance not too long ago. They were loaded with toxic derivatives. It took me a couple years to get rid of the derivatives. He writes the most famous shareholder letter. It's about 20 pages. There's never ever been a shareholder's letter written before and never will be one afterwards. It's so informative. It goes into a lot more than just Berkshire Hathaway. In this case he's talking about derivatives. Well, who wasn't listening? Alan Greenspan, the Federal Reserve. Rubin, secretary of state. Bill Clinton, if you Google him up you'll see where he says he made a mistake by not having derivatives regulated. However, he didn't know anything about them. In the case of Rubin, after destruction with the derivatives he said it took him eight hours to talk to accountants to even begin to unwind. They purposely were obtuse and hard to explain. So that's another thing in life. They give you a contract or whatever they give you, and hand in front of you, or a new way of computing, and this is supposed to really help you. The more dense and obtuse it is, just be on guard. Now we're on to the "Quality of Earnings" book, came out all the way back in 1987. And if I hadn't read about the "Lying With Statistics," because that's what accounting's all about-- lying with accounting legally. Once in a while my partner Bob [? Osteen ?] and I used to say, you know, there isn't that much fraud. They start with marijuana and then they'll go on to heroin. When they go on to heroin, accounting-wise, that's when everything breaks up, like Enron, WorldCom, you know, these big accounting scandals. But what you can do with the generally-accepted accounting-- and don't forget you pay the accountant. The accountant is paid by you. He will work as close as he can to you. You may know him socially. In the case of Enron's auditor, this big auditor, Arthur Andersen, one of the most famous auditors, was a runaway audit. They went far beyond the bounds they should have. They should have given Enron a classified opinion, a qualified opinion. It was so bad, and Arthur Andersen had been warned a few years about another audits, so the government went after them in civil. They actually closed them down. The company had 50,000, 60,000 employees. They-- and what's interesting is you would have made a lot of money on Arthur Anderson through a center, because they had what they call a advice. They give advice to corporations, and the center went public, and stock's up about 12 to 1 since it went public. That was a great buy, because all you were buying-- you weren't buying accounting now, you're just buying advice like McKinsley gives. Here we go again on the points of the analysts. The analysts are trapped. They've got to be bullish. If they're negative, they may lose their job. The corporation may shut them out of seminars. Most of them are involved with underwriting. That's why they-- the company will call up the research firm and they'll say, no more underwriting, so if you don't either get rid of the analysts or silence them. Trump personally fired an analyst years ago. Don Trump, the Taj Mahal Casino, they issued bonds that were very risky. And this analyst-- I still remember his name. No, I remember where he was from-- Roth Securities in Philadelphia, entertainment firm. And he said, the bonds are fraught with risk. Within one week he was gone. Trump called his-- the head of the firm and said, I'm liable to sue you. By the way, he has been involved in 2,000 suits, one way or the other. He holds the world record with suits. Either he's been sued or he's suing you. And he threatened, of course, to sue the firm, and the firm had a weak backbone and they fired the analyst. The auditor's reports may not be reliable, as the financial operations are very complex and there's a lot of leeway. You've got thousands of pages of regulation. You've got the SEC-- remember the more thousands of pages there are, and also dictum, the more you can game the system. So the bottom line is a corporation can tell the accountant to either be aggressive, not fraudulent, middle of the road, or conservative. Somewhat similar is the IRS tax code. It only has 85,000 pages now since 1913. It came from a couple pages, now it's 85,000 pages. So you read about these corporations, and they're dodging tax, they're doing this or that. Well, you can't blame them. They've got 85,000 pages to work with. A lot of it's a gray area. And here again, they're paying the accountant to eliminate as many taxes as they can. The chief executive's annual letters, very interesting. If you own a stock and you read the annual report each year, the president's letter might constantly make predictions that go astray. So there is a stock you wouldn't want to own. Or they'll be very bullish as usual, but in the back of the annual report, you look at the financials and so on and you'll see the company, the quality of earnings is deteriorating. The future doesn't look good, using the own financials in the back. In other words, a positive picture in the front, weak financials in the back. You have income that may be recurring or non-recurring, one time. The emphasis is to emphasize income. If you need to pad your earnings, emphasize the non-recurring income. The recurring income comes automatically. And by the way, Trump-- there was an article on Trump years ago on one of his companies, where he was flagged down by the SEC for overemphasizing non-recurring event in his presentation, a presentation of preliminary earnings. Now here's a good one. They have-- don't forget, the corporation has the shareholder books, they have the tax books. The tax books are a lot more conservative. They're conservative. They take higher depreciation expense than they do for shareholder expense. They may be writing off expenses immediately for shareholder reporting-- no, for tax reporting, but not for shareholder reporting. The bigger the gap between the shareholder earnings and the tax earnings, the lower the quality of earnings. This footnote is deliberately obtuse. It's hard to read. You may need an accountant to explain it to you. And this is self-evident. The higher the accounts receivable-- one red flag that comes up very quick, when the receivables or inventories really start advancing quickly in relation to sales, that's almost a dead giveaway that company sales are going to slow down ahead of time. They may change the way they report earnings. They may start accelerating revenue faster than they were. They may start capitalizing expenses like software. Enron, the last year they were in business is interesting. They earned $1, up from $0.90. The whole dime increase in earnings came from capitalized software, the first time they were capitalizing software. A large corporation like that's not able to do it, but you seldom do it. But they needed that dime desperately, so the whole increase in earnings came from capitalized software, which the investors, of course, ignored. Now the big bath-- this can be very bullish, and Hewlett Packard is a poster child. Hewlett Packard, by the way, never stops laying off employees. Carly Fiorina came-- Carly Fiorina laid off thousands-- tens of thousands of employees. Whitman took over, laying off thousands of employees. I pity the people working for Hewlett Packard. What they do is they'll take a big bath. They'll write off inventory, accounts receivable, reserves. In the case of the $9 billion company they got stuck with, that they bought in England-- and it's interesting. They bought a $9 billion company, and their own accountants look at the books-- this shows you how difficult it is to see accounting fraud-- and they also hired English forensic accountants to go over the books. They bought the company. Shortly later a whistleblower comes, not from the accountants, a whistleblower tells Hewlett Packard, you made a bad decision. You bought a company that's partially engaging in fraud. So now Hewlett Packard goes to the head of the company, the founder of the company, starts laughing at him. He says, wait a minute. You sent your accountants in, the forensic accountants came in, we have our own big accountants. I claim we're using generally-accepted accounting. One year later Hewlett Packard writes off every dime of that $9 billion. And when they write off the $9 billion, they wrote off as much of everything else as they can. This is very bullish, because now you're going to have less expenses going forward. Your earnings are going to look better. Here is Amazon's review. Amazon still reviews this book, and I like this footnote here about, "The most valuable lesson I learned from the book is to analyze the differences in income reporting to the IRS versus to the shareholders. Companies keep two types of books-- one for the IRS, one for the shareholders." There also can be a third set of books, what I call the rigged books. When a corporation engages in fraud, you've got shareholder books, and you have the IRS books, but then you have a third set of books that they keep internally where they see the difference between the regular earnings and what the earnings should be. Of course that's not public. That's not shown to the SEC. Now you have a picture of Houdini, the famous magician, and here's what you can do with earnings. Remember Cisco Systems, the great company-- it's still a great company-- went public in the 1990s? It split nine times in a row. It might be a record for a technology company to split nine times a row in 10 years. What are the odds that I, the company, will report for nine years, 36 consecutive quarters, I'm going to report one penny above Wall Street consensus? The odds are a million to one. But they did this for nine years. Every quarter was $0.01 above consensus. During the dot com boom the company got up to about 80. It was selling about 100 times earnings. I'm going to talk about the price-earning ratio later. The price-earning ratio collapsed, like most of the others during the dot com boom. By the way, most of those companies didn't even have earnings anyway. And Cisco no longer needed to show $0.01 above consensus. It was now down to 12 times earnings, and after going down to 10 or 12, for years remained down at 10 or 12. They still had decent earnings, but the price-earning ratio boom was over. Materiality. I would include my book on when a company will tell you we have an item that's immaterial. When they say something is immaterial, the odds are it's material. But they don't want to clutter up the balance sheet or income statement with materiality. The doctrine of materiality is about 5% of the base. If something is 5% of the base or lower, you don't necessarily have to disclose an item that's poor quality of earnings. However, let's say that item is 100% of the gain year to year. That's incremental. But the accountants and management do not look at it incrementally. So there's where the magic Houdini comes in. Now I'm going to go to the best pathway for individual success. I know Howard Marks was here a couple of months ago. They all-- everybody has their own formula for, quote, "beating the market." I can tell you one thing. Anybody who thinks the market's efficient should see a psychologist. They really should. The market cannot be efficient, because what is the formula for the market? Corporate earnings times the price-earning ratio. What will a dollar of earnings bring you? You sell for eight times earnings. Sell for 80 times earnings. The price-earning ratios are very volatile, up and down. Also it's influenced by inflation. If it's lower, you'll get a higher price-earning ratio. If it's higher, you get a lower price-earning ratio, What is some more about this long-term investing? Ideally you should buy as many stocks as you can as young as you can. Buy as many stocks as you can. Even if you only buy a couple hundred stocks, by the time you retire you should try to have 50 or 100 individual stocks. Almost never sell. Concentrate on branded names if you can. Warren Buffett, if you get to $120 billion stock portfolio in Berkshire Hathaway, $120 billion, this is individual stocks-- American Express, Washington Post, Bank of America, Goldman Sachs, so it goes. General Electric. He buys branded names. He's got $120 billion portfolio. He's got 90 operating companies. Many of the operating companies are all branded names-- Geico Insurance, See's Candy, Kraft, Heinz, Horton Foods, Burger King, Berkshire real estate. It goes on and on. Branded names. And the best way to find branded names at the inception is reading a prospectus. If the market goes down or you have a very poor market, that's the best time to buy new offerings. Costco, Microsoft, Nike, Home Depot, Starbucks, they all started as new offerings. Starbucks-- and by the way, you don't know how much they're going to go up. Starbucks, I believe, is up 13,000 to one since it went public in 2000. No, in 1993 it went public. I think it's up 13,000 to one. Microsoft at the height was up 800 to one. Many of these stocks are up 1,000 to one. It's incredible. You want to read a good book on branding, it's called "Branding Relevance" by Professor David Aaker. He's a professor at the University of California. He's also in the Hall of Fame in marketing. In his book he talks about branded companies and branded products. He doesn't really discuss the stock market. But what I told him-- I talked to him briefly. I said, you should take this book, and all these companies you name, you should research when they first went public and what the price is now, and this would be a best-selling investment book. Also it's a great book to read if you're going-- if you work for a branded company, obviously you have an edge. A branded company has a better chance of staying ahead of the competition. He tells those who work for branded companies how best to stay ahead of the competition. Some people go into business for themselves. Try-- easier said than done. Try to acquire for yourself a branded name. You understand about the price-earning ratio and how it can go up and down, so let me just tell you a little bit about the stock market. Now what is-- investors, you've got to be careful with the price-earning ratio, because investors like Howard Marks, they're not buying this last 12 months' earnings and they're not buying this year's earnings. They're buying tomorrow's earnings. Right or wrong, they're all buying tomorrow's earnings. The market is a discounting process. How does it do so well predicting only with hindsight? The depression, when the stock market went from 380 to 40, 380 to 40. The low in the depression was 1932. Industrial production reached the low. The market never went any lower after '32. In fact, the market had the biggest rally in its history, percentage-wise, went from 40 to 200 before the next recession came. 1942, June '42, the war had just begun. The Battle of Midway. The United States won a tremendous victory in the Battle of Midway. They sunk four of the Japanese top eight aircraft carriers. Naval-wise, the Japanese never recovered. The war went on for three more years, yet the American market never went any lower. World War II, the evacuation from Dunkirk. They evacuated 300,000 troops that were trapped in Dunkirk, France. That helped save England. The war had just started. The market never went any lower. In fact, these markets kept going up while the war was being fought. What about the history in America? And you can see why it's so hard to predict the market. When Eisenhower was president in the '50s, the market was 10 times earnings. When he left, it was 20 times earnings. And corporate-- also corporate earnings. The market is a function of corporate earnings. What are corporate earnings going to be? Corporate earnings doubled during his eight years, so now you had a triple in the market. When Clinton was president, you had a new post-war high in the Dow. I'm using the Dow because it's the best, I think, best indicator. You went from 15 times earnings to about 23 times earnings under Clinton for a time. So not only had the corporate earnings had been going way up, but look what the price-earning ratio did. By going from 15 to 22 times earnings, you got a 50% increase in price right there. What about Jimmy Carter? The opposite happened. You had an almost runaway inflation. The Dow Jones went down to six times earnings. The stocks busted because the price-earning ratios went way down. The book value was only one times earnings. [? Bowker ?] came along. He saved the economy from what would have been hyperinflation, and the market recovered enormously. Now when Howard Marks was here, he talked about the nifty 50. What happens with the market, and the reason it's so hard to predict, is you get these bubbles, or you get these fads. So in the '70s, almost every serious investor bought the nifty 50. The nifty 50 were blue chip stocks-- Merck, Procter and Gamble. The problem was they were selling at 50 times earnings. That bubble burst. The earnings did not go down. The stocks remained viable, but look what happened to these people. They bought at 40 and 50 times earnings, it went down 15 times earnings and stayed down there for many years. Some of them to this day, good companies, have not gone above 15 times earnings. Now how can I prove out very simply my thesis, the more stocks you buy? My wife, sitting here, belongs to an investment club. They own 35 stocks, and over a period of years, they have outperformed the market. They've tripled. The value of the investment portfolio has tripled. I run into people and they say, could you look at my portfolio? And I say, I don't want to-- I don't need to look at your portfolio, and don't tell me how many dollars in the portfolio. All I want to know is how many stocks you own. Just give me the names. I've never failed to run into an individual that has a large amount of stocks that hasn't outperformed the market. My next door neighbor, he's got 40 stocks. He's 88 now. He's never sold any of his stocks. I recognize all the names. I have another neighbor, he's an energy consultant. He has 100 stocks. Well, he's in pretty good shape. And he's never sold a stock. And then we have a woman acquaintance of ours. A couple years ago, I asked her how many stocks she owns. 300! Owns 300 stocks. And then a couple years later, I saw her. I said, do you still own 300? She said no, I own 200. I got in the hands of an investment adviser-- which is the worst thing she could ever do, and by the way, you cannot do this. If you have an investment adviser or stockbroker, they're going to turn you over, the number of stocks. You're going to have a turnover. And when you look at mutual funds, the higher the turnover, they'll have less success than some other mutual fund only turning over 20%. And I said, are you sorry now you sold any of these 100 stocks? And she said yes. And the other thing I asked these individuals, when they do sell stocks-- and by the way, look. I'm not saying you shouldn't sell any stocks. If the handwriting is on the wall, by the time you know it, the stock will already be down 50%. I guarantee you that. But in some ways it's better to sell the stock 50% down before it goes to oblivion, like Polaroid. And Avon is way down, and Eastman Kodak long ago is no longer a blue chip. If I was younger, I'd have a booking agent and I'd go on tour to lecture about Warren Buffett, the mind and the company. I think I know his mind, company, as well as anybody. He has the most multi-dimensional mind of any chief executive officer in the history of America. He's the greatest acquirer of corporate corporations ever. If you invested with him in '65 when he started, $10,000 became $15 million. He's also a world-class investor in individual stocks. Like I said, they've got a portfolio of $120 billion. He's an organizational genius, 340,000 employees. He's got 26 preside over the company. 26 at headquarters. General Electric, a much smaller conglomerate, has thousands. The market cap is $360 billion. He's got the company in a lock box because he owns an incredible 25% voting control as an individual himself. The other inside, he's got 40% voting control. He owns 20% economic interest in this company. That's $70 billion. He's only paid one cash dividend in all these years. He only had one spin-off. Every time at the annual meeting, they ask him, how about cash dividends or spin-offs? The two words are always the same-- absolutely not. But when you read the shareholder's letter, and fantasy would be to have him here, debate him for half an hour on why he should deconglomerate instead of continuing to-- what he calls a sprawling company. Those are his words. And he says he and his sidekick, Charlie Munger, are going to continue to buy companies. Buffett's 85, Munger's 92. That's their hobby now, buying companies. But if he spun off all these 90 companies, the stock would double overnight, and then what would happen is these spin-offs would have spin-offs of spin-offs. So you have Kraft, Heinz. There are so many companies he has where you could have many spin-offs. You'd have over 200 publicly traded companies on a tax-free spin-off basis all paying cash dividend. What does he say in the annual report? He contradicts himself. He says, I leave these managements alone to the point of abdication. That's his word, abdication. But then in the next sentence he says, I don't trust some of the excess cash flow. So the tens of billions of dollars of excess cash flow go up to headquarters so he can continue to make these acquisitions. But the fact remains every one of these companies was successful before he bought them. He's never bought a turnaround. In the annual report he says, if you have any tips for me to buy a company, I do not want a company with any problems or anything like that. We don't have the staff to handle it. And also he said the managements are so good, and their successors, that when I'm gone, even a fool would be hard-pressed to run it into the ground. And finally, another case he makes for dissolving this corporation in favor of the shareholders is Henry Singleton, he says is the greatest presider over conglomerates I ever met. He was famous for Teledyne. Henry Singleton shrunk 80% of his shares. By the time he was finished managing the corporation, 80% of the shares were shrunk. He was one of the pioneers in rebuying shares, and also he said there's a time to deconglomerate. So when he reached retirement age-- in his case, in his 70s-- he spun off the important divisions to shareholders. So Warren Buffett does not follow what he preaches. So what do we have here? We have an index company that would-- it's an index. It's the only index fund, like it has all the [INAUDIBLE] of an index fund, but has equity kickers. And here's my prediction, which may be the only one of its kind. Why does Warren Buffett-- why is he so confident there will be no change after he's gone? Because he's got Bill Gates. The lock box now goes to Bill Gates Foundation. The foundation already has $45 billion. Right now, with this $70 billion, two thirds of what Buffett has, his net worth is Berkshire, is going to go to the Bill Gates Foundation. Why would you leave two thirds to already which is the largest foundation, private foundation, in the world? The reason is you want Bill Gates Foundation to have the voting control. Bill Gates, who is his bridge playing partner, personal friend, sits on the board, they have agreed we will continue to do what we're doing under different managers. That's all. We're not going to get engaged in spin-offs or being paid cash dividends. I really thank you for your attendance. Are we about on target now? SPEAKER: Yes. THORNTON L. O'GLOVE: OK, so any questions you have on any subject and so on, just feel free. AUDIENCE: Yeah, thank you so much for the talk. So we've had a couple guests in the past couple of weeks talk about sort of the value of long-term investing. Do you think it's viable at all to think about short-term investing in the long term? So not exactly day trading, but things of that nature, where your period of holding is on average, like, a week or a month. Do you think that's a viable strategy at all for years to come? THORNTON L. O'GLOVE: I myself, I've never been able to succeed very well with short-term investing. There are some that-- a few individuals that do very well short-term investing. Bogle, the high priest of the index funds, he swears that over time you do better as a long-term investor in index fund. Most mutual firms investment advisers do not beat the market. And one reason they don't beat the market is the fees also weigh against you. And you'd be surprised with 2%, if you own a fund for 20 years, and how much 2% can wind up decreasing your performance by-- about one third. And there's another hidden factor out there. There's the spread in buying stocks. There is a spread in buying stocks. Sometimes there might be a dime spread. So there's a cost, the more you turn over that fund, the higher your costs are going to be. And I forgot to say something about long-term investing and owning a lot of stocks. Psychologically, you're going to be better off the more stocks you own, because when you have these market crashes-- a market crash is 40% or 50%, and the market crashes I can remember is in the '70s, '87, early '90s, early 2000, and then we had another one 2008. Although your stocks will go down-- I own 100 stocks, you own 10. Well, your 10 stocks are going to go way down. So are mine. But psychologically, you're going to feel much better off with those 100 stocks. You'll be less inclined to sell. You'd be surprised how these crashes really weigh on people, and the trigger-- all they need to trigger an investment adviser or their wife or whatever to say you own too many stocks. Sell them, you know, what you can. SPEAKER: How a technology company can capitalize software expense and the earnings can look really good for a one-time change? THORNTON L. O'GLOVE: Yeah, here again a great example. First of all, a small company is more likely to capitalize software for IRS purposes. You don't have to capitalize software. Software is an immediate expense. Most large companies don't capitalize software, but if you really need a jolt in earnings, you defer, you'll amortize the software. And Enron is a great example, selling at 100 times earnings. If they didn't capitalize that dime of software, the entire gain-- you've got to remember, 100% of the gain came from capitalizing software, that one item. $0.90 up to $1. Well, the earnings, the stock, if they earned $0.95 instead of $1, the stock would have gone down 50 points. SPEAKER: So the way he defines owner earnings, he says it's net income plus depreciation plus amortization minus capital expenditures. THORNTON L. O'GLOVE: You know what that is? Cash flow. What that is, that's the best definition of cash flow. Warren Buffett makes fun out of non-GAAP and all these other numbers they come up with. Here again, lying with statistic. You'll read in "The Wall Street Journal" day after day now bigger and bigger gap between GAAP and adjusted earnings, which may not include the compensation on workers. They may leave out what is recurring. I mean, what is recurring, they'll emphasize. What's non-recurring, they'll de-emphasize. That won't be part of adjusted earnings. And Warren Buffett is real full of this. He says you should- GAAP is tough enough, and you shouldn't have these other types of supplementary earnings. I would buy some ETFs, although they haven't been around long enough. I don't know how they're going to do in the next crash. Some people are leery of these ETFs. They become so large you may not be able get out of them. I'd be so much leerier of them, maybe have a few ETFs. I'd be very careful, especially ones with leverage. I stay away with leverage, and I would just try to buy individual stocks maybe. Oh, I forgot. Or a masseuse my wife has a masseuse that has come in for 20 years now. He's got 100 stocks. He reads "Value Line." "Value Line" is the best publication to give you a quick overview of all the stats and what they think about a stock. It's just one page. It's full of more information than any other source It'll give you predictions on earnings, what the cash flow has been. It's remarkable what "Value Line" does. They've been in business for 50 years. He looks at "Value Line." He spends a lot of time looking at "Value Line," or he went in Ross Stores. One mistake I made. I went in Ross Stores with my wife years ago, and they had-- it's a great discounter store selling all kinds of merchandise. They have a branded name. They have few competitors. Ross Stores is practically up 1,000 to one. You wouldn't believe it over the years. And another thing that happens when you get hold of one of these home runs, most of them don't pay dividends at the start. Starbucks didn't pay a dividend. Microsoft never paid a dividend. But what happened is the longer you own them-- and the price-earning ratio will go higher earlier, but as the price-earning ratio levels off, which it has to do, that's when they start paying dividends, and the dividends themselves can be a bonanza. Now, the stock market, when you look at how much the stock market's gone up, the Dow Jones, one third is a function of dividends. One third, function of dividends. No, I don't think the stock market is overvalued. Going ahead back to the '50s, it went from 10 times earnings to 22 times earnings when Eisenhower left office, and you know what's interesting? This shows you why anybody pretends to predict the market except on a long-term basis. Incredibly, Eisenhower left office in '62. Do you know the price-earning ratio of the Dow steadily went down from 22 times earnings-- not all at once-- to a low of six times years later when Carter became president? And then it went back up and reached a new high during the past 50 years. It hit about 23 times earnings under Clinton. And earnings are defined by "Value Line" as operating earnings. Operating earnings, you leave out non-recurring earnings. They usually leave out or write off, so they have their own what I call the best way of analyzing operating earnings. So I'll be talking about operating earnings now. SPEAKER: How do you know what's a good brand ahead of time? THORNTON L. O'GLOVE: Yeah. The question is there are so many offerings that go public. Obviously if you read David Aaker's book, at least all these companies are successful. He doesn't name the thousands that have gone public over the years. Especially during the dot com boom, there was really-- you want to talk about psychology, most of these companies went public and some of them went up from $10 to hundreds and hundreds. They had no earnings even to support them. And today there's a lot of these price-earning ratio-- these new offerings around have very little in earnings to support them. So that's a great question. One thing I've also looked at is the competition. The first thing I look at is competition. How much competition do they have? The little the competition they have, the more the branded name, or what they call the moat, M-O-A-T, the moat around them, and the more difficult it is to do what they do, then the better off you're going to be. Some of the great examples of all time, McDonald's. Never been a franchise. McDonald's only started with a few franchises. And the same thing on Burger King, and on Starbucks, Microsoft. But if you read, Microsoft, when it first went public, it was in the forefront of the internet. And one of the biggest mistakes IBM made was they could have bought them. They didn't buy them. And when you read a prospectus, he was a young guy-- sometimes you can see genius. When you read about-- one thing about prospectus, if you want to read the 80 pages, it will give you so much information that is not stilted, because they come under SEC regulation and they can't hide the warts and things like that. So if they have heavy competition, or they have a particular competitor, that has to be revealed in the prospectus. Also you have to look at the price-earning ratio. Remember now, in a bull market, they're going to come out with these new offerings that inflated values. The best time to buy a new offering is when the market is either sideways or you have recovered from a-- you don't have to have a crash, but a 20-- for example, a 20% decline. A bear market is loosely declined as 20% down. A crash, 40%. SPEAKER: We thank you so much, and thank you all for coming here. Thanks. [APPLAUSE]
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Channel: Talks at Google
Views: 34,417
Rating: 4.7359414 out of 5
Keywords: talks at google, ted talks, inspirational talks, educational talks, Quality of Earnings, Thornton O'Glove, quality of earnings report, quality of earnings, quality of earnings analysis, determining the quality of earnings
Id: I6VXHETUkbw
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Length: 53min 6sec (3186 seconds)
Published: Fri Jul 08 2016
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