Warren Buffett Vs. GAAP

A basic purpose behind accounting procedures, including GAAP, is to standardize financial statements. However, many companies are currently pushing non-GAAP earnings, which can exclude a number of non-recurring items. The write-down of an asset or restructuring are common non-recurring items. Another major item than can cause a big difference between GAAP and non-GAAP earnings is stock-based compensation, often in the form of employee stock options or restricted stock. As Warren Buffett argues: "If compensation isn't an expense, what is?"  We would advise you to learn about accounting, not only because a lot about a company from reading its financial statements, as Buffett warns "Accounting tells you a lot and it can be used in many ways to deceive."

Correlations They Are A Changin'

From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets.  However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.

Ratios And Lease Accounting

Beginning December 15, 2018, new FASB accounting standards will require public companies to include both capital and operating leases on balance sheets. Currently, only operating leases are reported. The effect of this new standard will be an increase in the reported value of assets and liabilities, which will result in an apparent overnight jump in the book value of many companies. According to one estimate, over $1 trillion will be added to balance sheets. Because of this increase in assets, several commonly ratios such as return on assets and the equity multiplier will be dramatically changed for companies that use lease financing. Of course, trained analysts have already been adjusting balance sheets for estimated lease liabilities. Although not mentioned in the article, there could be unintended consequences. For example, if a company has bonds containing a covenant that prohibit the company from exceeding a specific debt-equity ratio, the increase in liabilities could potentially cause a breach of that covenant.

It's Market Efficiency By A Length - Or Several Lengths Now

Back in 2013, we posted about Warren Buffett's bet with the founders of the Protégé Partners hedge fund that the S&P 500 would outperform a hedge fund index chosen by Protégé Partners over a 10-year period. At that time, the S&P had cumulatively outperformed the hedge fund index by about 8.5 percent. Even though the hedge funds outperformed the S&P 500 in 2015, the Vanguard Admiral index fund is up a  cumulative 65.7 percent in the last eight years, while the hedge fund index is up only 21.9 percent. One scenario for a possible comeback for the hedge funds, which is outlined by Ted Seides, the man who engineered the bet for Protégé, is a severe market downturn. Of course, he added about such a circumstance: "No one wins when that occurs."

Negative Corporate Bond Yields

Last year, we posted about how the size and number of negative interest rates were increasing in Europe, and how one member of the Federal Reserve was pushing for negative U.S. interest rates. Since then, negative interest rates have increased again in size and number. For example, Sweden increased its central bank rate from negative .35 to negative .50 percent and Japan moved its central bank interest rate into negative territory. What is also surprising is that the market has joined into the negative interest rate fray as 2-year Swedish government bonds yield negative 1.12 percent. And, recent comments by Janet Yellen indicate that even the U.S. Federal Reserve may consider negative interest rates, although the legality of such a move in the U.S. is not clear. While negative interest rates by central banks are uncommon, they are not without precedent. What is without precedent is negative corporate bond yields, which happened last week as the yield to maturity on Nestle corporate bonds went negative!

Golf And Investing

A recent article discusses how golf and investing may be related, but also talks about several behavioral biases that can affect investors. For example, loss aversion shows up in golf as golfers are more likely to make a putt of the same difficulty for par than they are to make the putt for birdie (one under par). Another behavioral bias discussed is probability neglect, that is, people tend to worry about bad outcomes that have a very low probability, such as a plane crash or losing 40 percent of their investment. By overweighting events with a low probability, investors can incur large opportunity costs. Finally, an informational cascade occurs when investors believe the signals from other investors, even if they do not agree. For example, if a stock you view positively begins to drop, you may sell based off what other investors are doing, rather than what your research has revealed to you. As the article notes, smart investors aren't loss averse, they don't neglect probability, and believe in their own analysis. 

Star Fund Managers Stumble

There is much disagreement over whether the stock market is efficient and what level of efficiency exists. Even if it is argued that the market is inefficient, it is still very difficult to identify those who can consistently beat the market as the recent performance of several well-known star mutual fund managers shows. For example, Bill Miller showed holes in his performance in 2008 when the Legg Mason Capital Value Trust fell 55 percent. Even worse, as the S&P 500 has fallen about 9.2 percent this year, the Legg Mason Opportunity fund, which he currently manages, is already down about 28 percent. Similarly, the Baron Partners fund is down about 24 percent for the year, the Federated Kaufman fund is down about 21 percent, and the Jacob Small Cap Growth fund is down about 27 percent. Each of the managers of these funds has been touted as a star manager during their career, but it appears none will be a star this year.