Earning Power and Intrinsic Value

One of my investing challenges has been managing a portfolio without getting whipsawed by fluctuations in 12 month trailing earnings or free cash flow. If you’re a quantitative value investor and you pay close attention to trailing 12 month results, either in deciding what to purchase or when to sell, then portfolio management, emotional/behavioral management, and portfolio turnover can become serious problems. That’s because your investing decisions rest heavily on short term results rather than a meaningful assessment of intrinsic value and long term earning power. Ironically, Benjamin Graham encouraged some of this short term focus in the 1973 edition of The Intelligent Investor and in subsequent interviews and writings, where he espoused a simplified, formulaic approach to value investing that gives special weight to a company’s trailing, 12 month PE ratio. Joel Greenblatt and Tobias Carlisle have promulgated a similar approach that rests largely on trailing, 12 month enterprise value to operating earnings (or EBIT).

For me personally these simplified approaches — particularly the low PE, low debt approach — have worked well, although the past three to four years have been challenging. As Charlie Munger notes, value investors keep recalibrating the “Geiger counter” to identify statistical bargains. It seems like investors have become better at detecting statistical bargains through a simple formula, possibly explaining why these approaches don’t work quite as well as they used to.

It’s strange that many value investors use short term earnings and simple purchase/sales criteria — as I’ve done myself — when this approach seems to depart from core Graham teachings, namely that: (1) an investor should treat a stock as an ownership interest in a business, not as a piece of paper; (2) investment is most successful when it’s most businesslike; (3) investors should invest intelligently and avoid speculation; and (4) investors should buy at a substantial discount to intrinsic value. Buy/sell decisions based largely on the most recent financial results, or based on short-term focused, mechanical formulas, seem to violate these four principles. In my case, while simple formulas have sometimes produced exceptional returns, they’ve also led to myopic thinking and unnecessary portfolio turnover. Simple, mechanical approaches — which I’ve espoused in this blog and which I’m still fond of — have moved me away from the core Graham concept of intrinsic value, arguably making my investing more speculative.

Warren Buffett has said the investing book that changed his life was the 1949 edition of The Intelligent Investor, so I went back and reread some past highlights. In chapters 10 and 12 of this book Graham notes that earning power should be assessed based on multi-year averages, not based on individual/separate years, since all companies have good and bad years. The Intelligent Investor, by Benjamin Graham, pp. 160-161, 175 (HarperBusiness, 1949). He says a company’s intrinsic value only changes when new developments arise that weren’t captured in the initial appraisal, and that this value does not change when earnings rise or fall due to an economic boom or bust. Id. at 175. Finally, he notes that stock price behavior “departs radically from this concept of intrinsic worth,” that “prices respond vigorously to any significant change in either current earnings or short-term earning prospects,” and that “both favorable and unfavorable situations are part of any normal long-term picture — and as a consequence should be accepted without undue excitement . . . .” Id. at 175-176.

The larger point is that investors may want to consider using averages and more meaningful statistical measures when estimating intrinsic value and deciding whether to buy or sell a company. From a big picture perspective, it makes little sense to estimate long term earning power, and conclude that a company is selling at a discount or premium to intrinsic value, based on 12 months of earnings or free cash flow. Making decisions on this basis promotes knee-jerk, irrational behavior and excessive portfolio turnover.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.