SPENCE Asset Management

All Earnings are Not Created Equal February 2012

Late in January, April, July, and October we get very busy for a few weeks pouring over the financial statements and earnings releases of companies we own or would like to own.

One of the most critical questions an astute business analyst must continuously answer is, “What percentage of earnings must the company use for new equipment, plant upgrades and other improvements (capital expenditures) that MUST be done simply to maintain its existing competitive position and unit volume?” Examples of businesses operating in high capital expenditure industries are: Airlines, Auto Manufacturers, Chemical Producers, Heavy Machinery Manufacturers, Basic Materials Producers, and Truckers.

We ask this basic question continuously because not all earnings are created equal.

While GAAP (Generally Accepted Accounting Principles) attempts to standardize earnings reports, any business analyst worth his or her salt must understand and employ more sophisticated analysis techniques that enable the differentiation of so-called “GAAP earnings” from earnings that are truly free for owner’s to access and not necessary to reserve for ongoing capital expenditures.

The best way for a lay person to relate to an “owner earnings” calculation is to think about local businesses that are particularly equipment intensive. These businesses seem to stay busy and they employ large numbers of people. However, sometimes it seems as if they can never find much of a breather between equipment replacement cycles. And, of course, each time they go to replace their equipment, inflation drives up the cost of their outlays. Additionally, anytime there is a general business slowdown, these businesses have expensive, unused machinery standing idle or worse yet, standing idle while the owner accrues interest payment liabilities.

These types of businesses mirror the high capital spending industries listed above in the second paragraph. In the stock market, these businesses will often trade at very low price-to-earnings ratios and appear to be “cheap.” However, the huge taxable earnings these companies tend to report actually masks the hidden liabilities of their inherent capital spending cycles. Effectively, huge cap-ex companies are dollar swapping machines that produce far less real earnings available to shareholders than what appears at first glance.

Our preference is for companies carrying no such balls and chains. We prefer operators that can grow unit volumes and sales volumes with little additional plant or equipment. Often at first glance these companies will appear to be more expensive. However, knowing that all earnings are not created equal is one of the first really important lessons we learned on our journey to becoming business analysts.

However, large purchases of property, plant and equipment, like large GAAP earnings, can be deceiving. Take, for example, everyone’s most enjoyable place to shop: Walmart. Walmart has a large capital spending budget each year- some of which is used to open new stores and some of which is used to remodel existing stores. A new store, in theory, generates additional sales for the company while a remodeled store, in theory, merely keeps customers returning and maintains existing sales. Thus, an analyst’s next challenge is to estimate which capital expenditures will lead to growth and which will are crucial to maintain the company’s current level of sales. Like all earnings are not created equally, all capital spending is not created equally.

Calculating owner’s earnings is not something that anyone can do with pinpoint precision- even the company itself. Calculating the cycles associated with future maintenance capital expenditures often requires rough estimates and idealistic assumptions. Legendary economist and investor John Maynard Keynes said, “I would rather be vaguely right than precisely wrong;” with this in mind, we still think it is worthwhile to do our best to estimate capital spending rather than to ignore it, just because some extra legwork is required in making this subjective estimate. Just as all earnings and all capital spending are not created equally, all stock analysis is not created equal- extra legwork can upend all previous assumptions.

Let the legwork resume.

Jim Spence, Eric Walton

The information contained herein is for informational purposes only without regard to any particular user’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors. To determine if investment in a Separately Managed Account with Spence Asset Management is an appropriate investment for you please call 1.800.230.1840.

Investment Advisory Services are offered through Spence Asset Management, a federally registered Investment Advisor. Investment Advisory Services offered through IAR’s of Spence Asset Management, a Registered Investment Advisor to all residents of the United States.

The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.