Warren Buffett thinks more and more companies are faking it, and Wall Street is helping them do it.
In his annual letter to shareholders, which was released on Saturday morning, the Berkshire Hathaway CEO took other executives to task for telling their shareholders to ignore what Buffett thinks are very real expenses. In addition, Buffett criticized Wall Street for endorsing and passing along those inflated financial figures to investors.
“Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring ‘earnings’ figures fed them by managements,” Buffett writes.
Buffett says it’s possible that the offending analysts “don’t know better.” But more likely, Buffett says, the analysts go along with the phony numbers because they fear losing access to management, which is key to a Wall Street analyst’s job these days. Buffett also says analysts may be swept up by a herd mentality and go along with these inflated financials because everyone else is doing it. None of these reasons lets them off the hook, Buffett says.
“Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors,” Buffett writes.
Buffett has had harsh words for Wall Street before. In last year’s letter, he called investment bankers and others who advise on corporate deals short-sighted and opportunistic, arguing that Wall Street bankers often push for deals that are not in the best interests of companies just to make a fee. And when these deals don’t work out, bankers offer to break those companies apart, for a fee as well. “Money shufflers don’t come cheap,” Buffett wrote derisively in last year’s letter.
When it comes to earnings inflation, Buffett’s biggest beef appears to be with companies that don’t count the cost of stock-based compensation when they report their earnings to shareholders. Some have argued that since companies pay with stock and not cash, they should not have to consider it an expense. But Buffett says that stock-based compensation is clearly an expense. Others have argued that issuing shares or options lowers the value of a company’s existing shares, so it is clearly a cost to shareholders.
A growing chorus has recently pointed out the growing divergence between what companies are actually earning and what they are telling their investors. The Wall Street Journal recently reported that the gap between earnings that comply with accounting rules and pro-forma earnings, the figures that companies tell their investors they should look at, is the widest it has been since 2008. Based on pro-forma earnings, profits for the S&P 500 rose an average of 0.4% in 2015. But if you stick with figures that conform to official accounting rules, profits actually plunged nearly 13%.
Valeant Pharmaceuticals, which has been one of the biggest stock market blowups of the past year, has been a heavy user of pro-forma accounting. It has often excluded charges related to mergers, research and development, and stock-based compensation. In the first nine months of last year, Valeant said it earned $2.7 billion by its own measure. However, by official accounting rules, the company’s profits were $70 million. Shares of Valeant have dropped by 60% in the past year. The company recently said it would restate its financials.
Last year, Buffett’s long-term partner Charlie Munger called Valeant a “deeply immoral” company, which set off a public brush-up with hedge fund manager Bill Ackman, who has a large holding in Valeant.
Oddly, Buffett’s denouncement of executives who doctor their earnings comes during a section of his annual letter in which he does a bit of his own selective accounting. Buffett says that Berkshire shareholders would do better ignoring a portion of the company’s amortization costs. Buffett acknowledges the slight contradiction by saying that he gives that advice with “some trepidation.” But he says some items of amortization, unlike compensation, are not a real expense. What’s more, Buffett says investors when calculating Berkshire’s true earnings should include depreciation, which he says is a often true expense, but doesn’t normally get counted.
“When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak,” writes Buffett.