As I said last year, Warren Buffett’s annual letter to Berkshire Hathaway (BRK.B) shareholders is on my must-read list, and I suggest adding it to yours as well. His letters always provide investing insights written in Buffett’s folksy but outspoken manner. This year’s letter was no different. Though the media focused on the what the “Oracle of Omaha” said about productivity and the U.S. economy, a significant portion of the commentary was devoted to how earnings and assets can be misstated.

This may sound like heady accounting stuff, but it has implications for how you view a company’s earnings and its balance sheet. An understanding of how assets, shareholder equity and earnings can be overstated (or understated) will help to you know when to be skeptical of the metrics a CEO wants you to focus on.

There are two big types of noncash charges you will see. I’ll start with depreciation and then move onto amortization. Depreciation is a charge taken to reflect the decrease in value a physical asset incurs. For example, say a firm buys one of its new employees (Jimmy) a cocobolo desk. Accounting rules require that a certain percentage of that desk’s value be deducted each year. These charges count against earnings, but because checks are not being written to cover the charge, the charges do not count against cash flow. Depending on how gentle or tough Jimmy is on the desk, it may retain or lose more value than the depreciation charges imply. I’ve seen fully depreciated assets that could be still be sold. On the other hand, depreciation can understate the amount a company has to truly spend on equipment and machinery. As Buffett observed: “The depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly.”

Amortization charges are charges taken to reflect the decrease in value of intangible assets. Software is a good example. Over time software depreciates in value, even though no checks are being written to cover the cost.

You may also see charges for the impairment of goodwill. Goodwill is the premium paid to acquire another company. The problem is that goodwill is a fuzzy asset. If a larger firm acquires Jimmy’s business, it may or may not be able to take advantage of Jimmy’s relationships with clients. The problem with accounting rules is that they recognize the decline in value of intangible assets, but not the potential for an increase in value. A smart acquisition that truly recognizes synergies can result in earnings far in excess of the goodwill recorded on the balance sheet. Accounting rules do not allow this appreciation to be recognized. (Shareholder equity may grow through the retention of the extra earnings, but that’s a different conversation.)

Put another way, here is what Buffett wrote: “For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality.”

The challenge is that, as outsiders, we don’t know what a company’s true replacement costs are or how much its intangibles are worth. As a general rule of thumb, it’s best to assume replacement costs are underestimated by depreciation expenses and the value of the intangible assets including goodwill is overstated. (You can also assume goodwill is understated if the company has a good, long-term record of turning acquisitions into actual sources of revenue and earnings growth. Such companies tend to be the exception and not the rule.) Buffett gives some guidance for Berkshire shareholders (of which I am one), but even his advice is inexact: “To embrace reality, however, you should remember to add back most of the amortization charges we report. You should also subtract something to reflect (Burlington Northern Santa Fe’s) inadequate depreciation charge.”

This haziness should give you reason to ignore CEOs who want to you to look at EBITDA (earnings before interest, taxes, depreciation and amortization). This number is neither a company’s profits nor its cash flow. It is a number the CEO thinks will make his or her company’s performance look better. (Buffett advises that “when CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.”) Do yourself a favor and look at the actual earnings. Then look at the cash flow statement. You may find a story that is different than what the CEO wants you to believe.

I’ve long struggled with intangible assets—including goodwill—when it comes to valuing companies based on their book value. I fret about them being inflated and I generally just don’t trust the reported figures. One solution I’m leaning toward is to require a certain level of asset turnover. The asset turnover ratio is revenues divided by total assets. This ratio reveals how effectively a company is turning assets into sales; it rewards companies whose goodwill is understated and penalizes companies whose goodwill is overstated.

As far as depreciation is concerned, it can be helpful to look at capital expenditures on the cash flow statement. By looking at the amounts recorded over a period of years, you’ll get an idea of how much is actually being spent on property and equipment.

• Insights on Warren Buffett from His Friend and Editor – Carol Loomis, who edits Buffett’s annual letter, spoke about his investing and management process.
  
• EBT, EBIT, EBITDA: Will the Real Earnings Figure Please Stand Up? – In this 2001 AAII Journal article, John Bajkowski compared and contrasted the different earnings figures companies report.
  
• Do You Read the Annual Reports Issued by the Companies You Invest In? – Tell us on the AAII.com Discussion Boards.
  

Just two members of the S&P 500 are scheduled to report earnings next week: Urban Outfitters (URBN) on Monday and Dollar General (DG) on Thursday.

There isn’t much on the economic calendar. Beyond February import and export prices (which will be released on Friday), the only reports of note will be weekly oil inventories and weekly initial jobless claims. The latter two are released every Wednesday and Thursday, respectively.

Federal Reserve Vice Chair Stanley Fischer will speak on Monday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $20 billion of 10-year notes on Wednesday and $12 billion of 30-year notes on Thursday.

The percentage of individual investors describing their short-term outlook for stock prices as neutral is now at a two-month high, according to the latest AAII Sentiment Survey. Meanwhile, pessimism continues to pull back from its recent high.

Bullish sentiment, expectations that stock prices will rise over the next six months, edged up 0.8 percentage points to 32.0%. The increase keeps optimism at its highest level since November 26, 2015 (32.4%). It is not a large enough move, however, to prevent optimism from staying below its historical average of 39.0% for the 17th consecutive week and the 50th out of the past 52 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.3 percentage points to 38.7%. Neutral sentiment was last higher on January 7, 2016 (39.6%). With the increase, neutral sentiment is above its historical average of 31.0% for a fifth consecutive week and the 57th time in the past 61 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 2.2 percentage points to 29.2%. Pessimism was last lower on December 30, 2015 (23.6%). This week’s decrease puts pessimism below its historical average of 30.0% for the first time in nine weeks and just the second time in the past 12 weeks.

Bearish sentiment has now fallen by a cumulative 19.5 percentage points over the past three weeks. The large drop follows what was nearly a three-year high of 48.7% on February 10, 2015. The decline in pessimism corresponds with what is turning out to be at least a short-term bottom for the major U.S. stock indexes.

Notably, though optimism has improved in recent weeks, less than a third of all survey respondents describe their short-term outlook of stocks as bullish. Many individual investors are still concerned about the pace of economic growth in the U.S., the pace of economic growth in China, tensions in the Middle East, the rate of earnings growth and prevailing valuations. Frustration with Washington politics also continues to be expressed in the answers to our weekly special questions.

This week’s special question asked AAII members how fourth-quarter earnings have influenced their outlook for stock prices. One out of three respondents said fourth-quarter earnings did not influence or have only had a minor influence on their outlook for stocks. Many of these respondents said they are more focused on other factors, while some said they take a long-term view. Nearly 23% of respondents said fourth-quarter results caused them to be more pessimistic or at least more cautious because of declines in profitability and/or current stock valuations. About 8% described themselves as being more optimistic as a result of fourth-quarter earnings.

Here is a sampling of the responses:

• “Added some caution as to their future growth prospects.”
• “Not really. Economic conditions have been more influential for me.”
• “They were close to expected, so no change in my outlook.”
• “I am more cautious as a result of earnings.”
• “I find them generally encouraging. Not up as much as in past years, but still positive.”

Bullish: 32%, up 0.8 points
Neutral: 38.7%, up 1.3 points
Bearish: 29.2%, down 2.2 points


Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%

Equity allocations among individual investors declined to a three-year low last month, according to the February AAII Asset Allocation Survey. At the same time, individual investors boosted their cash allocations to a three-year high. Fixed-income allocations were slightly lower.

Stock and stock fund allocations fell by 1.0 percentage points to 61.5%. This is the smallest allocation to equities and the biggest monthly drop recorded by our survey since March 2013 (59.5%). Even with the decline, stock and stock fund allocations remained above their historical average of 60% for a 35th consecutive month.

Bond and bond fund allocations edged down 0.1 percentage points to 17.2%. During the past three months, fixed-income allocations have stayed between 17.1% and 17.3%. February was the seventh consecutive month with bond and bond fund allocations above their historical average of 16.0%.

Cash allocations rose 1.1 percentage points to 21.3%. The increase keeps cash allocations at their highest level since March 2013 (22.8%). The increase was not large enough to prevent cash allocations from being below their historical average of 24% for a 51st consecutive month, however.

The rise in cash allocations and decline in equity allocations corresponds with the rough start the stock market experienced this year. The proportion of individual investors describing their short-term outlook for stock prices as “bullish” remained below 30% for 12 consecutive weeks in our weekly Sentiment Survey before rising to 31.2% near the end of February. Pessimism, meanwhile, has been above its historical average of 30% for eight consecutive weeks. It is worth noting, however, that some individual investors have viewed the market’s correction as a chance to buy stocks at discounted prices or are looking for buying opportunities.

This month’s special question asked AAII members what type of account they prefer to use for their cash. More than four out of 10 respondents (43%) said money market accounts or money market funds. Checking and savings accounts (both at banks and at credit unions) were the next most popular type of account, more than 20% of respondents. Certificates of deposit (CDs) and brokerage accounts were each named by just under 13% of respondents. Some members listed more than one type of account. Common themes given as to why included ease of accessing funds, interest rates and—in the case of bank and credit union products and accounts—safety.

Here is a sampling of the responses:

• “Brokerage account. Cash is available for stocks when the market improves.”
• “CDs, because you can get 1.5% interest or better by looking around.”
• “In a brokerage account for quick deployment if market conditions warrant.”
• “Insured bank deposits because of safety, liquidity and convenience.”
• “Money market accounts. It’s all about how handy it is.”
• “Online savings account. You can get a 1% yield, quick access to your money and it’s FDIC insured.”

• Stocks and stock funds: 61.5%, down 1.0 percentage points        
• Bonds and bond funds: 17.2%, down 0.1 percentage points
• Cash: 21.3%, up 1.1 percentage points

• Stocks: 30.3%, down 0.2 percentage points
• Stock Funds: 31.24%, down 0.8 percentage points
• Bonds: 4.3%, up 0.1 percentage points
• Bond Funds: 12.9%, down 0.2 percentage points

Take the Asset Allocation Survey.

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