Part I also noted that day-to-day changes in a stock’s price occasionally stem directly from the appearance of genuinely new information about the business, its operations and financial results. Most fluctuations, however bear little or no direct relation to these things. Rather, prices are set at the margin – i.e., by the most eager buyer or most eager seller. They are set, in other words, by the most euphoric, despondent and hence emotional participants in the market. As such, not only is it hard to argue that market participants always price goods, services, commodities and assets rationally: it is evident that prices are occasionally nonsensical. It is therefore absurd to define the ‘performance’ of a financial asset or bundle of assets solely in terms of short-term price changes.

In The Warren Buffett Portfolio, Robert Hagstrom asks “if you owned a business and there was no daily quote to measure its performance how would you determine your progress? Likely you would measure the growth in earnings, or perhaps the improvement in operating margins, or a reduction in capital expenditures. You would simply let the economics of the business dictate whether you are increasing or decreasing the value of your business.” In order to exchange a financial asset, in other words, one requires a price. In order to evaluate its quality, on the other hand, one does not: rather, one requires valid and reliable information about the business to whose ownership the asset confers title.

This evaluation can produce a subjective estimate of the asset’s value; and a comparison of this estimate with a market price (if one exists) may indicate that it is appropriate to rearrange one’s financial affairs. If the asset’s objective price greatly exceeds one’s subjective estimate of its value, then a sale of the asset may make sense. In contrast, if estimated value greatly exceeds price, then the purchase of more of the asset (if more of the asset and means of exchange are to hand) may be in order. In order to enter into such transactions with any degree of confidence, however, we first require information about the business underlying the asset. Only after we have evaluated this information and formed a subjective estimate of value is a price of any use to us. And at no point should we regard a price as an exact arbiter of value. In Benjamin Graham’s words, a market is a voting machine and not a weighing machine: its prices are often indicators of greed, fear, fad and fashion – and therefore only infrequently of value.

‘Look Through’ Earnings and Return on Equity

The computation of “look through” earnings provides one – by no means the only but nonetheless eminently sensible – means of measuring the results of one’s investment decisions. Warren Buffett’s 1990 Letter to Shareholders set out its elements; Robert Hagstrom’s The Warren Buffet Way restated its logic for a general audience. So does Green Mountain Asset Management Corp. To compute “look through” earnings, take the net (i.e., after tax) income of the business for the year under consideration, multiply that number by one’s ownership interest and (if necessary) adjust for taxes.

Using Green Mountain’s example, if one owns 100 of a company’s shares and the company has 105,200,000 shares outstanding, one owns a very small but nonetheless quantifiable percentage of the company: 0.000000951% to be exact. Further, if the company reported a net after tax income of $225,860,000, then your share of this income is 0.000000951 times $225,860,000 or $214.70. If you purchase price was $40.00 per share (i.e., a total outlay or cost basis of $4,000.00) then your “look through“ return is $214.70/$4,000.00 or 5.37%.

Under certain circumstances, e.g., if one is considering a sale of the shares, it is important to estimate one’s return on an after-tax basis. Green Mountain’s example assumes a capital gains tax rate of 28%, not far from Australia’s maximum CGT or the 30% company tax rate which will shortly apply. Provision for capital gain reduces the $214.70 pre-tax earnings to $154.58 after tax, which implies an after-tax “look though” return on equity of 3.86%. Green Mountain’s example also assumes that the company pays a dividend of $0.45 per share and that the recipient’s marginal tax rate is 33%. Accordingly, on an after-tax basis the $30.00 can be added to the $154.58 of look through earnings, and the total after-tax return becomes $184.58/$4000.00 or 4.61%.

Implications

“Look Through” earnings and other measures of results used by value investors bring to the fore several sets of factors which facilitate the growth of capital. High Focus and Low ‘Churn.’

The first set of factors comprises intensive research into a business before a purchase (in order to establish its above-average bona fides); close monitoring of its results after its purchase (in order to confirm its continued quality) – and retention of the investment as long as the business generates above-average returns.

To the extent that one is able to purchase quality businesses at bargain prices, and unless their market prices rise to exorbitant levels, it makes little sense to sell one asset, buy another and thereby ‘churn’ one’s portfolio. Many Australian unit trusts have yearly turnover rates of 50% or more, and some of their American counterparts manage 100-200%. (If a portfolio manager sells all the stocks, bonds, etc. in a portfolio and uses the proceeds to buy other assets – or, as not infrequently occurs, repurchase the same assets – then the turnover rate is 100%).

When executed consistently and capably, a low turnover strategy will tend towards the ownership of relatively few (15-25) quality securities which comprise a large portion of one’s portfolio. A revealing analogy, in Mr Buffett’s words, occurs when the investor “follows a policy of purchasing an interest in, say 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the [Chicago] Bulls trade Michael Jordan because he has become so important to the team.”

Compounding and After-Tax Returns

“Look Through” earnings and other measures of results used by value investors also highlight the importance of taxes and the influence of after-tax returns on the compounding of one’s investment capital.

Taxes, particularly the capital gains tax (CGT) are among the biggest – and often the single biggest – expenses that investors face. They are usually higher than brokerage commissions and often higher than the other expenses incurred in order to place, hold and realise an investment. If the market price of an asset increases above its purchase price and the asset is sold, then a capital gain is realised and CGT is payable on the difference between the two prices. For Australians who place funds in a unit trust (mutual fund), for example, any realised capital gain generated by the fund’s managers triggers a CGT liability which is passed to and payable by unit holders. (Whether or not they sell their units, in other words, unit holders may be liable to an annual CGT. An investment company, on the other hand, pays any tax generated by the turnover of its assets. Its shareholders pay CGT only when they sell their shares at a profit). As a rule, the greater the churn of the trust’s portfolio the greater the unit holders’ CGT liability. Accordingly, on a pre-tax basis a high-churn trust may ‘outperform’ its rivals, the All Ords, etc.; but from the unit holders’ perspective and on an after-tax “look through” basis, the returns may be mediocre.

If the asset is not sold, on the other hand an unrealised gain is incurred and no CGT is payable until the asset is sold. Clearly, then, to reduce the churn of one’s portfolio is sensibly – and perfectly legally – to defer the payment of capital gains tax. To let sleeping unrealised capital gains lie is to enable your capital to compound at a higher annual percentage rate. Value investors keenly appreciate the enormous value of this unrealised gain – what Mr Buffett has called an “interest-free loan from the Treasury.”

Conclusion

At the core of value investing, in the words of Benjamin Graham (widely regarded as the founder of modern financial analysis), is the contention that “investment is most successful when it is most businesslike.” This focus upon businesses, their economic foundations, technical operations and financial results – and not ‘the market’ – permeates value investors’ thinking and behaviour. It also forms the basis of their measurement of the results of their investment decisions. The short-term price volatility of the company’s stock has nothing to do with the company’s operations and financial results. For this reason it should play no part in any short-term assessment of the company’s return to its owners.

Yet value investors are a reprobate minority, and for the vast majority of market participants prices and short-term price changes are a be-all-and-end-all. The greater the short-term increase of an asset’s or an index’s) price, the more favourable the evaluation of its ‘performance’; conversely, the smaller the rise or the greater the decrease the more negative the interpretation. And if Asset A or Index A increases relative to Asset B or Index B then A has ‘outperformed’ B.

From the point of view of a value investor, this pervasive “double-barrelled foolishness as Robert Hagstrom has called it, is not only counter-productive – at times it is also dangerous. It prompts many people to check stock quotes every day, to rejoice when prices rise and worry when they fall. It prompts institutions with responsibility for billions of others’ savings constantly to buy and sell, to churn assets at dizzying rates and therefore to generate appreciable transactions costs. It is one reason why speculation is presently far more pervasive than investment on financial markets. And it is one reason, as many learnt during 2000, Why Speculation Inevitably Ends in Tears.