Why Great Investors Like Charlie Munger and Warren Buffett Look Beyond Earnings

Joel Litman

Education is the first tool for wealth creation...

"I guess not everybody studied accounting," said Warren Buffett in the first 10 minutes of Berkshire Hathaway's (BRK-B) 2019 Annual Shareholders Meeting. The 'Oracle of Omaha' has made similar remarks in three of the last four annual meetings.

Becoming more enlightened into the quality or lack thereof of financial statements is important to the greatest investors in the world, including Buffett.

Finding the light in the darkness of financial statements isn't a new concept. The Greek philosopher Plato had three famous allegories on the importance of enlightening education, involving the cave, the sun, and the divided line.

All three illuminate how a person's view of the world can and needs to evolve and change over time. The allegory of the cave might be one of the most well-known in philosophy.

In the allegory, prisoners in a cave grow up seeing nothing more than shadows on the cave wall, cast by torches. They see nothing but two dimensions of the world.

For our purposes, these "shadows" are as-reported earnings and earnings per share ("EPS").

Later, they learn that a lit torch behind moving statues creates those shadows. They have a greater realization of what is really behind those shadows, and they understand more about what makes those shadows appear.

The fire of knowledge is blinding at first, though it reveals more about the nature of the world as they've understood it. They see there is a third dimension.

In our perspective, we could say those 3D statues are the notes to the financial statements that provide a crude backdrop of what's casting those shadows of earnings numbers.

Finally, the prisoners are walked out of the cave. At first, they are blinded by the sun, and they can't comprehend so much information at once.

As their eyes adjust, they realize the real nature of the world, that the shadows and statues were both incredibly simple copies or representations of reality. At that point, they understand what a bird is really all about – that it has feathers, colors, and lifelike movement.

For our analogy, that's the level of corporate performance and valuation based on Uniform Accounting. While blinding at first, it provides a whole new array of perspectives of earnings and assets and debts and equity and the real movement of all those items.

Plato constructed this allegory of the cave to explain how people can only grasp shadows without truly enlightening education, never truly understanding what the world is really like.

The vast majority of individual investors are stuck in the cave. They rely on mere shadows of as-reported earnings and EPS based on GAAP. And entire industries like Wall Street have been built on the shadows, as they spend days and weeks and months discussing and debating the shadows of surprises and estimates and machinations of as-reported earnings.

Lacking the education of Uniform Accounting and Uniform Financial Analytics, they know nothing other than what they see in the cave. So, the lengths, heights, and changes in the flickering of those shadows become important to them.

The allegory of the cave is perfect for explaining what we do at Altimetry...

It's much more comfortable to stay in the cave, in the giant industrial complex that has been built around those as-reported earnings numbers.

But these shadows distort the actual shape and size of the real true earnings of a company, the Uniform earnings.

When the greatest investors, including Buffett, tell us not to focus on GAAP as-reported numbers and ignore the as-reported bottom line, they are saying, "Come out of the cave!"

Meanwhile, the financial media pundits and Wall Street say "how interesting" for a moment... and then proceed to run back into their cave, ignoring the bright light that has been momentarily revealed to them.

Whether they hear it from Buffett or Charlie Munger, Seth Klarman or Shelby Davis, or a whole line of great investors, it's just too uncomfortable to see the light.

The world's great investors spend their valuable time and effort on economic reality, reaping the benefits of outsized investment performance...

As-reported earnings, or net income, take up a huge portion of the financial media's attention, even if they have little if any impact on long-run stock prices. In the short term, earnings surprises in either direction can create volatility. These short-term changes convince many novice investors that their shadows are full of meaning.

Over time, the stock's value settles on levels that Uniform Accounting-based performance shows.

Munger, one of the great investors of the last four decades, says as-reported earnings are "only a crude approximation."

Wall Street and the financial media so often report earnings misses and beats. But these are just measures of how much a shadow has changed from quarter to quarter or year to year.

So often, it is only the shadow that is changing so wildly, while the actual corporate earnings may be on a different scale or moving in the opposite direction.

That's what we see all the time in the Altimeter. As-reported earnings may be falling or even show as negative, like at Amazon (AMZN) for many years, while the Altimeter showed that actual earnings were skyrocketing.

This is crucial as the stock market, over time, followed the track of the real earnings number in the Altimeter, not the shadow of as-reported numbers.

And if the as-reported earnings number is wrong, this means the price-to-earnings (P/E) multiple is also wrong. So often, we see a P/E ratio that's significantly different.

If the real earnings number is more than double its shadow of as-reported earnings, as it was for Amazon in 2019, then the P/E ratio is half of what's reported.

When Buffett says, "not everybody studied accounting," that applies to the naysayers who said Berkshire Hathaway was crazy for buying Amazon stock. And these naysayers were wrong when Amazon appreciated by 120% over the past three years.

The Altimeter shows an undistorted, true-to-life view of a company's earnings.

When you first see the results of Uniform Accounting, in our reports or the Altimeter database, it's almost blinding, just like the light outside Plato's cave.

Great investors go beyond the as-reported numbers...

It requires some knowledge to understand why the as-reported numbers do not give retail investors an accurate picture of how valuable a company is...

The Altimeter uses our proprietary system, Uniform Accounting, and it sifts through all the financial data to get to the real story lurking underneath. Subtle distinctions can dramatically change how a stock's earnings look to investors... A company may not be as profitable as its as-reported numbers suggest.

Here at Altimetry, we clean up all the data and make it all uniform – so you can run your favorite stocks through the Altimeter and see which ones are overvalued... and which ones hold promising returns.

We guarantee you'll find some big surprises when searching through the Altimeter tool. And for a limited-time offer, you can try the Altimeter for free for seven days.

Learn more about this risk-free trial by clicking here.

All the best, as always,

Joel Litman
January 7, 2022