The fundamental problem that investors face is that, even if investing is a fair game, which is to say, one has equal chances of winning or losing, in the long run, wealth is destroyed. This leaves investors with two choices: not to invest, or to change the game and tilt the odds in one’s favour, for instance, by investing in an index fund. As an active investor, there are two routes that I see for escaping the gravitational pull of wealth destruction: portfolio construction and making adjustments to the financial statements.
The paper, “Core Earnings: New Data and Evidence”, by Ethan Rouen, Eric C. So, and Charles C.Y. Wang, which was written using a dataset from what I consider the world’s best investment research firm, New Constructs, describes a clear, and replicable methodology for making accounting adjustments to determine a firm’s core earnings. Some quotes from the paper will highlight their findings:
[New Constructs’] Total Adjustments differs significantly from the items identified and excluded from Compustat’s adjusted earnings measures. For example, our Online Appendix (Table OA.1) shows that about 50% to 70% of the variation in Total Adjustments is not explained by IBSPI Adjustments, OIADP Adjustments, or OPE Adjustments individually. Moreover, larger values of non-core earnings (either by economic or location categories) identified in the NC data correspond to larger absolute differences between NC and Compustat adjustments, consistent with systematic differences in data collection protocol or quality.
“Core Earnings: New Data and Evidence”, page 14, paragraph 1, by Ethan Rouen, Eric C. So, and Charles C.Y. Wang
A final source of differences is due to data collection oversights. Our examination suggests that, in general, Compustat does a thorough job identifying and collecting income-statement- related data points disclosed in the 10-K. Nevertheless, we identified cases where Compustat did not collect information relating to firms’ income that is useful in assessing core earnings.
“Core Earnings: New Data and Evidence”, page 16, paragraph 2, by Ethan Rouen, Eric C. So, and Charles C.Y. Wang
The success of the methodology in hoovering up the accounting adjustments needed to calculate core earnings, led to my embrace of the methodology, a methodology that forces the investor to read through the footnotes and notes of periodic reports in order to find these adjustments. How does this aid the analyst or investor? The authors found that trading strategies that used this data enjoyed,
…monthly excess returns [that] are both statistically and economically significant, equating to an annualised difference of 8.2%.
“Core Earnings: New Data and Evidence”, page 32, paragraph 3, by Ethan Rouen, Eric C. So, and Charles C.Y. Wang
Abnormal excess returns of over 8% is the reward for the hard work of uncovering the true economics of a business. Below are the adjustments that I make, following this methodology, to determine net operating profit after tax (NOPAT), invested capital, and the economic book value (EBV) of a firm.
Income Statement Adjustments
- Asset Write-Downs
- Non-Operating Expenses Hidden in Operating Earnings
- Non-Operating Income Hidden in Operating Earnings
- Pension Plan Costs
- Change in Reserves
- Income and Loss from Discontinued Operations
- Implied Interest from Operating, Variable and Not-Yet Commenced Leases
- Employee Stock Option Costs and Goodwill Amortisation
- Reported Net Non-Operating Charges and Gains
- Foreign Currency Exchange Losses and Gains
- Non-Operating Taxes
Balance Sheet Adjustments
- Off-Balance Sheet Reserves
- Discontinued Operations
- Accumulated Other Comprehensive Income (OCI)
- Asset Write-Downs
- Deferred Tax Assets and Liabilities
- Overfunded Pension Plan Assets
- Excess Cash
- Accumulated Goodwill Amortisation and Unrecorded Goodwill
- Time-Weighted Acquisitions
- Non-Operating Unconsolidated Subsidiaries
- Deferred Compensation Assets
- Operating, Variable and Not-Yet Commenced Leases