Historical earnings are a mirage

It is no secret that inflation is the enemy of equities. Between 1966 and 1982, according to Ben Carlson, the S&P 500 nominally returned 6.6 per cent. Yet, thanks to the runaway inflation of the 1970s, peaking at 14.8 per cent in 1980, its real returns were actually flat.

But there's another side to inflation that is often less discussed: how it distorts the value of assets, and in turn, our view of market history.

A lengthy new white paper, titled “The Earnings Mirage”, by West coast quantitative investment firm O’Shaughnessy Asset Management, seeks to address this, and in the process, makes a few discoveries which some might have felt to intuitively be true, but have never been able to prove.

The paper revolves around the popular concept of book value (or equity), defined as assets minus liabilities. Thanks to the “cigar butt” investing style of Benjamin Graham & David Dodd, book value, usually framed relative to a share price (hence price-to-book), has since become a staple tool for both aspiring and practising value investors.

However, the metric is not without its flaws. A popular criticism of it often revolves around how it fails to capture the upside of intangible assets, such as brand power, which are in effect invisible on a company's balance sheet.

Yet this isn't its only flaw according to Jesse Livermore, the pseudonymous author of the paper. It turns out book value is also understated thanks to the “cost basis” accounting method used for assets under generally accepted accounting principles. He argues this explains why return on the book value of equity looks much higher than the market returns from owning the shares.

Think about it this way. A company pays $10,000,000 for a factory in 1965. They expect the factory to last 20 years, with it being worth $500,000 by the period's end. Using the straight-line method, they therefore depreciate it by $475,000 per year through the profit and loss statement.

Yet while the factory remains moored in the price level of the years it was built, the returns from it don't. Sales, costs and profits trend up with inflation, even if there's no real growth, which leads to an increasing divergence between the nominal returns from an investment, and its original cost.

Therefore after a period, particularly one with high inflation like the 1970s, the popular return on equity metric (earnings divided by book value), becomes naturally distorted upwards due to an understated equity figure, all else holding equal.

Confused? Let's start with how things normally work. Aside from issuing new shares, book value only increases through accumulated retained earnings, which can be kept as cash or reinvested.

As an example, here is a comparison of Caterpillar's nominal reported book value and the sum of its unadjusted nominal retained earnings per share since 1964:

The problem with the normal approach is these earnings are reinvested at a historic, rather than real, price levels. But, as above, the returns they generate trend with inflation. This means return on equity looks higher than it really is.

To counter this, Livermore has taken it upon himself to adjust the original book value, and each year of retained earnings, for inflation (this is discussed in detail on page 14 of the paper, if you're curious).

Here's industrial heavyweight Caterpillar's retained earnings from 1964 to 1983. The left column shows how much is being retained for each share at historic prices. The right column is readjusted for rising prices, giving a more accurate picture of their true value:

By tallying these adjusted-investments up, Livermore arrives at a new book value metric which he calls “integrated equity”.

It turns out this method for measuring equity it brings the return on equity (or return-on-integrated-equity) metric in line with a company's historical returns in the stock market and cost of equity. This suggests that it is a better measure of a business' ability to generate returns than the traditional ROE metric.

For example, here are the results for a host of companies, including Johnson and Johnson, and Boeing. Notice how in-line the new ROIE (return-on-integrated-equity) figure is with stock market returns, compared to the traditional ROE figure:

There's plenty else to dig into in this paper (too much to cover in one post), so here are a few thoughts on this particular aspect of Livermore's discoveries.

The first is that the paper helps to explain why emerging market businesses typically have exceptionally high return-on-equity figures versus developed markets. Basically, it's all about inflation. To take one example, Ceylon Tobacco, the Sri Lankan cigarette manufacturer, has an average return on equity (book value) of 259.2 per cent over the past decade, according to S&P Capital IQ. Yet its shares have only returned 36.36 per cent per annum over the same period, per Bloomberg data.

This may be because it's simply a world-class business, but Livermore's explanation of depressed asset prices thanks to inflation may also hold true. A quick look at the Sri Lankan inflation data from the World Bank, show that inflation regularly held above 10 per cent between 1998 and 2008, before falling over the past decade. It is fair to suggest that the likelihood Ceylon's legacy old investments are significantly understated is high, boosting the return-on-equity figure.

Livermore's work also offers an explanation as to why the leveraged buyout boom of the 1980s generated such fantastic returns. Of course, it's long been suggested that undervalued assets after the 1970s inflation crisis was a significant factor, but this new approach shows us how private equity could pick up a dollar of hard assets for the price of a dollar decades earlier. Combined with the tailwind of collapsing interest rates after Volcker strangled inflation in '82, which allowed debt to be constantly refinanced at less usurious rates, private equity arguably had twin macro-forces powering it in the 80s, a combination which in this rates environment seems unlikely to recur.

For those private equity kingpins looking for the next market to target then, both Turkey and Argentina, with their high levels of inflation over the past half decade, may prove happy hunting grounds in the future. Assuming, of course, inflationary forces recede.

Alphaville is generally of the belief that accounting rules shape the market's perception of a business. But, as it turns out, it can also shape our perception of markets themselves.