Bargain hunters might want to pay attention to an often-overlooked number – retained earnings – among the beaten down rubble in the stock market.
It’s a somewhat dry term for the cash a company has left after covering all its costs, including dividends paid to shareholders.
Companies that report retained earnings show they are generating extra cash they can use to reinvest in their business, a positive sign about management performance, especially in turbulent economic times such as now when cash on hand and cash generation seem more important than ever.
Warren Buffett will hold a truncated virtual annual meeting on Saturday to share his wisdom on investing in these troubled times. He spent some time writing about the importance of retained earnings in his annual letter to shareholders earlier this year.
Investors can use retained earnings as a way to evaluate how well management performs. As Mr. Buffett sees it, a management that can get an above-average return on its retained earnings is a good investment for his company, Berkshire Hathaway Inc., and its shareholders.
How a company uses its cash depends on the nature of its business. Industrial companies have to spend on new plants and equipment to keep up operations, and that can eat away at retained earnings. Other companies don’t have heavy equipment costs and can use that money to buy other companies or otherwise generate growth.
Investors can judge how well management handles this task by comparing the total profit per share retained with the change in profit per share over a given time.
Mr. Buffett uses Berkshire’s own balance sheet to make his point. Berkshire doesn’t pay dividends and only recently began to return money to shareholders in the form of stock buybacks. That means it uses its retained earnings to buy controlling stakes in companies, acquire non-controlling stakes in public equities or make capital investments among other things internal to the company.
Berkshire’s retained earnings have helped Mr. Buffett amass more than US$120-billion in cash he can deploy. Berkshire looks to buy companies that have good returns on net tangible capital, good management and attractive market values relative to intrinsic value. Berkshire buys private companies outright and also has a good portion of its assets invested in public stocks, roughly US$185-billion invested in approximately 50 blue-chip companies, including names such as Apple Inc. and Bank of America Corp.
As Mr. Buffett points out, there are different ways to recognize the value of the assets Berkshire owns. Berkshire accounts directly for the earnings of the businesses it owns outright, but it only reports dividend income from the stocks it holds in its portfolio of public stocks. The retained earnings of each of those portfolio stocks isn’t immediately recognized.
That means Berkshire's shareholders are getting extra value that isn't realized.
Mr. Buffett showed Berkshire’s top 10 stock holdings and broke down their contributions in terms of dividends and the retained earnings estimated to be Berkshire’s portion. The portfolio of these 10 stocks generated US$3.7-billion in dividends, but more than double that from retained earnings, US$8.33-billion.
In Apple shares, for example, Berkshire recorded US$773-million in dividends and US$2.5-billion in retained earnings attributable to Berkshire. In Bank of America, the breakdown was US$682-million and US$2.1-billion. Berkshire held 5.7 per cent of Apple stock as of the end of 2019 and 10.7 per cent of Bank of America.
Whether Berkshire shareholders will ever fully realize the value of those retained earnings remains to be seen, of course. The companies use that money to reinvest, acquire or make payouts to shareholders just like Berkshire does and, at least in the short-to-possibly mid-term, earnings may be non-existent or far lower for most companies because of COVID-19 and the seizing up of the global economic engine.
“Sometimes, alas, retentions produce nothing,” Mr. Buffett said in his letter. “But both logic and our past experience indicate that from the group we will realize capital gains at least equal to – and probably better than – the earnings of ours that they retained.”
Even in the most uncertain times such as now, buying good businesses, using logic and understanding history are the things investors can rely on in order to be successful over time. The accompanying table contains five U.S. stocks and five Canadian stocks, sourced from my quantitative models on Validea and Validea Canada, that score highly according to my Buffett-based model. All of these names have attractive valuations and at least 12 per cent long-term returns on retained earnings – an important characteristic based on Mr. Buffett’s message to long-term investors.
John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.